Calculating Construction Damage Claims
By David N. Kaplan and Karl A. Jarek
Alpern Rosenthal
INTRODUCTION
Construction claims present unique and challenging aspects for financial
experts who analyze and quantify the dollar impact of the harm claimed.
This is largely due to the significant interaction of several parties
under contract to complete a project on time, on budget and within specification.
The parties to a construction project can include the owner, owner’s
representative, architect, engineer, construction manager, general contractor,
subcontractors and prime contractors. Delays, changes and other issues
can give rise to a complex chain of events among all parties that can
challenge financial experts in quantifying damages related to the cause
or causes of action that give rise to the claim.
Accordingly, construction litigation can involve damages under a variety
of claim theories or concepts. This article focuses on the damages that
are commonly claimed by a contractor against owners, design professionals
and constructions managers. These claim issues include:
• Extra work,
• Delays,
• Acceleration,
• Disruption,
• Unabsorbed home office overhead,
• Cost of capital, and
• Lost bonding capacity.
Complex construction project issues will frequently give rise to many,
if not all, of these claim components in the litigation of a single
construction project. For example, a design error may cause extra work
that may disrupt the expected work and also cause a delay. If the owner
does not grant a time extension for this delay, then the contractor
may incur acceleration costs to meet the project deadline.
The complexity of these claim issues often creates problems for contractors
in preparing construction damage claims. Typically the damages related
to various events over the course of a construction project cannot be
quantified with exact precision. As such, the test that Courts generally
apply is whether the damages are quantified with a reasonable degree
of certainty. This lies somewhere within the two extremes of exact precision
and mere speculation. There is no general rule of thumb regarding “reasonable
certainty” that can apply in all cases. Plaintiffs must be cognizant
of this issue in developing claims.
Claims for extra labor and material are usually clear-cut in terms
of calculation and presentation. However, issues related to disruption,
productivity, overhead and other damages can be much more complicated
to prove and calculate. The dollar magnitude of these additional damages
is often substantial and well worth consideration in preparing a construction
claim.
PROJECT RECORDS
The quality of the records maintained by the parties to a construction
project is paramount to a successful claim calculation and presentation.
The integrity of the claim is premised on the evidence that supports
it, otherwise the claim may be subject to greater challenge by opposing
parties. Contractors often give up potential claim dollars simply because
they did not prepare or maintain documentation sufficient to support
a claim.
In addition to the quantification of damages, project records are also
important to proving liability issues. Contemporaneous memoranda and
related documents can help support issues related to the causation of
delay and other claims. In construction claims, damages and causation
issues are closely related. Financial experts often work closely with
the contractor’s in-house personnel, project superintendent and
outside engineering consultants to assess causation issues and the related
link to damages.
Common information that contractors should prepare and maintain includes
the following:
• Job cost reports,
• Daily logs and progress reports,
• Daily payroll records,
• Change orders and related support,
• Meeting minutes,
• Job correspondence,
• Documentation of design changes, and
• Photographs.
The process of keeping project records should begin with the bid. This
may sound premature, but bid documents are often used in litigation
to help substantiate the costs that a contractor expected to incur on
the project. This is particularly true in cases involving a change of
scope or unforeseen site conditions.
We also recommend that contractors gather and maintain information
to track the time, materials and other costs incurred on each phase
of a construction project. This will enable the contractor to assess
what work was performed, how much time it took and how much it cost.
This information can be used to illustrate what went well on the job
before a damage event, such as delay or disruption, occurred. For example,
on a bridge rehabilitation project, a contractor could maintain records
to support labor productivity and costs for each span of the bridge.
If a damage event occurs in the fifth span of a nine span rehabilitation
project, the contractor can use productivity data from the first four
spans to prove inefficiencies and other harm sustained on fifth and
subsequent phases of the project. This information will provide a “measured
mile” or productivity measure upon which to prove damages later,
if necessary. This information also has the benefit of enabling the
contractor to assess the accuracy of his bidding, which can be helpful
with future projects.
CONSTRUCTION CLAIM METHODOLOGIES
No single claim methodology is applicable to all construction claim
calculations. Issues such as the type of damages sustained by the plaintiff,
the information available and the coordination with liability aspects
of the case can impact the claim methodology used. As such, financial
experts typically work closely with the contractors and the contractor’s
legal counsel, as well as the contractor’s scheduling expert and
other consultants.
In this section, we discuss common claim methodologies and various
factors that should be considered with each approach.
Total Cost Approach
The Total Cost Approach and the Modified Total Cost Approach are commonly
used to assess damages in construction claims. The Total Cost Approach
is the more basic of these two methods.
In the Total Cost Approach, the actual contract costs less the bid
amount represents the basis for the claim. If an $800,000 contract (bid
amount) costs the contractor $1.3 million, then the difference of $500,000
is used as the starting point for the claim. This $500,000 claim is
typically increased to reflect amounts for appropriate overhead and
profit.
Clearly, the Total Cost Approach is simplistic. This simplicity raises
many issues related to the appropriateness of this approach in many
complex construction claims. For example: Was the contractor’s
bid reasonable? Are the actual contract costs reasonable and appropriate?
Was the contractor responsible for any unplanned costs that were incurred?
In virtually all construction claims, these are loaded questions. The
defendants will likely argue that the Total Cost Approach is not appropriate
based on one, if not all, of these three issues. For this reason, the
Total Cost Approach is often the method of last resort.
Modified Total Cost Approach
The Modified Total Cost Approach addresses the potential problems associated
with the Total Cost Approach by adjusting or “modifying”
for certain factors. For example, costs related to change orders and
other claim items are adjusted out of the claim calculation. Likewise,
costs incurred by the contractor that are not recoverable from the owner
or other defendants are eliminated from the claim. Also, any necessary
modifications to the costs estimated in the bid are taken into consideration.
Even with these adjustments, the use of the Modified Total Cost Approach
may be subject to challenge by owners and other defendants. In many
cases, this is directly related to the subjective nature of the contractor’s
adjustments. The defendant will most likely try to demonstrate that
the application of the Modified Total Cost Approach goes beyond mere
subjective adjustment and that the contractor’s use of this method
results in speculation. Accordingly, Courts typically require that the
contractor show that the nature of its losses makes it highly impractical
to accurately quantify damages based on a specific identification of
the losses sustained.
Specific Identification or Actual Cost Method
Under ideal circumstances, any type of claim might be quantifiable through
the specific identification of the increased costs and other damages
sustained. One of the key factors involved in applying the Actual Cost
Method is the adequacy of documentation to support a claim with this
approach. As discussed earlier in this article, the complexity of the
project and of the issues giving rise to the construction claim can
render the Actual Cost Method impractical. For example, the Actual Cost
Method may not be feasible in quantifying damages for a time-impact
claim, such as delay or acceleration.
CLAIM QUANTIFICATION ISSUES
Extra Work
A claim for extra work is probably the most basic of construction claims.
It is simply a claim for increased compensation for work that is allegedly
not covered by the contract. The extra work may relate to a change in
scope that is directed by the owner. A claim for extra work may also
relate to issues involving errors and omissions in the design of the
project or unforeseen site conditions.
The Actual Cost Method is well suited to quantifying a claim for extra
work. A contractor can establish a separate job code or cost center
in which to track time and materials related to the extra work at issue.
This is often referred to as tracking work on a “force account”
basis, particularly on work for the Commonwealth of Pennsylvania, including
PennDOT.
Site Overhead
A claim for site overhead is often warranted in a construction delay
claim. Since this is overhead that is directly related to a specific
project, the Actual Cost Method may be appropriate since many of these
site costs can be readily tracked and quantified over the course of
the alleged delay. Site overhead claims typically include costs for
site supervision and administration, site security, trailer rental,
and similar expenses.
Home Office Overhead
Claims for home office overhead are common in delay claims. Such claims
are often hotly contested in litigation for two main reasons: 1) the
amount claimed can be significant and 2) the methodology used to quantify
the claim is a subjective allocation.
As the name implies, this claim component seeks the recovery of home
office costs. Since the contractor’s home office oversees the
entire business of the company, many home office expenses cannot be
directly attributable to one specific project. For example, home office
overhead includes items such as executive management, accounting, information
systems, general insurance and marketing.
The recoverability of home office overhead in a construction claim
is a legal issue that is beyond the scope of this article. Parties to
construction litigation should consult with legal counsel to assess
such issues. Recoverability can vary with the case law in different
venues. It can also vary in contracts with federal versus state governments.
The remainder of this section assumes that home office overhead is recoverable
for purposes of our discussion.
The formula most commonly used to calculate a claim for home office
overhead is the “Eichleay Formula.” The Eichleay Formula
dates back more than 40 years. Although it has been in and out of favor
with Courts at various times, the Eichleay Formula has clearly stood
the test of time. Simply stated, the Eichley Formula allocates home
office expenses to a specific construction project based on the relative
volume of contract billings.
Use of the Eichleay Formula is supported by the premise that the contractor’s
overhead was “unabsorbed” during the delay period. It assumes
that the contractor was not able to obtain other work with which to
absorb its home office costs during the delay period. The Eichleay Formula
is often criticized because the mere allocation of costs may yield a
weak relationship to the contractor’s actual damages. Other methodologies
for quantifying home office overhead include direct cost formulas and
allocations based on other factors such as labor hours.
Regardless of the formula or methodology applied, the starting point
for any calculation of a claim for home office overhead is the total
pool of overhead costs that form the basis for the allocation. Contractors
should thoroughly analyze their home office overhead costs and ensure
that any costs that are subject to a valid challenge by the defendants
are either removed or can be defended. This will save the contractor
from embarrassment at trial and will improve the contractor’s
credibility before the Court. For example, perquisites for executive
management should be scrutinized to ensure that such costs do not appear
excessive in the eyes of the trier of fact. Other costs that should
be analyzed in this light include entertainment, advertising, and bonuses
for employees and company owners. There is no rule of thumb as to what
home office expenses are or are not appropriate. Contractors and their
damage experts should use common sense and they must remember that the
details of their claim calculations will be thoroughly examined by the
defendants in the litigation.
Lost Productivity
Labor productivity losses present challenges in the quantification and
presentation of damages. Again, maintaining thorough records is important
to proving the claim. Lost productivity can result in acceleration claims
in which excessive overtime may impact worker productivity. Also in
acceleration situations, a contractor may try to advance the progress
of the project by scheduling multiple trades to work in the same area.
This is referred to as “stacking of trades” and can impede
work efficiency since laborers must incur time to share space and coordinate
their work in the same area and at the same time with other trades.
A contractor may also pursue a claim for lost productivity in a delay
claim. This can be accomplished under the theory that the learning curve
for the contractor’s employees is impaired or even lost. As a
contractor works on a project its workers gain experience and learn
a process that enables greater efficiency as the job progresses. When
a project stalls during an extended delay period, those same workers
can lose this learning curve benefit. In cases in which the contractor
is not able to rehire the same workers for the project, the resulting
lost productivity can be even greater.
Perhaps the best way to quantify lost productivity is to compare the
contractor’s productivity after a damage event with the contractor’s
productivity on the same project before the damage event. If a damage
event occurs early in the project, the contractor may not have sufficient
history on that project to use as a basis to assess lost productivity
after the damage event. In this situation, the contract should consider
using its actual productivity on other similar projects as a basis for
the claim. If no other projects are sufficiently similar to use in this
regard, the contractor may rely on published studies of efficiency and
productivity to support its claim to some degree.
Interest or Cost of Capital
Cash flow is important to any company. It can be particularly critical
to a construction contractor. When problems with a project sufficiently
impair a contractor’s cash flow, it should consider a claim for
interest as part of its overall damage claim. A contractor may have
to borrow additional funds to make up negative cash flow on the project.
A contractor may also have to delay repayment of debt because of decreased
or delayed cash flow on the project.
The interest rate used to quantify this claim is dependent on the terms
and conditions of the contractor’s debt and equity agreements.
Generally, the overall cost of capital rate is appropriate to apply
in this situation. The contractor may also use the interest rate applicable
to the debt that it would most likely repay with the cash flow at issue.
This may yield a higher interest rate than the average cost of capital.
Lost Bonding Capacity
A problematic construction job can have a ripple effect throughout the
financial aspects of a construction contractor. If a decline in the
financial strength of a contractor is significant, the contractor may
be denied further bonding on all or some portion of its potential new
projects. When the cause of the financial decline and lost bonding capacity
can be sufficiently linked to the problem job at issue, there may be
a valid claim for the present value of the lost profits on bonded jobs
lost as a result.
Assuming that a claim for lost bonding capacity is warranted from a
legal standpoint, then the challenge for the financial expert is to
quantify a damages figure with a reasonable degree of certainty. The
first step is to assess the bonded work that the contractor lost. If
a contractor has a close working relationship with an owner that requires
bonded contractors, then the loss of bonding may be closely linked with
the loss of all or some portion of the projects that that owner developed
after the loss of bonding. A contractor may also be able to prove harm
from loss of bonding by illustrating a decline of bonded work in relation
to the contractor’s historical performance.
After lost revenue is quantified, then the associated lost profits
must be analyzed. This can be based on the contractor’s overall
historical gross profit or the perhaps the contractor’s profitability
on projects most similar to the types of projects lost. Any estimate
of future lost profits must also consider a discounting to present value.
Lastly, the contractor’s efforts to mitigate its losses must
be assessed to the extent this would reduce the damages claimed. For
example, if the contractor was able to replace some portion of its lost
bonded work with non-bonded work, this would reduce the contractor’s
related claim for lost bonding capacity. Contractors should also consider
whether non-bonded work was either more or less profitable than the
lost bonded work. If the non-bonded work obtained was more profitable,
then this would indicate a further mitigation of losses. On the other
hand, if the non-bonded work is less profitable than the lost bonded
work, then the mitigation factor is less and the damages for lost bonding
capacity would be greater.
CONCLUSION
The successful resolution of a construction dispute largely depends
on the quality of information and documentation maintained from the
project. Whether you are asserting a construction claim or defending
against one, mastering and linking the details of the project with the
calculation of damages is very important. This will enable the parties
to a dispute to better assess the unique and challenging aspects of
construction claim damages.
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