The Good, The Bad and the Ugly

by Bernard S. Kamine

ECA Legal Counsel

Here's a trio of legal notes of interest to contractors and public agencies. The good: Caltrans CPA Audit Desk
Guide. It has a clear and succinct explanation of home office overhead delay issues. The bad: City of Santa Monica. It has
arrogantly rejected the level playing field and lowest responsible bidder concepts and, instead, has adopted favoritism and
stacked decks as the method for awarding public works contracts. The ugly: Change orders that extend contract time but fail to
cover general requirements (also called fixed field costs or field overhead) and home office overhead.

The Good: Caltrans CPA Audit Desk Guide

In an effort to improve its contract administration, Caltrans employees Phil Kiefer, Guy Harris and Tony
Hamamoto have produced a CPA Audit Desk Guide for evaluating contractor delay claims. It has a great discussion of
construction project home office overhead issues.

First, it defines home office overhead (HOO) and identifies the usual method for allocating the fair share of HOO
to a particular project: "HOO generally refers to indirect costs that are not associated with any specific project. HOO is also
referred to as general and administrative (G&A) expenses. The Eichleay formula is a method of allocating G&A expenses to the
project for the project performance period based on the relationship of the project to all of the contractor's projects during the
same period."

Then, Caltrans' guide explains why unabsorbed (or under-absorbed) home office overhead should be paid to
contractors when contract completion is delayed by events or conditions for which the owner is responsible: "When a contractor
submits a fixed-price bid on a construction contract, the contractor reasonably expects a certain flow of revenue from the
contract. This expectation is based upon the contract price, the progress payment provisions, and the scheduled performance
period. The contractor expects this flow of funds to absorb or compensate for a portion of the contractor's fixed home office
expenses during the contract time period. If the owner suspends work on the contract, the contractor will be unable to receive
progress payments at the anticipated rate of pay. The contract price has been fixed, but the extended contract period reduces
the flow of payments and extends the overhead costs due to the extended contract time. If the contractor's standby is of
uncertain duration, the contractor may be unable to demobilize from the site and utilize its resources to perform other work. If
demobilization is not done, the contractor would have less available revenue with which to meet its fixed expenses. This is the
unabsorbed (or under-absorbed) HOO that is measured by the Eichleay formula."

Finally, Caltrans' guide lays out the Eichleay formula:

The Bad: City of Santa Monica

Santa Monica rejects the vast American experience proving that the public is best served when contracts are
awarded to the lowest responsible bidder. Instead, Santa Monica has opted for the stacked deck and favoritism as the way to
award its contracts.

For over 100 years, California law has required cities to award public works construction contracts, over certain
threshold amounts, to the lowest responsible bidder. The current statute is Public Contract Code § 20162; it requires contracts
over $5000 to "be contracted for and let to the lowest responsible bidder after notice." Absent conflicting language in a city charter
or city ordinances, the Public Contract Code requirement applies to charter cities like Santa Monica (Pub. Cont. Code § 1100.7).
Santa Monica contends that its charter and ordinances have such conflicting language. Therefore, the city contends it can, and
apparently often does, reject the lowest responsible bidder for a higher priced bidder who is favored by city staff.

In a recent case the engineer's estimate for a reservoir rehabilitation project was $725,000. The lowest bid was
$725,125. At the time, the low bidder was working with the city's outside design firm on a much larger project in another county;
the outside design firm had recruited the low bidder for the Santa Monica project. The second low bid was $877,750 - in other
words, $152,625 or 21% higher. Most of that $152,625 was the difference in price between a pipe supplier who thought it had a
lock on the job, and another pipe supplier located by the low bidder. City staff admitted, and the city council found, that the low
bidder was "responsible." Nonetheless, the contract went to the second low bidder, because staff believed it could work better with
that bidder.

In other words, staff wanted the city to pay 21% more to assure staff a smooth and quiet job. Academic research
into bureaucracies has discovered that staff interests often conflict with the interests of the public. The public wants the best
prices. Staff wants jobs to go smoothly, so staff will not have to explain problems to the governing authority or the press. This
appears to be what is happening in Santa Monica. Another contractor, who does a lot of work in the city, reported that he often
gets jobs as the second or third lowest bidder, because, staff has told him, they like working with him.

Of course there may be other reasons for the city to throw away money by giving jobs to the 2d or 3d lowest
responsible bidder. Public Contract Code § 100 explains why contracts must be awarded to the lowest responsible bidder: "To
provide all qualified bidders with a fair opportunity to enter the bidding process, thereby stimulating competition in a manner
conductive to sound fiscal practices. . . . To eliminate favoritism, fraud, and corruption in the awarding of public contracts."
Apparently, these public policies are not important in Santa Monica. Some other not-so-public policies appear to control.
Taxpayers and contractors beware!

The Ugly: Change Order Markups Failure to Cover Time-Related Costs

Contractors include money in their bids for general requirements (fixed field costs or field overhead), which are costs
that are a function of time on the job, not the quantity of work being performed, e.g., the superintendent, his truck, any job site clerk,
the job site office, office supplies, and other similar expenses. The bid only includes those costs for the period of time that the
contractor expects to be on the job site. In addition, as the Caltrans CPA Audit Desk Guide points out, the bid also only includes
the share of the home office overhead the job is expected to carry for the time that the job is expected to run.

When a contractor bids on a contract that has a changes clause, it must anticipate the possibility of changes.
However, the contractor includes no money in the bid for possible changes. There is no way to estimate changes before they are
requested. Besides, the typical changes clause assures that the contractor will be paid for the changes. Payment will be at a
negotiated amount, and if negotiations fail, payment will be made for all of the labor, equipment and material consumed by the
change, plus overhead and profit. The "overhead" attributable to a change is not only the administrative expenses involved in every
change order (e.g., pricing the change, scheduling and supervising the change work), but also, when the change order extends the
contract time, the costs that are a function of the extended time (e.g., general requirements and, sometimes, unabsorbed or
underabsorbed home office overhead).

Greenbook § 3-3.2.3 assures that all elements of "overhead" will be covered: "Unless otherwise provided in the Special Provisions, a
reasonable allowance for overhead and profit shall be added to the Contractor's costs as determined under 3-3.2.2. [for labor,
equipment and materials costs] and shall constitute the markup for all overhead and profit on work by the Contractor." To be
reasonable, that allowance must include not only the administrative expenses involved in every change order, but also, when the
change order extends the contract time, the costs that are a function of the extended time.

However, most Greenbook users avoid the § 3-3.2.3 "reasonable allowance" by specifying percentage markups for
overhead and profit in the Special Provisions. Few change orders impact the project duration, thereby requiring time extensions.
Most change orders just modify the scope of work without affecting time. The Special Provisions markups are established for the
typical change order. Thus, those markups only cover the administrative expenses associated with change orders (e.g., pricing the
change, scheduling and supervising the change work). Those markups are roughly fair: Generally, the more labor, equipment and
material required for the change, the greater the administrative expenses will be. And, roughly correspondingly, the more labor,
equipment and material required, the more dollars will result from applying the Special Provisions markup percentages. Sometimes
those markups are tiered on the theory that doing so makes the result more likely to correspond to actual increases in administrative
expenses.

There is no way those percentage markups can cover costs that are a function of time. Time extensions required
by changes are unique to the particular change, often depending not upon the changed work, but when the change hits the job. The
time impact has little if any relationship to the quantity of labor, equipment and material needed, so there is no relationship between
the dollars produced by the percentage markup and the dollars needed to cover time-driven costs.

When these changes are negotiated, the contractor should receive compensation for increased general requirements (fixed field costs
or field overhead) and, in appropriate cases, for any resulting under absorption of home office overhead. When negotiations fail, the
typical time and material change order with the Special Provisions-type of percentage markups, does not cover general requirements
or home office overhead. As a result, the contractor is deprived of legitimate costs of delay. Until the Greenbook and other contracts
can be changed to recognize this fact, contractors must point out to agencies that depriving them of those delay costs makes the
Special Provisions-type percentage markups a limited no-damage-for-delay clause. Such clauses are specifically prohibited by Public
Contract Code § 7102 and Howard Contracting, Inc. v. G. A. MacDonald Construction Co., Inc. (1998) 71 CA4th 38, 49-52, 83 CR2d
590.