This essay has been submitted by a law student. This is not an example of the work written by our professional essay writers.
Published: Fri, 02 Feb 2018
Recovery of Contractors Head Office Overheads
Compensation required by the contractor for extended or additional head office overhead can be one of the more controversial issues faced on construction projects. One of the less understood elements in construction damage claims is the head office overhead that is incurred when a project is delayed. However it is compensable and there is no doubt that head office overhead is an entitled expense of the contractor. However, the approaches for the calculation of the expense incurred have been widely debated as well as the circumstances under which the methodology should be applied.
There are many studies attempt to manage the HOOH claim effectively and quantify the unrecovered of HOOH during the project prolongation situation due to the client cause delays. Cateret Work Uniforms (1954), Eichleay Corporation (1960), Manshul Construction crop (1981), Finnegan Ltd (1989), Alfred McAlpine Heads North Ltd (1995) are some of contracting firms developed formulas to recover the HOOH loss. Meanwhile, Fordham (1995), Zack (2001), Tamm and Singh (2003) are most recent researchers on this area. They pointed out that the “HOOH costs are hard to calculate” (Zack, 2001), “obtaining a 100% accurate estimate of head office expenses is practically onerous” (Tamm & Singh 2003, p.234).
There are several issues are affecting the HOOH claim during the stages of initiation, quantification and evaluation. These issues generally restrain the HOOH claim and make dead lock. Specially, it is known that the reasonable choice of a quantification system will lead to the less disputes in this claim area. If a wrong quantification, may cause loss to one party and profitable to another party. This unrecovered HOOH is an actual loss to contractor, therefore the contractor shall claim with the actual cost he incurred during the delay. Consequently the selection of most suitable recovery or calculation method is critical for both clients and contractors.
To explore the HOOH claim process model, primarily this study identifies and analyse the existing HOOH claim related areas at the current. This session one reviews the construction cost and the taking part of the HOOH within it. The second section focuses on the unrecovered HOOH in detail manner and the chapter ended up with the review of formula approach to recover HOOH loss and the general summary.
In the construction industry, where contract documents define rights, obligations, and procedures, a claim is a request by the contractor for an extension of time and/or additional cost and can evolve into a disagreement that may not be amicably resolved by the parties concerned (Clough & Sears, 1979; Jervis & Levin, 1988; Barrie & Paulson, 1992 cited in Abdul Malak et al, 2002). In any construction project, significant additional costs can be experienced by the contractor, the owner, or both, due to the actions of the other party or parties involved.
A major criticism facing the Sri Lankan construction industry is the growing rate of delays in project delivery. However in countries such as United State of America (USA), United Kingdom (UK) and Western Germany, Mobbs (1982) found that ‘construction time’ is better.
Even if just a few delay costs are exist, a variety of problems incur on contractors’ overhead costs both site overhead and head office overhead (Ibbs & Nguyen, 2007). An overhead cost can be defined as a cost that cannot be identified with or charged to a construction project or to a unit of construction production (Coombs & Palmer 1989 cited in Hobson & Holland, 1999). Overhead costs generally are divided into two categories (Peurifoy & Oberlender, 1989), such as job overhead costs or site overheads and general overhead costs or head office overheads. Head office overheads are usually posted to accounts that are not project related, and lumped together; they are called the head office overhead “pool” (Irwin, 2005). In normal practice, it is how this pool is allocated amongst the projects using some basis and varies from contractor to contractor.
The problem is that the site overheads are associated with the contractor’s individual projects but the head office overhead costs are not associated with any particular projects (NCHRP Synthesis 315, 2003). If one project is delayed such that no work is performed and no income from billings are received during the month and additional expense incurred when the completion of a project is prolonged beyond its scheduled completion date then a certain percentage of the business’s overhead expense is unrecovered and can presumably be attributed to the delay. This is called “unrecovered head office overhead.” (Gregory et al, 1997).
In compensable delay cases, the contractor has the right to claim head office overhead loss or overburden (Taam & Singh, 2003; Scott, 1997). Many contract conditions like JCT98 clause 4.11(need to consider online artical http://books.google.co.uk/books?id=7eLWYZTltakC&pg=PA279&lpg=PA279&dq=jct+clause+4.11&source=bl&ots=yorhm9rb9Q&sig=PmkXhk7_x6X0J_qUjveX1ThWYLE&hl=en&ei=3OTsTMuAHMXLhAe828zODA&sa=X&oi=book_result&ct=result&resnum=8&ved=0CEsQ6AEwBw#v=onepage&q=jct%20clause%204.11&f=false), ICE 5 clause 1(5), FIDIC and ICTAD published conditions of contact are supporting to the above statements. The recovery of head office overhead from compensable delay is not new to law. Zack (2001) stated as far back as 1941 Federal courts awarded recovery of head office overhead to a contract for a government – caused delay.
Within the past four decades from the Eichleay formula development the construction industry has being filled up with more than thirteen formulas. Each approach is based on several assumptions and on the other hand they have several obvious and signification flaws (Kenyon, 1997). The alternative methods have similarities and significant differences. The utilisation of these methods to recover the unrecovered head office overhead creates many questions in application. Most of the contractors and clients still have the low confidential step in quantifying such head office overhead claims.
A need for an overall step-by-step procedure for HOOH claims analysis and administration is therefore crucial for achieving proper resolutions and for preventing claims from developing into disputes. The foremost step to develop this claim process tracking model, the current main issues of HOOH claim stages have to be identified. Further the causes and effects related to this HOOH claim initiation, quantification and evaluation stages need to be identified in order to establish a HOOH claim tracking model.
1.3 Construction Costs and Overhead Components
1.3.1 Construction Costing
The terms direct costs, indirect costs, job overhead, and general overhead are varying in meaning from construction firm to construction firm. Ahuja and Campbell (1988) define, that the construction costs into two classifications: direct and indirect. Direct costs are considered to be the costs for labour, materials, production equipment, and supplies that must be incorporated into a distinct feature of the completed work. Indirect costs include other items that are not made a part of the completed work such as contractors’ overheads, profit, contingencies, escalations, and interest during the construction period.
From the issues of direct verses indirect cost, the indirect construction cost can be defined as a cost that can be identified with a construction project but not a specific unit of production. The distinction between overhead costs and indirect costs is blurred further by their usage in the literature. One source uses the term ‘job overhead’ and ‘indirect costs’ for project overhead (Neil, 1981). Another source equates job overhead with general conditions and/or direct overhead (Dagostino, 1993).
Finally, this research defines that the direct costs is labour, material, production equipment, and subcontract cost, which is identifiable with a construction activity however the indirect costs cannot be related with the construction activity directly.
1.3.2 Overhead Costs
Overhead costs are those charges that cannot be attributed exclusively to a single product or services (Tipper, 1996), or the summary of expenses that benefit more than one cost objective (Fultz, 1980). Another definition states that the OH costs are costs meanwhile are not a component of the actual construction work but are incurred by the contractor to support the work (Cilensek, 1991). Pulver (1989) states that total overhead costs may vary from 8 to 30% of the sum of materials, labour, and equipment costs or from 12 to 50% of the labour costs, depending on the project characteristics.
Although overhead costs are extremely important in construction estimation, they can be easily overlooked. In fact, neglecting overhead has forced some contractors out of business because these costs constitute a significant portion of total construction costs. Furthermore, overhead costs rise continuously and never go down on their own, producing even higher production costs (Snodgrass, 1999).
184.108.40.206 Composition of Overhead Component
There are two major types of overhead costs in construction: HOOH costs and SOOH costs.
Figure 2.1- Overhead Components
220.127.116.11 Site Office Overhead
SOOH (project overhead) must be distributed over the associated project, since it cannot be allocated to specific work packages (Neil, 1981). SOOH costs include items that can be identified with a particular job, but are not materials, labour, or production equipment. SOOH includes expenses that cannot be charged directly to a particular branch of work, but are required to construct the project (Dagostino, 1993). Standard Method of Measurement of Building Works and ICTAD prepared Method of Measurement of Building Works (SLS 573) illustrates the comprehensive list of site office overhead items. The few of typical site office overheads are listed below as example;
Site office supply
Temporary telephone and the paying of all charges
Maintenance of site office, etc.
18.104.22.168 Head Office Overhead
HOOH is also called general and administrative OH and includes all costs incurred by the construction firm in maintaining the firm in business and supporting the production process, but are not directly related to a specific project (Adrian, 1982). HOOH costs vary considerably from time to time but range from 8 to 15% of the total construction volume (Pulver, 1989). This component can vary from every organization depending on the size, efficiency of the management, diversity of business taken, branches of the organization etc. HOOH normally consists of the fixed costs and time related costs of operating a head office. According to the Mccaffer et al (1994, p.164), Carr (1989, p.5), Damayanthi (1994, p.16) and NCHRP Synthesis 315 (2003, p.4), the typical items of HOOH are listed below;
Rents & Utilities
Auto mobile maintenance and travel costs
Other staff professionals’ fees and registration
Real estate taxes
Non project related bond or insurance expenses
Depreciation of equipment and other assets
Office equipment & supplies
Support and clerical staff not assigned to the field
This Typical HOOH items were categorized into eight foremost HOOH categories with the base of ‘MAC Model Contract’ (MAC, 2008) and modified by brainstorming approach for application among the Sri Lankan contractors. The followings are identified as HOOH categories and all the HOOH items can be located within those appropriately.
Staff’s and Labours’ (Head Office) salaries and wages
Equipment and Plants related costs
Materials related costs
Charges (Head Office)
Insurance (Head Office)
Fee Schedule Constituent
Vehicles and travelling expenses
Miscellaneous Items (Others)
Identification of Typical HOOH Items in HOOH Pool
Staff’s and Labours’ (Head Office)
Wages and Salaries
Payments to people for
Bonuses and incentives
Allowance for working in special circumstances
Other special allowance
Absence due to sickness and holidays
Payments made in relation to employees
Subsistence and lodging
Passport and visas
Occupation accident benefits
Equipment and Plants related costs
Equipment damage/ repair costs
Depreciation and maintenance of equipment
Materials related costs
Material yard maintenance
Delivery to yard and removal from the yard
Samples and tests
Charges (Head Office)
Compensation for loss of crops or buildings
Advertising, leaflet drops and the like in connection with the services
Specialist services (Advices etc)
Head office building rental
A/C, sanitation, power, lighting and water
Depreciation and interest of capital assets
Supplies and consumable stores
Cleaning and maintenance
Telephone, telex, fax, post and electronic mail
Recruitment and training of staff
Marketing and other external expenses
Refreshments and food
Insurance (Head Office)
Head office related resources ( including employee, equipments, assets etc) – premiums
Fee Schedule Constituent
Franchises, Royalties, Licences
Accounting and Auditing
Research and Development
The amount of any excess borne by the contractor in respect of any claims under Employer’s liability
Finance and Interest charges
Health and safety
Supply chain (LC)
Vehicles and travelling expenses
Vehicle damage and repair
Parking charges and fines
Miscellaneous Items (Others)
1.3.3 Allocation of Head Office Overheads to Projects
22.214.171.124 HOOH Cost within the Tender Sum
Tender sum derived from all the costs which incur when carrying out the contract.
Figure 2.2 – Tender Sum Components (Source: Jasitha, 2001)
The HOOH cost percentage of the contractors are estimated based on the annual turnover and the total overhead cost and added within the tender sum through mark up.
126.96.36.199 Methods of Including HOOH Cost within the Tender Sum Formation
Include as a percentage in the unit rates of the BOQ
All the HOOH costs are included in the unit rates.
Front loading – Add more HOOH cost to early stage billing work items.
Back loading – Add more HOOH cost to end stage billing work items.
Smooth distribution – Equal distribution among work items.
Added as a amount within the tender sum
In this case the estimated HOOH cost id inserted within the tender sum as lump sum amount and no allocations within the rate.
188.8.131.52 Allocation Base of Head Office Overhead
There are seven possible bases that can be used to estimate the amount of HOOH that has to be allocated to a project at hand. The allocation bases are listed below.
Number of projects
Project bid value
Material and labour cost
Material, labour and equipment cost
Direct cost including project OH
Fixed amount is added (Source: Al Shahri et al, 2000; Pulver, 1989)
184.108.40.206 Factors Affecting the Magnitude of Head Office Overhead Allocations
In many instances, the top managers in contracting companies not consider the actual figures coming from the estimators, but insert the HOOH cost as lower or higher values. Contractors may choose to do so because of;
The nature and type of the contract
Project complexity, location and size
Need for work
Contractor’s cash availability
Client’s strictness and nature
Percentage of subcontract work
Number of competitors (Source: Al Shahri et al, 2000; Pulver, 1989)
220.127.116.11 Reasons for Increasing Head Office Overhead Costs
This question investigates the potential causes for increased HOOH costs. Knowing the major sources of high HOOH costs helps in concentrating efforts towards specific causes. Seven potential causes were identified from the literature. It should be noted that some causes of increased HOOH costs are inter-related, which makes it difficult to evaluate them individually. For example, a decision to expand the company, which stands as a cause of increased HOOH costs by itself, involves also marketing costs and constitutes an inter-organization mistake if taken at the wrong time. The main causes for increased HOOH are listed follows.
Lack of new projects (recession)
Increased marketing cost
Client related reasons
Other (internal mistakes)
1.3.4 Head Office Overhead Practice in the Local Contractors
18.104.22.168 Head Office Overheads of the Contractors
All local contractors have the clear idea on the HOOH and they included certain amount as overhead expenditure within the mark up percentage. Head office expenditures differ from contractor to contractor however this differentiation is in low level between same grade contractors and more between different grade contractors (Damayanthi, 1994). The way of identification of the HOOH items also differ from contractor to contractor.
It was identified that within the HOOH items the highest proportion of the HOOH is for directors salaries and the second is staff salaries (Damayanthi, 1994). It is clear that each and every department of the firm involves different level within the particular project and incurs the expenditure. The total HOOH cost for the particular project has to feed all the departments in a proportional way.
22.214.171.124 Quantification of Head Office Overheads
The most commonly used allocation mechanism is to total all HOOH costs for a given accounting period (fiscal year) and scale them against the total direct costs for the same period, which gives the percentage of HOOH costs that can be applied to forthcoming projects (Adrian, 1982; Frank, 1984). After the overhead rate is calculated, it is added to the total estimated direct costs of the projects in hand.
This quantification calculated form the past accounts data related to turnover and the HOOH cost.
The expected adjustments are made to the past data on behalf of inflation, recession in construction market and the resource recruitment within the company etc by the contractor. If the contractors may reduce the HOOH through proper utilization, they can enter into better competitive bid.
126.96.36.199 Allocation and Recovery of Head Office Overheads
The contractor needs to recover these costs by allocating these costs to the projects it performs. In construction contracting, the HOOH is normally added to the bid or contract price as a percentage of the direct cost amount. The number of projects that a contractor has during a given period affects the markup percentage that he would allocate to any given project. The existing studies (Damayanthi, 1994.) shows that the Sri Lankan contractors do not have the proper check before the end of the financial year whether they have recovered the amount of HOOH for the year or not. That study further stated that the contractors wait until the end of project to monitor the HOOH recovery from the particular projects.
1.3.5 The Government Directives Concerning on Overhead in Sri Lanka
The government of Sri Lanka has issued several directives relation to construction overheads development, inclusion and recovering. The “Financial regulations of Ceylon” published during the colonial era and the “Financial manual of Sri Lanka” stipulates that the overhead components should be included within the BOQ item rates. This implementation cut off the requirement of separate preliminary section in the BOQ. In 1972 the General Treasury has issued a circular pointing out that the State Engineering Cooperation of Sri Lanka entitled to add 35% of the basic cost as overhead and profit component. The Sri Lankan construction consortium classified the Local construction organizations as class A, B and C. According to grade the contractors were allowed to insert overhead and profit component as 35%, 30% and 25% respectively. The fixed overhead concern replaced in 1988 with the ICTAD. They implemented the pricing of primary bill separately. This has to be cost with important site overhead items by respective tenderers. The ICTAD recommendations and implementation mandated in 1990 for state projects (Damayanthi, 1994).
1.4 Unrecovered Head Office Overheads due to Compensable Delay Events
1.4.1 Delays and Construction Costs
Contract delays are common to construction industry. They occur with exceptional frequency and with virtually every contract change. Consequently, when a delay occurs that increases a contract’s performance time and the contractor’s costs of performing that contract. Because the construction costs are time dependent.
Table 2.1 – Delays Categorisations (Source: Niesse, 2004)
a – Owner may assess liquidated damages, b – For concurrent period
The above table shows the delay categories and the entitlements of the parties in each category. Specifically the HOOH claims falls within an excusable and compensable delay can be defined as a delay caused by an owner’s actions or failure to act, which entitle a contractor to additional time and compensation (Braude, 1997).
Fordham (1995) explains the unrecovered overhead as follows. Every contract usually requires a contractor’s commitment of resources such as facilities, equipment, machineries and personnel. During the early stage of the projects the commitment of these resources is minimal but it increases as performance continues and level off or reduce with contract performance close. Commonly, the firm must allocate adequate resource capacity to perform at the maximum level of required effort. Once that peak has achieved, the firm must relocate the excess resources according to the requirements. At the end of the project stage the firm may invest those resources within the next project.
The consequence of delaying all or some part of the contract work is generally to reduce the amount of planned contract activity in the original performance period and delays not only cause performance of the work to occur in later time periods but the company must also retain the resources in the certain level of effort necessary to complete the contract over a longer period of time. This situation increases the contractors’ costs.
1.4.2 Compensable Damages
Compensable damages are damages that compensate the claimant for losses or costs incurred because of a breach or a wrong committed by another party within the contract. A category of compensable damages is ‘‘consequential damages’’ that flow from a breach of contract but are not the direct result of it. The damage arises not as a result of ordinarily predictable factors but from the intervention of circumstances not directly involved in contract performance. For example, the resultant effect of a delay in the completion of a project for a contractor, the resultant effect of a similar event would be unrecovered, extended, or increased HOOH or SOOH expenses. When a compensable delay occurs, damages usually result in five different areas. These areas are an increase in labour costs, material costs, equipment cost, SOOH expenses, and HOOH expenses. HOOH damages due to delay are a very controversial issue and is an area that is difficult to understand. Yet, in many cases, it can be the largest component of the delay claim (Taam & Singh, 2003).
1.4.3 Unrecovered Head Office Overhead
188.8.131.52 What is Unrecovered HOOH?
The concept of unrecovered HOOH as an item of damages arises at least in part from the basic accounting concept that all business costs are incurred to support ultimate, specific revenue generating objectives and therefore should be allocated to these objectives. HOOH costs do not directly benefit any specific objective; therefore, the overhead is referred to as ‘‘indirect’’ costs.
If the delay is attributable to extra work, the contractor may receive HOOH compensation from the markup on a change order. If there is no extra work and project experiencing delay, then the contractor face under recovery of HOOH from the particular project. In general, if a project is suspended or delayed, the contractor experiences extended HOOH. Contractors may or may not incur additional expenses. However, since it is very difficult to determine extra resources used in the head office, courts have allowed contractors to claim for unrecovered HOOH, regardless of actual expenses (Taam & Singh, 2003).
Effects of Delay on Contractors’ HOOH
Shortfall of turnover
Figure 2.3 Illustration of Delay Effect on HOOH (Source: Kulatunga, 2001)
Short fall in turnover caused delay
Displaced turnover due to delay
Line ‘a-a’ represents the contractors’ anticipated or actual HOOH. Line ‘b-b’ represents the contractors’ anticipated turnover on all projects. Profile ‘c-c’ represents the contractors’ anticipated turnover on the particular project. Profile ‘d-d’ represents the contractors actual turnover on the present (delayed) project. Profile ‘e-e’ represents the contractors’ actual turnover on all projects.
There is a time dependent relationship between the contractor’s costs and its contracts. The cost allocation structures of the most firms are based on this concept. An example of such a performance based allocation system is overhead cost allocation. In such allocation structures, the consequence of a delay is to reduce the planned pattern of fixed overhead cost allocation (recovery) for the delayed contract.
The result is that overhead costs are misallocated to other contracts. This misallocation of indirect cost has been termed “unrecovered HOOH”.
184.108.40.206 Unrecovered Head Office Overhead Claim
An element of contractors’ claims which can prove particularly problematic for those charged with ascertaining the same is that relating to the recovery of HOOH and loss of profit. It is now accepted practice, on the grounds that it is settled law, that the recoveries of HOOH are allowable heads of claim (Hackett & Trickey, 2001).
Reimbursement of the HOOH costs is the important element in a prolongation claims when a project delayed. However such a claim, and the basis upon which it is made, is often misunderstood. In simple terms a contractor may seek reimbursement of its HOOH costs in one of the two alternative ways (Molloy, 2001):
As lost opportunity costs; or
As additional overheads actually expended as a result of the delay
In case of lost of opportunity cost due to delay arises from the inability of the contractor’s organization to free move to another project and earn the combined profit and HOOH of which it is reasonably capable. In order to pursue the HOOH claim on the base of opportunity costs approach it is necessary for the contractor to prove the following:
That the HOOH represents a reasonable one by reference to audited accounts for the appropriate period.
Prove on the same level of HOOH recovery was available during the period of delay.
That the method of working of the Contractor was suitable for this approach. This can be proved by showing that the Contractor is actively seeking extra work during the period of delay, and by providing details.
The best a contractor has to do is to be aware of the need for such evidence and ensure that records of how delays are affecting HOOH.
Whilst the opportunity costs approach provides a straightforward and easy method of calculation, and whilst it is probably easy in principle to prove an entitlement to opportunity costs, the reality is that evidence will be far from easy to provide.
However, in the more recent construction cases, the court affirmed that there was no objection in principle to a claim for extended HOOH, and further that there was no objection in principle to such a claim being calculated by reference to a formula. Here it should be noted however that in this case the court in fact refused to adopt such an approach principally because it was the contractors’ working arrangement that they only ever undertook one construction project at a time and did not undertake another until the project was complete. It was therefore inappropriate to use opportunity costs as the basis of calculation (Molloy, 2001).
Accordingly Molly (2001), the second method of calculating a HOOH claim is the actual costs approach. The basis of this claim is that the prolongation has resulted in the contractor allocating more overhead expenditure to the project than was originally contemplated at the date of the contract.
220.127.116.11 Contractual Provisions for Head Office Overhead Claims
Conditions in JCT Contracts (internet article to consider, http://goliath.ecnext.com/coms2/gi_0199-2007323/Changes-to-the-JCT-Standard.html)
In JCT 80 the clause 26 permits claims for both disruption and delay (prolongation). Clause 26.1 refers to ‘the regular progress of the works or any part thereof materially affected by anyone or more of’ the matters listed in clause 26.2, which, it is said, means that it is only delay in progress which can be compensated and that the effect upon the progress is to be equated with ‘delay’, that ruling out any claim for loss of productivity.
Conditions in FIDIC Contract
FIDIC fourth edition mentions the compensable delay situation very clearly. FIDIC provisions are less problematic to practice because it has clearly defined the adjustment of price by stating the cost and profit provisions (refer Table 2.2).
Conditions in ICTAD (SBD 2)
In Sri Lanka the most popular form is ICTAD conditions of contract. This form was developed based on FIDIC third edition. In this form some clauses are not directly expressing the time extensions and the compensations (refer Table 2.3).
Table 2.2 – HOOH Claims Provisions in Fourth Edition of FIDIC Conditions of Contract
Employer – Caused Delay
Adjustment to Contract Price
Ambiguities in documents
T + C
T + C
T + C
Cite This Essay
To export a reference to this article please select a referencing style below: