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Jack Harris
Jack Harris
 

Contractors in Pricing Construction Claims

How CPAs can provide winning strategies.

January 25, 2010
by Jack Harris, CPA, CFF and Sonia Desai, CA, CBV

CPAs are in a unique position to analyze and prepare construction claims. In situations where most parties involved are typically engineers or architects, our training and experience as a CPA enables us to process detailed and often voluminous cost and project records from a financial perspective. CPAs can leverage their skills in helping contractors present their claim in a simple, concise and convincing manner.

In the construction industry, contractors submit bids that include the estimated costs of construction projects and markups for overhead and profit. In preparing a competitive bid, the contractor must estimate the costs of construction with a reasonable degree of accuracy, with the goal of being awarded the project and making a profit. In doing so, the contractor makes various assumptions including: the scope of work has been appropriately defined; the project specifications, designs and drawings have been accurately prepared; the owner has fulfilled all conditions necessary for the contractor to begin work; and that the site conditions are as represented by the owner or as inspected by the contractor. If any part of these assumptions proves to be invalid, this will inevitably cause delays and disruptions to the project and result in cost overruns. In other words, actual costs of construction will exceed the estimated costs or contract price. To recover some or all of these costs, the contractor will file a claim against the owner. This claim must be based on sound financial theory and the claimed costs must be linked to the causation, and supported by the underlying cost and project records, in order to prevail in court. Two strategies a contractor can use to price its claim include: the total-cost method or the direct-cost method.

Total-Cost Method

This method essentially claims 100 percent of the out-of-pocket costs incurred in excess of the estimated costs. While this method is often preferred by claimants for its ease of use, it is usually frowned upon by the courts. The failure of a total cost claim methodology is that it assumes the contractor is virtually fault-free. It alleges that the entire fault of the cost overrun rests on the owner. While contractors often believe this to be true, in reality the contractor is almost never free of fault for cost overruns on a construction project. Use of the total cost method comes with a rigorous set of standards, which must often be addressed in order to justify use of this methodology, including:

  • Other methods of pricing the claim are impossible or impractical due to the nature of the costs, or occurrence which gave rise to the increased costs, not due to the limitations of the contractor’s accounting system;
  • The original estimate was accurate and can be supported using expert testimony, comparison to other work, and comparison to an independent third-party cost estimate; or there is an estimate of what the contractor should have bid or what the work would have cost using updated information; The actual costs are reasonable, which is presumed; and
  • Overruns cannot have been the result of any performance problems caused by the contractor or its subcontractors.

The total cost approach does not identify the specific extra costs incurred as a result of the specific failings on the part of either owner or contractor. Instead, this method assigns full liability for all costs in excess of the contractor's bid estimate to the owner. Contrary to basic causal-connection damage principles, the total cost method makes no attempt to relate any specific amount of increased costs to any particular alleged breach of contract.

What is often most contentious in the use of the total cost method is the burden of proof that full responsibility for the increased costs of construction lies with the owner, and that the contractor was not at fault. The implication that the contractor was 100 percent efficient and made no mistakes in the execution of the contract is a difficult one to prove.

The Direct-Cost Method

While this method is more time-consuming to prepare, it is the preferred methodology for the representation of damages. The direct-cost method identifies specific events or conditions that gave rise to the cost overruns for which the contractor was not responsible. The segregation of direct costs attributable to those specific events or impacts establishes the causal relationship between damages and the act constituting the breach of contract. Under this approach, the contractor assumes fault for part of the cost overruns and only charges the owner for the overruns it caused. The “event” or “impact” that results in damages can be classified into various categories, including:

  • Delay;
  • Disruption;
  • Acceleration;
  • Differing site conditions;
  • Changes in scope;
  • Termination; and
  • Liquidated damages.

Case Study

RGL was engaged to assess the reasonableness of a damages claim that an expert prepared for a contractor. The project in question was a demolition project, which required the contractor to remove existing substructures, amongst other items of work. It was alleged by the Contractor that the substructures demolished and removed turned out to be substantially different than what had been represented to the contractor at the time of entering into the contract. As a result of this alleged differing site condition, the contractor claimed that it was compelled to procure larger and more expensive equipment which was used over a longer period of time than originally anticipated. The contractor claimed damages equivalent to the total cost of equipment and labor used over the actual performance period in excess of what was included in its original budget. Essentially, the contractor asserted that all cost overruns for this item of work were the result of the alleged differing site condition, assumed no fault of its own, and failed to recognize that some of the equipment and labor costs claimed were also incurred on other un-impacted scopes of work. RGL took exception to the use of the total cost method in quantifying the contractor’s damages, because the method resulted in claimed cost overruns for other scopes of work for which the contractor had no claim.

RGL demonstrated that a more reliable and accurate way to quantify the damages in this case was to use the direct cost method. By reviewing the contractor’s cost and project records, RGL was able to identify the equipment and labor costs that were attributable to the alleged differing site condition. By segregating the costs, RGL was able to isolate cost overruns that resulted from the alleged differing site condition. The link between cause (differing site condition) and effect (increased cost of equipment and labor) were more appropriately established using the direct cost method.

Additional Resources: Practice Aid 06-4: Calculating Lost Profits.

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Jack Harris, CPA/CFF, CFE, CIA, CVA, MBA, is a director in the Denver office of the international forensic accounting firm, RGL Forensics. He has more than 30 years of experience in accounting, auditing and litigation support services. Sonia Desai, CA, CBV, is a supervisor accountant in the Denver office of RGL Forensics. For further analysis on this topic, readers may refer to Proving and Pricing Construction Claims by Robert F. Cushman, Craig M. Jacobsen and P.J. Trimble.