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Management of Construction Contracts
Variation [Change] Orders
by Gursharan Singh
1.0 INTRODUCTION
1.1 Pricing of Building Construction contracts are generally based on Bills of Quantities [‘BOQ’] or Provisional Quantities [‘PQ’]. It is common for these contracts to have changes/modifications that will result in the original quantities changing and thus be subject to re-measurement. Similarly pricing of Infrastructure Construction contracts are also generally based on ‘PQ’ that need to be re-measured and normally vary on completion of the works. The variance due to these changes will affect the original contracted value of the contract. The financial implication of the resultant variance in quantities is brought to account through the issuance of Variation [or Change] Orders [‘VO’]. The ‘VO’ can cause the cost of contract to either increase or decrease.
2.0 DEFINITION OF VARIATION
2.1 The definition of a variation has been has been stated by legal and technical professionals involved in construction contracts as follows:
[a] Any alteration or modification of the design, quality, quantities of the Works as shown in the Contract Drawings and Specifications;
[b] Addition, Omission or Substitution of any work;
[c] Alteration of the Kind or Standard of any building Materials or M & E Components that are incorporated in the works;
[d] Removal from Site of any Work, Materials or Items executed or brought by the Contractor for Purposes of the Works but excluding those not relevant to the Contract or arising from remedies of defective works; and’
[e] Changes should be directed for implementation during the contract period. Any change ordered after the completion of the contracted works may not be defined as ‘VO’; and
[f] Increased costs due to introduction of new laws, changes to existing laws and any conditions that may be imposed by Local Authorities may be defined as ‘VO’ but subject to any prescribed conditions in respect of this aspects.
OBJECTIVE OF THE ‘VO’ CLAUSE
3.1 The main objectives of the clause pertaining to the clause for ‘VO’ are:
[a] To authorize the Client to make changes to the original scope of works that is legally binding on the contractor as has been prescribed. Absence of such a clause in the contract could make the ‘VO’ legally ineffective and the contractor could reject it.
[b] To provide authority to the Superintending Officer [‘SO’], also designated as ‘Engineer’, to direct contractor to implement changes to any existing scope of works. ‘VO’ can be ordered verbally but it must be followed with a written authorization that should be issued within the shortest possible time. This is important as a ‘VO’ is only legally binding if it is in writing. A written ‘VO’ entitles the contractor to additional payments for any additional works and it also entitles the Client to reduce the original contract sum by the value of the omitted works.
[c] To ensure that the contractor implements the ‘VO’. A written ‘VO’ does not invalidate a legally binding contract and does not provide the contractor the authority to refuse implementation of the works directed under the ‘VO’ or reject the contract.
3.0 VALUATION BASIS OF A ‘VO’
4.1 Valuation of any ‘VO’ is based on the following principles:
[a] The prescribed rate will apply for any work for which there is an existing rate in the ‘BOQ’. This is subject to provisions that the work is similar in character and working conditions.
[b] The Infrastructure Works contracts are accompanied by Schedule of Rates ‘SR’. The relevant ‘SR’ is required to be used to compute the value of the variance of the specific type of work.
[c] In the absence of any prescribed rate in the ‘BOQ’ or ‘SR’, the valuation of a ‘VO’ will need to be computed and agreed by both parties. A schedule listing Day Work Rates [DWR’] is included for this purpose in contract documents. The schedule provides ‘DWR’ for components that would be needed in any work. The basis of computation will need to be justified by substantiation with documentary/supporting evidence regarding its reasonability.
[d] An element of Preliminaries [Mobilization] cost may be taken into in computation of ‘VO’ arising from the difference between the Prime Cost Provisional Sum and the final cost of implementation of specialized works such as Mechanical & Electrical components.
[e] Changes made after the completion period may be subject to negotiated rates even when their may be a ‘BOQ’ or ‘SR’ rate for the scope of works.
4.0 PAYMENT FOR ‘VO’
5.1 The contractor will be entitled to payment for any ‘VO’ the cause of which is attributable to the Client. However, in most cases it is not possible to ascertain the final cost of the ‘VO’ due to its large quantum, the length of period for the ‘VO’ to be completed or reaching agreement on the basis of computation of the ‘VO’. In such cases, it is normal and practical to issue ‘Provisional Valuation Order’ [‘PVO’] with a final measurement to be done when the whole works are completed. The objective is to authorize payments to the contractor.
5.2 The contractor may be entitled to compensatory payments in the event of delay in issue of a ‘VO’ when such delay is caused by the client and/or the implementation period is long.
6.0 EXAMINATION OF ‘VO’
Responsibility
6.1 It is mandatory that all claims for ‘VO’ are justified and substantiated by supporting documentation. It is the responsibility of the ‘SO’ to examine the computation of all ‘VO’ before they are approved or recommended for approval and forwarded to the relevant authority. The extent of examination would differ in accordance to the extent of the variance to quantities and whether it is an addition or an omission. Any marginal differences to the original quantities and the resultant financial implications do not need any further in-depth study.
Substantial Variance to Quantities – Financial Implications
6.2 It is important that the individual rates be referred to in the event of any substantial increases or decreases to the original quantities as shown in the original ‘BOQ’ or ‘SR’. It is a common pricing strategy of contractors to over price items of work where the original quantities stated in the ‘BOQ’ or ‘SR’ are small but could be subject to substantial increases in the future. Similarly quantities of items of work that are likely to reduce would be under priced. Thus the substantial increases/decreases would not be in the best interest of the Client. It is generally a rare case there the contractor would over price items expected to decrease and under price items with possibility of any increase.
Weaknesses/Shortcomings & Fraudulent Opportunities Possibilities
6.4 It should be noted that the ‘SO’ [and others involved of the tender evaluation and approval of the ‘VO’] could be susceptible to bribery/corruption. In cases where the management of contract is outsourced to private technical professionals [Project Manager, Architect, Engineers, etc.] any reduction in total cost of the contract would reduce their quantum of professional fees where it is agreed to be computed as a percentage of total contract costs. Thus there could exist conflict of interest situation.
7.0 NEW WORKS AS ‘VO’
7.1 Additional scope of works that differ substantially from the original scope of works generally cannot be authorized as ‘VO’. However, the additional works may be approved for implementation as ‘VO’ if it can be substantiated that it benefits both parties, is cost-effective and cost-efficient and would be subject to consent of the contracting parties. However, both parties should be aware that it will have other legal and financial implications and take appropriate remedial measures. The ‘implications’ refer to extensions of completion period and defects liability period, taking of supplementary insurances and possible increase in the value and period of financial safeguards [performance bonds, bank guarantees,] etc.
7.2 Benefits could include substantial reduction in costs of mobilization costs [for facilities that already exist] early completion of the additional works due to time savings in avoidance of tender invitation and award procedures, addition business for the contractors/suppliers, etc. One example is quoted below.
[a] The construction of approach roads at both ends of a bridge that was over 13km length of waterway was estimated in-house to cost USD242.0.0m. The bids received from three short listed contractors were valued between USD242.0m and USD251.0m. The Tender Evaluation Committee [‘TEC’] comprising of technical and financial professionals recommended the acceptance of the bid valued at USD242.0m. The auditor requested the Project Director [‘PD’] permission to view the report of the recommendation though this is not the practice for the auditor to have access to documents prior to the award of any construction contract as this could be construed as pre-audit and interference with the management functions. However, in this case the ‘PD’ agreed due to the past good relationship between the two.
[b] The auditor’s initial scrutiny of the evaluation report revealed that the lowest acceptable bid was valued at USD182.00.0m. An in-depth scrutiny of the detailed bid showed that the cost of ‘Mobilization’ was entered as only USD5.0m compared to the in-house estimate where the cost of ‘Mobilization’ was stated as USD65.0m and other contractors had bid between USD65.0m and USD75.0m. The high cost of ‘Mobilization’ was due to the need for specialized floating equipment that was essential and needed to be sourced from foreign countries and brought by sea. The reason for the low cost of ‘Mobilization’ was stated that the specialized equipment and all other facilities were readily available from the ‘Bridge’ works contract that was then in final stages of completion. The USD5.0m was to maintain them during the roads construction period. The resultant savings were being passed on to the Client. The cost of the ‘Construction’ aspect was stated as USD177.0m by the lowest contractor that was within the in-house estimate and lowest among all the other bidders. This information had been provided by the lowest bidder.
[c] The ‘TEC’ had rejected the lowest bid even though it was aware of this material information. The ‘PD’ informed that the ‘TEC’ had rejected the lowest bid without any evaluation citing two reasons as follows:
[i] The price variance of the lowest bid of USD182.0m was over 20% of the in-house estimate thereby indicating that the contractor may not be able to complete the construction of the roads at such low cost.
[ii] The ‘Road’ scope of works was not within the ‘Bridge’ scope of works and thus could not be issued as a ‘VO’ to the ‘Bridge’ contractor.
Both the reasons were in line with the existing approved policies and procedures.
[d] The ‘List of the Received Bids’ showed that this bid was submitted by the contractor who was responsible for the construction of the bridge that was valued at USD600.0m. The ‘PD’ confirmed that the ‘Bridge’ construction contract had been implemented satisfactorily and that the contractor had the technical expertise to complete the ‘Road’ works within the bid sum of USD182.0m. The ‘PD’ recommended to the Client to award the ‘Road’ works contract to the lowest bidder as a ‘VO’. The recommendation was approved resulting in substantial savings.
7.3 There could be payments to contractor that are compensatory in nature and classified as ‘VO’ and its cost included in the final contract value and paid to the contractor. While the contractor would be entitled to the compensation, this amount should not be included in the ‘Cost of Contract’ for computation of professional fees that would be payable to technical consultants. Example of such a payment is as follows:
[a] A client had to pay USD6.0m [plus ancillary costs totaling USD22.3m that were substantiated by documentary evidence] due to his inability to hand over the sight for piling works that could not be commenced due to site problems that resulted in changes to piling design. The technical consultants included the USD28.3m as ‘Cost of Works’ and claimed additional professional fees amounting to USD2.9149m being 10.3%. Based on the auditor’s view that this ‘VO’ amount of USD28.3m was ‘compensation’ and thus not subject of professional fees, the Client referred the matter to legal experts who agreed with the auditor’s view. Though the over claim quantum was confirmed, the client could not recover the interim payment amounting to USD1.4m that had already been approved and paid.
8.0 RECOMMENDATIONS
Rationalization
8.1 It is important that the over/under pricing of individual items in ‘BOQ’/’SR’ be prevented prior to the acceptance of any tender. This can be done by rationalization of the individual rates during the evaluation of tenders when it should be ensured that the individual rates are priced reasonably to reflect current market rates. Another method would be to provide rates based on sliding scale of quantities whereby the rates of small quantities could be high whereas it would be lower for higher quantities.
Justification
8.2 It is important that any claim in respect of works that are classified as ‘VO’ are justified for payment to the contractor and also to any professionals [technical or others] whose professional fees is to be based on contract costs that may include the ‘VO’ value.
Monitoring
8.3 It is important that the Client be aware and ensures that the contract is monitored independently from inception to its final completion. This can be done by the internal auditors and other members of the management by asking probing questions from those involved.
Documentation
8.3 Substantial valued ‘VOs’ are generally susceptible to disputes. Thus it is important for both parties to ensure that relevant documentation is fully supported, comprehensive, systematic, indexed and maintained safely at all times from inception to final settlement of the ‘VO’.
9.0 CONCLUSION
9.1 The Clients delegate the monitoring responsibilities to their technical professionals with the expectation that their interests would be safeguarded. However they should ensure that there are checks and balances in the forms of internal controls that should be complied with. Any neglect of monitoring the compliance could prove financially disastrous to the Client. It should be remembered that the policies, procedures and internal controls are for compliance and not for cosmetic purposes. Also they should be scrutinized regularly and revised as and when necessary.
All Policies, Procedures and Internal Controls are Useful only if Implemented
They are for Guidance and not Blind Compliance
GSK/May 05
[The writer welcomes any comments/criticisms on the contents of this article]
- GURSHARAN SINGH C.M.I.I.A.
[Trainer – Retired Audit Officer]
116 Jalan Hujan Manik, O.U.G. Jln Kelang 58200 Kuala Lumpur
[Tel. No. [H] 03-79824492 [E-mail: gsk38@hotmail.com]
- The opinions, beliefs and viewpoints expressed by the various authors and forum participants on this web site do not necessarily reflect the opinions, beliefs and viewpoints of AuditNet®
