Global Arbitration Review - Arbitration News, Features and Reviews

# Damages in Construction Arbitrations

22 November 2016

## Introduction

Damages to a contractor can result from a number of employer-caused events that may occur before a project commences or during actual contract performance. These events can include project delays and disruptions, shutdowns or suspensions of work, resequencing of work, incomplete or incorrect designs, excessive change orders and untimely responses to requests for information from the employer. Each of these events will likely cause the contractor to incur increased costs. While mathematical precision is not a prerequisite in the calculation of damages, it is important to establish and calculate damages to a reasonable degree of certainty to clearly associate these increased costs (i.e., damages) with the underlying, employer-caused events, and to substantiate the proof for additional costs incurred. To quantify the impacts and successfully establish the cause-and-effect relationship, there is a variety of damages pricing techniques and models that can be used.

The purpose of this chapter is to provide the reader with an overview of the types of damages typically experienced by contractors, and the pricing techniques and models used for the quantification of the resultant increased costs. The types of damages discussed below are limited to increased costs. This chapter does not address the concept of lost profit damages, which contractors often also experience as a result of these or similar events.

## Damages calculation methods

### Total cost approach

The total cost approach, often referred to as the method of last resort, simply calculates the difference between the actual contract costs and the tender amount. This method assumes that the full amount of the overrun is due from the employer as a result of the claimable events. The total cost method is typically used in situations where there are pervasive and continuous effects on performance that cannot be easily segregated into a single event or groups of events subject to measurement. To prevail when using the total cost method, there are typically four conditions that should be satisfied. The four conditions are:

• there is no other practical or viable method for calculating the damages;
• there are no tender errors or underbids;
• the cost overruns are a result of the employer’s actions; and
• the actual costs are reasonable.

### Modified total cost approach

A more accurate method for quantifying damages is known as the modified total cost approach. Under this approach, the contractor identifies and removes from its damages calculation the costs that are unrelated to the employer-caused events. These would include cost increases resulting from the contractor’s actions, errors on the contractor’s part, rework to correct any contractor mistakes, and tender errors or underbids. The other conditions for the use of a total cost approach are still applicable.

### Direct or discrete pricing approach

The direct or discrete pricing approach is the most accurate method for quantifying damages, as it ties and associates actual costs, taken from the contractor’s books and records, to the specific events for which the contractor is seeking compensation from the employer.

## Delays

### Delay analysis – scheduling

Delay damages are often determined in conjunction with the contractor’s schedule analysis, which both measures and demonstrates the causes of the increased contract duration. The increased duration can manifest itself as additional days of performance, idle time or less than fully productive performance.

### Delay analysis – quantum

Once a schedule analysis has been completed and the additional contract duration days are linked to the employer’s actions, the increased costs to the contractor can be calculated. The increased costs usually fall into the following categories: extended general conditions, unabsorbed home office overhead, idle equipment and escalation.

#### Extended general conditions costs

These are the direct costs that result from extended contract performance time and include such items as: the cost of the project manager; project administrative personnel, like the field office accountant; job site trailers; utilities; personnel relocation costs; and job site security. When quantifying extended general conditions, care must be taken to only include costs that are incurred as a function of the extended performance period. Costs that would have been incurred irrespective of the delays, such as utility hookups and job site trailer mobilisation or delivery, as well as computer or other infrequent purchases, should be removed from the calculation. Once the time-related costs are isolated, a daily rate for the general conditions can be calculated. Additional considerations for the calculation of the general conditions daily rate are initial performance period costs and end of project performance costs. These daily costs can significantly differ from, and are typically less than, the costs for the period of actual delay impact, and should be excluded from the daily rate calculation. To the extent the delay days are isolated to specific time periods, care should be taken to calculate the daily costs for those discrete time periods to best isolate the cause-and-effect relationship.

#### Unabsorbed home office overhead costs

Another effect of delays is on the contractor’s ability to absorb its fixed home office overhead costs. These costs are normally priced into and recovered through a contractor’s tender amount. When a contractor experiences a delay or suspension of its work, it is often unable to fully recover its home office overhead through the anticipated level of revenue. Home office overhead includes the costs for the contractor’s corporate management personnel other than direct job site project management, payroll and human resources department costs, engineering support, and other home office costs. Care should be taken to exclude any direct project costs or general conditions costs to avoid duplication within the quantum calculation.

There are several well-known and widely accepted formulas used to calculate a contractor’s unabsorbed home office overhead, including the Hudson, Ernstrom, Emden and Eichleay formulas.[2]

##### Hudson formula[3]

This formula calculates a daily home office overhead and profit rate based on the contractor’s tender amount, and assumes that this rate is applicable throughout the duration of the project. The formula is as follows:

[Tender Overhead Markup] x [Original Contract Amount/Original Contract Duration] = Daily Contract Home Office Overhead.

The resulting daily rate is extended by the compensable delay days. When using this formula, the issue of how much of the tender markup consists of overhead v. profit will need to be addressed.

##### Ernstrom formula[4]

This formula calculates home office overhead in relation to all project labour costs and applies the resulting ratio to the labour costs incurred by the contractor for the impacted project during the delay period. The formula is as follows:

[Total Home Office Overhead for Contract Period]/[Total Company Project Labour Costs] = Project Labour to Overhead Ratio.

The next step is to apply the project labour to overhead ratio to the labour costs incurred during the delay period, with the end result being the unabsorbed home office overhead for the delay period.

##### Emden formula[5]

This formula calculates home office overhead and profit using the relative amount of home office overhead to the total company revenue applied to the planned project revenue on a per-day basis to arrive at the allocable daily overhead rate for the project and the delay. The formula is as follows:

[Total Company Overhead and Profit/Total Company Revenue] x [Planned Contract Revenue/Planned Project Duration] = Allocable Daily Overhead Rate.

The allocable daily overhead rate is extended by the number of delay days. As with the Hudson formula, an important consideration is that the result includes both home office overhead and profit.

##### Eichleay formula[6]

Similar to Emden, this formula allocates home office overhead for the contract period to the impacted project, and determines a daily rate that is applied to the number of compensable delay days. The formula is as follows:

[Contract Billings/Total Company Billings During the Contract Period] x [Total Company Home Office Overhead During the Contract Period] = Home Office Overhead Allocable to the Project.

The next step is:

[Allocable Home Office Overhead]/[Actual Contract Duration Days] = Daily Home Office Overhead Rate.

The final step is:

[Daily Home Office Overhead Rate] x [Compensable Delay Days] = Total Unabsorbed Home Office Overhead.

Considerations when calculating unabsorbed home office overhead:

• Was the contractor able to mitigate its losses by shifting project resources or personnel to other projects and generate revenues that absorbed home office overhead?
• Did the contractor experience a significant change in revenues and home office overhead unrelated to the delays on the project at issue?
• Did the contractor absorb any part of its home office overhead through change orders or other claims?

To the extent that events such as the above occurred, an adjustment to the home office overhead calculation should be considered.

#### Idle equipment costs

During a period of delay, another impact to the contractor often results from equipment that is idled as a result of the delay. While the idle equipment does not incur operating costs, such as fuel, it does continue to depreciate during the delay period. Depreciation is one element of a contractor’s equipment ownership costs. For leased or rented equipment, the contractor may continue to incur rental or lease charges, despite not being able to use the equipment in a planned, productive manner. Both ownership and lease or rental costs are components of idle equipment costs. For the pricing of the impact of leased or rented equipment, the contractor’s measure of damages is simply the rental or lease charges incurred during the delay period. For owned equipment, the calculation is more difficult, as the contractor may not have developed or maintained internal equipment costs or rates. In the absence of an internal equipment cost or rate, there are a variety of equipment manuals that can be used to calculate idle equipment costs. Examples of equipment rate manuals are the Alberta Roadbuilders & Heavy Construction Association (ARHCA) Equipment Rental Rates Guides and the US Army Corps of Engineers (USACE) Construction Equipment Ownership and Operating Expense Schedules. These rate guides are used to approximate a contractor’s owned equipment costs and include provisions for calculating idle equipment costs. Care should be used in selecting the proper make and model of the equipment, its age and condition, and the geographic location.

#### Escalation costs

As a result of a delay or an extended project performance period, a contractor often experiences increases in its costs for labour and materials. To quantify these cost increases, a comparison of baseline costs or rates to the actual costs or rates incurred during the delayed or extended period is necessary. The cost or rate differential experienced by the contractor is the resulting measure of damages. It is important to only include the differential in the costs or rates, as the underlying work would have been performed absent the delay or extension.

### Delay mitigation

In addition to the costs a contractor incurs as a result of delays, there may be costs incurred to mitigate delays and maintain the programmed schedule. These mitigation costs may include additional overtime, additional equipment, acceleration through added manpower, increased crew sizes, process modifications and improvements, additional shifts, extended work weeks, additional supervision, quality improvements and productivity improvements. Costs for these activities are better quantified on a discrete pricing basis. For example, additional manpower costs can be determined using salary and wage records in conjunction with time records reflecting the actual time spent on the project by the additional manpower. It is important to establish that the need for increased manpower is the result of employer-caused events, and is not the result of contractor performance issues or underbidding the project.

## Loss of productivity

In addition to, or as a result of, delay impacts, contractors can also experience disruptions to their productivity. Loss of productivity is often a significant component of a contractor’s damages.

Contractors typically rely on their past experience and the nature of project work to develop productivity rates they will use to estimate for the tender for new work. On many construction projects, the single element most susceptible to risk of cost overrun is craft labour. There are a variety of forces on a construction project that have the potential to negatively impact a contractor’s workforce. Among these forces are broad categories, including: acceleration of the work; excessive change orders; stacking of trades; resequencing work; excessive overtime; changes to the work; and natural or environmental conditions at the worksite. All of these potential impacts to labour productivity can cause the contractor to suffer losses on the project resulting from inefficiencies. To the extent it can be established that the employer is responsible for the causes of labour inefficiencies, the contractor has available to it a variety of methodologies to quantify labour inefficiency damages, including: a measured mile approach (Zink, 1985); industry/trade or scholarly studies; modified total cost approach; and total cost approach.

### Measured mile approach

The measured mile approach compares a contractor’s actual rate of productivity, achieved during an unimpacted portion of the project, to the rate of productivity achieved in the impacted portion of the project. In terms of construction, productivity can be defined as the craft hours necessary to produce a unit of work. The following formula can be used to calculate a contractor’s productivity rate:

 Productivity rate = Output (units completed) Input (labour hours)

A contractor experiences a loss of productivity, and resulting cost overruns, when its actual productivity rate is less than the baseline, or planned, productivity rate. This comparison of baseline, or planned, productivity to actual productivity is typically measured using productivity or performance factors. A performance factor is calculated by dividing actual productivity by planned productivity. As such, a performance factor of greater than 1.0 indicates a loss of productivity, or inefficiency. An example of the calculation of the performance factor is provided below:

 Actual productivity rate (Labour hours per linear metre (LM) of pipe) 3.25 ÷ ÷ Planned productivity rate (Labour hours per LM of pipe) 2.65 = = Performance factor 1.23

In the above example, the contractor has incurred a loss in productivity of 23 per cent. To quantify the damages associated with the loss of productivity using the measured mile approach, the contractor should recalculate the productivity on the impacted work as if it was performed during the unimpacted period. Assuming that the contractor expended 16,250 craft labour hours at an average hourly cost of €65 to install 5,000LM of pipe in the impacted period, and an unimpacted productivity rate of 2.95, the calculation of the contractor’s damages is demonstrated below:

 Actual output (LM of pipe installed) 5,000 x x Measured mile productivity rate (Labour hours per LM of pipe) 2.95 = = Should-have expended labour hours 14,750 (a) Actual expended labour hours 16,250 (b) Additional labour hours expended on impacted period work 1,500 (b-a) x x Average hourly labour cost €65 = = Damages due to productivity loss €97,500

#### Potential issues encountered when utilising the measured mile approach

##### Lack of an unimpacted period of work

Some projects are impacted by employer causes throughout the project from inception to final completion, thus, there is no baseline or unimpacted portion of work to be used in a measured mile calculation. In these circumstances, an alternate approach would be needed to quantify productivity loss. Alternatives include using the tender productivity factors as a baseline to the extent they can be established as reasonable. Other measured mile baselines include similar projects’ productivity factors.

##### Insufficient project productivity data or information

Contractors do not always maintain production records with enough detail to perform the calculations necessary for the measured mile approach. As in the above paragraph, an alternate approach to quantifying productivity loss would be necessary.

##### Comparability of the work

When selecting periods of unimpacted work, it is very important to select work that is comparable to the impacted work and performed under similar circumstances. An example of work that is not comparable is the installation of large and small bore pipe as compared to electrical cable tray installation. Another example is the comparison of straight runs of duct work with duct work for corners, bends and tie-ins. It is also important that the circumstances for the comparable work be similar. For example, changes in work crews or supervision could have an impact on productivity. Under these circumstances, an adjustment to the calculation is necessary to account for these changes.

##### Sufficient sample size

The work performed should be representative of the impacted work, from the standpoint of both the nature and the amount of the work. The nature of the work is covered in the above paragraph. Selecting unimpacted or less impacted work that comprises less than 5 per cent of the subject or impacted work may not be considered as representative of the work.

##### Isolation of negative variables in impacted work

It is important for the contractor to identify and isolate other variables that have the potential to affect productivity and are unrelated to the claimed impacts. Ideally, the impacts of these variables should be removed from both the impacted and unimpacted periods.

##### Industry/trade or scholarly studies

Second to the use of actual costs, the measured mile approach is the most preferred method for calculating a loss of productivity.[7] When the measured mile method cannot be performed, contractors have other options available. One such option is the use of industry/trade or scholarly studies. Although not the traditionally preferred method for quantifying damages resulting from lost productivity, studies have been used by contractors in the absence or insufficiency of contemporaneous productivity data. Studies can also be used as a tool to support the integrity of a contractor’s claim using other alternate methods, such as a measured mile or modified total cost approach.

Two commonly used studies to quantify damages due to labour inefficiencies are published by the Mechanical Contractors Association of America (MCAA) and the National Electrical Contractors Association (NECA). The MCAA study, entitled Factors Affecting Labor Productivity, lists 16 factors that may cause inefficiency, including overtime, stacking of trades and crew size inefficiency. Each of the 16 factors has a range of losses expressed in percentages for minor, average and severe. The percentages are added to the impacted labour costs to arrive at a damages amount. The NECA study, entitled Overtime and Productivity in Electrical Construction, is based upon a survey of electrical contractors. The study indicated how productivity was impacted by the varying levels of overtime. The source of the data presented in both the MCAA and NECA studies is based upon surveys of contractors and not an empirical study of actual job productivity.

The effect of overtime on labour productivity is the subject of two other well-known studies, the US Army Corps of Engineers’ Modification Impact Evaluation Guide and the Business Roundtable’s Scheduled Overtime Effect on Construction Projects. Both of these studies show the relationships between varying amounts of overtime to levels of productivity, and generally demonstrate that, as overtime is sustained, a continual decrease in productivity occurs.

Two additional studies, conducted and published by Charles Leonard and William Ibbs, analyse the effect of change order size, frequency and proportion on efficiency of contractor labour. Both studies note correlations between levels of productivity and number of change order hours.

Caution should be used when using any study to support a claim for loss of productivity, as they do not rely on actual project data or costs to quantify loss of productivity.

## Bond and insurance premiums

Bond and insurance premiums are often determined as a percentage of the contract price. As such, any bond or insurance increases anticipated on the claim amounts should be included in the quantum calculations.

Notes

1. Wiley R Wright III is managing director and Mark Baker is director at Secretariat International.
2. Others include the Manshul and Allegheny formulas.
3.  J F Finnegan Ltd v. Sheffield City Council, 43 Build. L.R. 124 (Q.B. 1989).
4. The Construction Lawyer, Volume 3, Number 1, Winter, 1982.
5. Alfred McAlpine Homes North Ltd v. Property & Land Contractors Ltd, 76 BLR 59 (1995).
6. Eichleay Corporation, ASBCA No. 5183, 60-2 BCA (CCH) paragraph 2,688 (1960).
7. Calvey and Zollinger 2003, W.G. Yates, U.S. Industries.

Practical insight from experts on the ground