Change Orders and their Effect on Surety Bonding
Change Orders are a necessary and vital part of construction and contract bonding. Learn more about what they are, best practices and how to avoid costly mistakes.
A Change Order is simply an amendment to a construction contract, agreed to by all parties, that changes the Contractor’s scope of work and may or may not change the contract price and completion time of a project.
Change orders happen frequently in construction and a single project could have many change orders before it is complete. However, change orders need to be managed well or they could result in a significant loss to the contractor.
Design Change is one of the most common reasons for a change order. An owner may decide that they want more or less work done. A contractor may suggest an upgrade to the owner. There are many reasons for a design change throughout a project.
One of the biggest reasons for extra costs, delays and change order is bad drawings. Having to redesign while under construction is not ideal.
For example, suppose that after construction has started, a contractor notices that a structural beam runs through the middle of the room. The project will likely have to be redesigned and a change order issued.
Another common cause of change orders is unforeseen conditions. This includes items that the contractor and owner could not know about before construction began.
For example, during a renovation project, it is discovered that the utility lines are broken and need to be replaced. The contractor could not have known this during the bid, so this is an unforeseen condition.
Some delays are beyond the control of the owner or Contractor that give reason for a change order.
For example a labor dispute may prevent all workers from showing up to the site. This could cause delays that can affect the project timeline that are out of the Contractor’s control. A change order may need to be issued extending the allowed completion time.
Another common cause of change orders is substitution.
For example, an architect may specify a certain product, but that product may be unavailable or time consuming to obtain. A comparable product may be available but a change order will need to be issued. This is very common in the current environment with material shortages.
Change Orders do not always increase a contractor’s scope of work, completion time or price. A Deductive Change Order is when a Contractor’s scope of work is decreased by the Owner. Deductive Change Orders can be very problematic for contractors.
For example, assume a contractor has a contract to build an addition to a building and renovate the older section of the building. During the project, the owner decides not to do the renovation and issues a deductive change order. The contractor may have bid the project with little or no profit in the new construction in order to obtain the more profitable renovation. In this case, the deductive change order would certainly affect the contractor’s profitability.
Almost every standard construction contract allows for change orders. Many times these clauses are listed on the General Conditions section of the contract.
The most detailed information that a change order contains, the better. At a minimum, a change order should include the following:
Each of those elements are vital to an effective change order, but the most important aspect is to get the change order in writing. Almost any written signed change order is better than a verbal agreement.
Whether a change order adds or subtracts work from the contractor’s scope, it’s important for the contractor to price the change order accordingly. Contractors should take into account the following:
Direct Costs include things such as labor, material, equipment, supervision, bond costs, insurance costs, mobilization and demobilization.
Indirect Costs include things such as overhead, and profit. It could also include things such as damages if the schedule is accelerated. Owners and Contractors should come to an agreement on a fair value to compensate the contractor for these items. Not taking indirect costs into account is a common mistake.
Opportunity Costs include things such as other projects and backlog the contractor could be pursuing.
Many construction contracts give the Owner the ability to issue a Change Directive. A Change Directive allows the Owner to move forward with a change in the scope of the contract without the agreement of the contractor. It is used when an Owner wants changes but the Owner and Contractor cannot agree on a change order. It is called an Interim Directive by ConsensusDocs.
The intent for a change directive is to allow immediate action while the parties negotiate payment. Typically a change directive is signed by only the owner and the architect. It is easy to see how such a contract change could result in a dispute. Contractors receiving a change directive should contact a construction attorney to review their potential options.
One of the biggest financial mistakes contractors make is accepting verbal change orders. There is pressure to keep the project moving, and keep the Owner happy.
Unfortunately, this often results in contractors performing work without a signed change order. In many cases, this makes getting paid for their workload difficult or even impossible.
Architects, Superintendents and project managers can change companies with little notice and their replacements will almost never agree to a change order from a previous employee.
Even when the staff remains, all parties often have different memories of what was agreed upon. In fact, change orders are one of the leading causes of disputes and litigation in construction. Some sources say the percentage of construction disputes caused by change orders is as high as 90%.
There are many great companies and systems available for tracking change orders. At the very minimum, use a written contract. Contractors may use our simple Construction Change Order Template for free.
Some contracts specifically call for change orders to be submitted and approved in a certain manner. Failure to follow these procedures leaves the contractor with little to no defense if the owner decides not to pay.
One very common condition is that the change order must be in writing and signed by certain parties. See above.
Surety Bond companies are very interested in a Contractor’s change order management. Change Orders can have devastating financial consequences and cause expensive disputes. Therefore, surety bond underwriters like to review and discuss how a contractor handles change orders. These internal controls are part of the Capacity underwriting Contract Bond underwriters perform under the 3Cs.
Performance Bonds guarantee that a contractor will complete a contract on time, according to the contract and at the contract price. Therefore, any change order affects the surety bond company’s liability under the performance bond. Bond underwriters like to be made aware of major changes in the scope of a project.
Some Performance Bond Forms and Contracts allow for automatic increases in the Penal Sum of the Performance Bond if the contract is amended. Other Performance Bond Forms require approval from the surety bond company if the changes exceed certain amounts. It is important for both the Owner and Contractor to check the contract and bond forms and make sure they are following the correct procedures.
Payment Bonds guarantee that certain subcontractors and material suppliers will be paid on a project. Therefore, change orders also affect payment bonds and the surety bond company’s payment liability. A change order that adds significant subcontractor costs or material to a project will also increase the surety’s liability. Like Performance Bonds, it is important to check the payment bond forms and contract to see whether the surety bond company’s permission is needed before a significant change in project size.
If a change order is significantly large, or significantly alters the course of the work, surety bond companies may prefer that a new contract is issued. This method is preferred if the new scope of work can be reasonably separated from the existing contract. However, there are many times this is not possible due to funding, scope of work etc.
Another reason that surety bond companies closely monitor change orders is because they can turn into underbillings and losses. For example, a contractor and owner verbally agree to add $1,000,000 to the scope of a project. Excited to get started, the contractor performs the work. However, until an approved change order is signed, the contractor cannot bill for the extra work under the contract. This work will show up on the contractor’s balance sheet as a current asset because work has been performed that the contractor should be able to bill for and collect later.
Unfortunately, when a signed change order is not collected upfront, the owner may dispute the work or the amount of the change order. Now the underbilling is unbillable, uncollectible and a financial loss for the contractor.
Similarly, contractors often hide losses in underbillings. If a job is over budget or poorly estimated, the difference often shows up as an underbilling while the contractor tries to get the owner to pay for a change order.
For these reasons, surety bond underwriters examine underbillings very closely. When large underbillings show up on a contractor’s balance sheet, the underwriter will look for a signed change order and project billings very quickly.
Change Orders are important to surety bond underwriters and should be even more important to contractors. Getting signed change orders before performing new work is key to being a successful construction company. Contrary to popular belief, it’s actually better for all parties as it can save timely and costly litigation and disputes later. For all surety bond questions, including how they might be affected by change orders, contact Axcess Surety anytime.