Jean-Francois Djanett and Jean-Luc Guitera, Argos Construction, KPMG SA
This is an extract from the third edition of GAR’s The Guide to Construction Arbitration. The whole publication is available here.
Delay and disruption are commonplace in construction projects, significantly increasing overall costs and giving rise to numerous arbitrations. Coordination between those involved in the delay and financial experts is key for the accurate computation of damages.
This chapter presents an overview of technical and financial methods used in the context of a construction arbitration.
A construction contract places an obligation on the contractor to provide an asset defined in terms of quality and costs (i.e., the contractual price) within a specified time. Time for completion is of great importance both for the employer, as late delivery of the asset may entail loss of profit, and for the contractor, since an extended construction period usually entails additional costs and lower margins.
In this context, best practice suggests that contracting parties agree from the beginning (i.e., within the contractual provisions) on the type of records to be kept and on the tools to manage and measure the construction progress, including:
- the programming software, in order to share native versions of programmes, logic-linked in order to determine the critical path or paths;
- the critical path-based programme-impact methodology to be used for the application for extension of time; and
- the documents to be used and kept: programme records; progress records; resources and costs records; correspondence and administration records including technical records regarding transmittal and approval of all design documents; etc.
When a delay occurs, delay analysis is conducted to understand the root cause or causes of the difference between the initial forecast at contract inception (the ‘as-planned’) and the actual timeline of the construction (the ‘as-built’).
The difficulty of the analysis is threefold:
- there may be multiple causes (referred to as ‘risk events’) for the delay;
- the risk and responsibility for each cause needs to be allocated individually to the employer or to the contractor; and
- the impact or consequence of each cause is difficult to isolate as causes could interact with one another.
The as-planned – the baseline programme
The as-planned forecast should be agreed between the contracting parties as soon as practicable after entering into the contract (i.e., after the commencement date.) The as-planned forecast should be drafted by the contractor and submitted for the approval of the employer. It should set out a detailed programme, which includes the scheduling of works.
Once accepted, this detailed programme is often referred to as the ‘accepted programme’, or sometimes as the ‘initial detailed programme’, ‘initial contractual programme’ or ‘baseline programme’.
The accepted programme sets out the contractual completion date, which is often determined after taking into account various ‘floats’ (i.e., periods of excess time built into the programme as a precaution should a delay occur), as well as a ‘global float’. Together these floats define the maximum period of delay that can be sustained by the project’s critical path without impacting the completion date.
The baseline programme is based on a work breakdown structure (WBS), which organises the works required into manageable sections or tasks (by area, specialism, phase, etc.), and usually contains up to several thousands of activities or tasks. Baseline programmes are prepared using planning software, which usually presents the WBS vertically and time horizontally (Gantt Diagrams).
The most commonly used software are Oracle Primavera for large-scale projects (plant and infrastructure) and Microsoft MS Project for building construction projects. For linear infrastructure projects (such as roads, railways, pipelines and tunnels), specialised time-location diagrams, such as TILOS, are used that combine time vertically and location horizontally and represent the activities (workshops) in different colours.
A few practical tips when relying on dedicated construction programme software:
- If the file is not shared in its native (i.e., original) version, it needs to present the logical linkages between activities and to show the critical path and floats. It is not good practice for the contractor to present the ‘at the latest’ dates (last start, last finish) instead of ‘at the earliest’ dates (early start, early finish), as in the former the floats are not visible.
- Given that the programme is prepared after the commencement date, it could already take into consideration events that have occurred after the commencement date and that have created delays. Care ought to be taken not to include these events as the programme is meant to present the contractor’s initial forecast, ‘as planned’, at the inception of the contract.
The accepted programme is a relevant tool for the contractor to manage and organise resources ‘as-planned’ and to determine the initial budget (t0) or initial forecast. The initial budget is a useful point of reference from which actual costs differences can be assessed, as it will usually present an initial detailed costs forecast consistent with the detailed price breakdown presented in the contract. This initial budget will also be the basis for the estimate-at-completion (EAC), which is one of the main tools used to monitor the operational and financial performance of the contract.
The as-built – programme or data
In contradiction to the view that some practitioners may continue to hold, it is not acceptable, in a delay analysis, to rely on interim payment certificates to assess a possible delay in the works progress at a given date, even if many contractors present the ‘progress of works’ in percentage in their monthly reports in comparison to the initial forecast. The interim payment certificates mention exclusively the progress of the billing, and are not evidence of the progress of the works.
A proper delay analysis relies on the as-built logic-linked programme where available, or, if such a programme is not available, on the as-built data collected by the delay analyst.
The collection of relevant as-built data is a time-consuming task for the delay analyst, as there may be relevant information available in thousands of monthly reports, site reports, meeting minutes, site progress photographs or webcam footage, correspondence, costs records, programme records, site tests records, testing and commissioning records including certificates, etc.
It is usually also useful to consider the design documents database and all the detailed information, organised chronologically, regarding change or variation orders or requests.
Analysis of delays and risk events
There are two types of delay analysis:
- ‘cause-and-effect’ type analysis, in which the delay expert first considers a risk event as a possible cause for the delay, and then seeks to establish the impact of this identified event on the works schedule; and
- ‘effect-and-cause’ type analysis, where the delay expert first identifies the critical delay (the effect) and then seeks to establish the risk events that might have caused it.
The SCL Delay and Disruption Protocol states that the effect-and-cause type analyses are generally considered more reliable because they aim to take into account all potential causes of the experienced delay. Such an analysis allows the delay analyst to find multiple causes that might result in cumulative delays or concurrent delays.
It is worth noting that the overall impact of two successive causes (risk events) is not always the addition of the time delay caused by each event, even if both impact the project completion date. As an illustration:
- event 1 can have an impact of 20 days’ delay on an activity, but a critical impact delay – namely, on the time to completion – of only 10 days;
- event 2, occurring after event 1, can have an impact of 20 days’ delay on another activity and also a critical impact delay of 10 days; and
- the cumulative critical impact delay of event 1 and event 2 can be different from the sum of the stand-alone impacts of events 1 and 2 (20 days). It could be, for instance, a delay of only 15 days.
After having identified the effect-and-causes of the delay, the delay analyst has to determine the risk allocation according to the contractual provisions. The analyst will frequently present his or her technical opinion under certain legal assumptions provided by the instructing lawyers.
The causes for a delay can be either employer risk events or contractor risk events, depending on the contract that determines which party is responsible for each event.
Some risks and responsibilities are usually borne by the employer, for example the provision of access to the site. The contractor may claim for extension of time, cost and, under certain circumstances, a reasonable profit, if the employer fails to provide appropriate access to the site within the time periods stated in the contract. This allocation of risk is common under both contract for construction, plant design and build (FIDIC) contracts and also engineering procurement and construction (EPC) contracts.
The contractor may also usually claim for extension of time and cost if he or she encounters physical conditions that were unforeseeable, but this varies depending on the contractual provisions: under FIDIC contracts for construction and plant design and build this is the case, whereas in EPC contracts this type of risk is usually borne by the contractor.
It is worth mentioning that some risk events (such as adverse climatic conditions) might be defined in a contract as ‘neutral’ events, namely, allowing the contractor to be granted an extension of time, and therefore avoid contractual penalties for late delivery (liquidated damages), but providing the contractor with no entitlement for financial compensation.
Delay-to-progress and delay-to-completion
A delay-to-progress is caused by a risk event having an impact on the execution of the works without causing the contract completion date to be missed. This delay is therefore non-critical, but the risk event may nevertheless translate into additional costs for the contractor. If the responsibility of this risk event is attributable to the employer under the contract, then the contractor is entitled to financial compensation. Such compensation should correspond to additional costs (also known as ‘disruption costs’), but should not include associated time-related costs (as there is no critical delay impact).
A delay-to-completion is caused by a risk event that impacts the project’s critical path and will cause the contract completion date to be missed. When attributed to an employer risk-event, delay-to-completion usually leads to associated time-related costs (in addition to disruption costs), which, depending on applicable law and contractual provisions, should also form part of the contractor’s damages.
Critical delays (with an impact on the project completion date) might occur in situations when there is still a remaining ‘float’ in the programme (no impact on the contractual completion date). In this case, it is generally considered that the ‘float belongs to the project’. This means that the float does not belong to the contractor and, even if the event causing a critical delay is at the employer’s risk and responsibility, the contractor is generally not granted an extension of time.
Methods of analysis
As previously mentioned, we consider that the ‘effect-and-cause’ method of delay analysis is the most reliable. Guidance for its implementation can be found in two documents:
- the SCL Delay and Disruption Protocol mostly used in Europe; and
- the Association for the Advancement of Cost Engineering (AACE) Recommended Practice No. 29R-03 for Forensic Schedule Analysis – 2011, mostly used in the United States.
The AACE Recommended Practice presents 10 different ways to implement the effect-and-cause method.
The SCL Delay and Disruption Protocol presents three ways to implement the cause-and-effect method and three different ways to implement the effect-and-cause method, as shown in the table below.
When determining what method to use, the delay expert will need to keep in mind:
- the choice of a specific method will be based primarily on the contract provisions. If the contract specifies a specific schedule delay analysis method, the delay analyst will have to comply with the contract and apply it;
- if there is no method imposed in the contract, the delay expert ought to identify the events that occurred and consider if certain issues (such as concurrent delays, pacing delays, delay mitigation, acceleration, etc.) are relevant and may have led to concurrent delays;
- if concurrent delay is an issue, the chosen method ought to enable the separate identification and analysis of each delay;
- the choice of method will also be largely conditioned by the availability of reliable data;
- if there is no logic-linked baseline programme available, it will not be possible to implement the first three methods described in the SCL Delay and Disruption Protocol;
- if there is no as-built programme available, the use of the ‘retrospective longest path analysis’ and the ‘collapsed as-built analysis’ will not be possible. If there is only as-built data available, only the ‘as-planned versus as built window analysis’ will be possible. This latter method is commonly used and preferred over the ‘impacted as planned analysis’, which is the simplest method but only relies on the baseline programme (which needs to be assessed and rated as consistent and flawless); and
- the dynamic methods – times impact analysis and time slice windows analysis – need update programmes to be available or sufficient information with which to update the baseline programme. These methods allow the identification and analysis of concurrent delays as they enable the measurement of the delay impact of individual events independently from other events. The latter method allows the determination of delay impacts retrospectively while the former is a prospective method in which to model delay events.
Whatever the chosen method, the analyst will have to present a relevant and simple flow diagram of causes and consequences.
Output of the delay analysis
Through his or her technical analysis, the delay expert will provide the financial expert with a detailed assessment of the different nature of delay events and a quantification of their impact, in relevant units, which the financial expert can then use to value and determine the costs or damages.
The delay expert will have to assess what are the successive delays to completion (or the part of the global delay to completion) resulting from the employer risk events that entitle the contractor to extension of time and to relief through the possible award of damages.
The delay expert will also have to carefully identify the actual periods in which said risk events have had their effects and which consequences of risk events give right to a financial compensation for the contractor.
Indeed, there is no automatic link between the entitlement to an extension of time and the entitlement to monetary compensation. Financial compensation may be sought under other contractual clauses than the ones providing entitlement to an extension of time.
The delay expert will have to carefully examine the increase of time related costs and to allocate it among various components: time for mobilisation or installation, demobilisation or withdrawal/removal and real time-related costs for rental, maintenance, etc.
The delay expert will also have to carefully examine the project management costs, as they are often presented globally, and to distinguish between variable people time costs (which depend on the project duration) and people time costs relating to a specific and discrete task (such as testing and commissioning officers or design engineers).
Once the delay expert has identified the delay events, attributed technical responsibility for them to the employer or the contractor and quantified them in physical or temporal units (additional hours spent, tons of concrete poured, etc.), it is the role of the financial expert to quantify the damage in monetary units based on the findings of the delay expert.
As a reminder, the award of financial damages aims to place the claimant back in the situation it would have been in the absence of the damaging event. Therefore, and in the absence of specific provisions in the contract, the award of financial damages to the contractor may include, at the tribunal’s discretion:
- the costs incurred by the contractor that it would not have incurred in the absence of the damaging event; or
- in addition to costs incurred, the loss of profit resulting from the damaging event, this loss being, depending on the specifics of the situation, a lost profit (if the damage is related to supplementary work as defined in the contract) or a loss of opportunity to make a profit (if the employer was deprived of the opportunity to service other potential projects and earn profit on these).
We will consider in sequence:
- how financial information related to a given project is recorded in the contractor’s financial statements;
- how the costs of a specific event can be traced in the accounting records (the ‘bottom-up approach’);
- if an allocation of overhead costs should form part of the determination of damages;
- how the project financial estimate at completion can be used to identify the existence of cost overruns at project level (the ‘top-down approach’); and
- what the appropriate basis is for indemnification (costs or costs plus a profit element).
How is financial information related to a given project recorded in the contractor’s financial statements?
The accounting information related to construction projects is usually recorded through projects accounts, the sum of which correspond to a great extent to the operating margin section of the profit and loss account of the contractor’s financial statements. These statements are prepared under accounting standards such as International Financial Reporting Standards (IFRS), or the US Generally Admitted Accounting Principles (US GAAP), and are generally subjected to an independent audit performed by an accounting firm, which gives them a measure of reliability.
For construction contracts under both US GAAP and IFRS, contract related costs and revenue can be recognised throughout the execution of a project, provided that the following conditions are met:
- first, the company must have implemented accounting tools and processes so that costs related to a given project are properly allocated to said project; and
- second, the company must be in a position to reliably estimate and quantify the remaining effort necessary to complete the project.
The basic principle behind project accounts is that the cumulative revenue and expenses recognised for a given project since its inception must always be equal to the total revenue and expenses at the end of the project as estimated by the company, multiplied by the percentage of completion of said project as at the financial statements’ date.
At project level, the cost accounting system (run in parallel to and reconciled to the general accounting system used for the production of the company’s financial statements) provides information in relation to project costs incurred to date. The project manager, with the assistance of the project financial controller, is responsible for the quantification of the remaining effort to complete the project. This quantification needs to be regularly updated during project reviews, which is usually performed at least once a year for the production of the annual financial statements.
In addition to cost and revenue estimates at completion, project reviews also generally address the following topics in relation to a given contract:
- overall presentation of the project;
- main contractual changes since the previous project review (amendments, change requests, variation orders, etc.);
- execution of works during the period under review, including update of execution planning for remaining tasks, completed and remaining milestones, etc.
- risks and opportunities foreseen up until completion of works;
- significant items of discussion with the employer, the contract administrator and subcontractors;
- detailed analysis of project costs incurred to date, including discussions of deviations against previous estimates; and
- main assumptions employed for the estimation of remaining efforts necessary to complete the project.
There is usually a formal internal review process during which the assumptions employed by the project manager are challenged and financial information (including assessment of remaining effort) is reviewed and validated. During their audit of financial statements, the statutory auditors will, on a sample basis, independently review and challenge the assumptions underlying such project reviews.
The approved project review represents the company’s best estimate, as at the date of the review, of the operational execution, and of revenue and project costs up until project completion date. From a financial perspective, the project reviews form the basis for the production of annual financial statements.
Therefore, project reviews provide a contemporaneous and reliable view of the operational and financial performance of the contractor with respect to the contract.
The projects accounts, on the other hand, show the individual entries booked in relation to the resources being used and the revenue being recognised.
How can the cost of a specific event be traced in the accounting records (the ‘bottom-up approach’)
Since the award of damages should compensate additional costs incurred by the contractor resulting from risk events that the employer was responsible for, in most situations the financial expert should be able to rely on the project accounting data to:
- confirm the quantification of additional resources as identified by the delay expert; and
- to estimate corresponding damages.
For instance, if the delay expert concludes that the contractor has incurred 10,000 additional hours because of risk events over a given period, the accounting data should show at least an equivalent number of hours charged to the project over such period.
Since project reviews present an accurate assessment of costs incurred to date on the project, they often also provide a reasonable estimate of unit costs for these additional resources. Generally, contractor’s employees charge their hours to projects through timesheets. Internal processes and controls exist at project and company levels to ensure that the hours charged to a given project through timesheets fairly represent the actual effort incurred over a given period. Actual hours charged to the projects are in a second step valued using daily or hourly rates.
Most accounting standards do not provide a detailed methodology to determine such rates, but in practice the rates usually represent the direct costs of the employees (salary, benefits, and social charges) and their direct ‘environment’ cost, such as the cost of their desk space, the depreciation expense of IT equipment, etc. The contractor usually uses standard labour rates, based on budgeted costs for a category of personnel. Such standard labour rates are compared at least once a year against actual costs, and where significant divergences exist, total project costs are revalued based on actual costs.
The financial expert may decide to base his or her quantification of damages on labour rates derived from project reviews, but he or she should nevertheless check the detailed components of such rates in order to avoid double counting, and enquire about any revaluation of such rates based on actual costs incurred by the contractor.
Similar processes and controls exist in relation to subcontractors’ costs and materials and equipment costs recorded at project level. This accounting information should represent an appropriate basis to confirm the existence of additional costs incurred by the contractor and to enable their quantification.
In addition, in situations where additional resources correspond to the prolonged use of contractor’s own assets (e.g., a project crane kept on project site for three additional months), the depreciation expense for such extended period could, in most cases, represent a reasonable basis for the estimation of the contractor’s damages. Indeed, from an accounting and financial perspective, the depreciation expense corresponds to the cost of the asset allocated over the useful life of said asset.
Should an allocation of overhead costs form part of the determination of damages?
There are two categories of overhead costs: site overheads and HQ overhead costs.
Site overhead costs directly relate to the realisation of the project and the financial expert should retain such costs when quantifying damages. As mentioned above, when adding such costs to the damage assessment, the financial expert should nevertheless verify that such costs have not already been included in the project direct costs through labour rates.
HQ overhead costs represent central or head-office costs that cannot be directly allocated to projects. Certain contracts provide a detailed price breakdown evidencing an explicit percentage of overhead costs and profit. In such situations, contractors and employers usually use these percentages for the price determination of contract change orders. However, from a cost perspective, there is no direct relationship between costs incurred on a project and the total amount of HQ overhead costs incurred at company level. This is particularly true when addressing disruption costs with no prolongation of the contract execution period. Addressing extended negotiation periods with the employer and dealing with additional orders with subcontractors does not imply an automatic increase of contractors’ head office costs.
HQ overhead costs exist independently of the realisation of the project, and risk-events at project level are usually unlikely to affect total HQ overhead costs at company level.
Therefore, from an economic point-of-view, HQ overhead costs represent a portion of the project margin realised by the contractor, this margin having two components, one related to HQ overheads coverage and the second representing the profit on the contract. We will further develop this issue in the final section of this chapter.
How can the project financial estimate-at-completion be used to identify the existence of a cost overrun at project level (the ‘top-down approach’)?
Project reviews provide estimates of the overall project margin at different points of time throughout the execution of the contract. The first estimate is usually performed after the award of the contract and shortly after the project ‘handover’ to a project manager. This first estimate is usually run in conjunction with the contemporaneous project planning and integrates the technical solutions employed by the contractor for the execution.
As mentioned above, project reviews are regularly updated throughout the execution of the project (at least once a year for the production of financial statements). These reviews involve the project team preparing and documenting revised estimates of costs and revenues at completion.
To the extent that any claim resulting from risk events is material to the contract, the financial expert should be able to evidence a degradation of margin throughout the various project reviews.
In our view, this analysis of the evolution of the overall project margin forms a reasonable cross-check for the financial expert’s conclusions. However, such test, in isolation, is insufficient to conclude on the reasonableness of the claim assessment. There are, indeed, many reasons why the project margin may fluctuate, not all of them related to risk events attributable to the employer. However, when combined with the analysis of contemporaneous explanations of project margin fluctuations provided by the project team to company management (or to its auditors), such test should reinforce the credibility of most material claim estimates.
There are sometimes situations where a delay may exist but where the overall project margin was unaffected or not apparently affected. This could result from several situations:
- a significant error in the first estimate, which occurred upon project handover. Although this is an easy explanation, it should be thoroughly substantiated because, in principle, any company applying contract accounting is supposed to have implemented tools and processes to accurately forecast its project costs and revenues;
- a change in the timing when an expense is incurred (for example engineering labour cost), but where the overall amount of said expense category over the life of the project stays the same as originally planned;
- a project margin improvement owing to changes in circumstances or changes in the project execution that the company would have secured even in the absence of the damaging event. Although such situations could exist from a theoretical standpoint, we believe that the financial expert should further investigate and document these situations and ensure that the quantum presented to the tribunal is a fair representation of actual damages incurred by the contractor; and
- a project margin improvement, which is the consequence of the damaging event (such as a decrease in raw material costs) that the company could not have secured but for the damaging event. In such situations, the financial expert should liaise with the legal team to determine whether the quantum of the claim ought to be adjusted to account for the positive margin impact of the damaging event.
What should be the basis for indemnification? Costs or costs plus a profit element?
As mentioned earlier, the role of the financial expert is to quantify under certain assumptions (legal as communicated by counsel, and technical as communicated by the delay expert) the sum of money that would be necessary to put the contractor back in the financial position it would have been in the absence of the damaging event.
Three situations may exist in this regard:
- the damage only consists of additional costs that would not have been incurred by the contractor but for the damaging event. In this case, the quantum is likely to be based on directly attributable costs only (which include site overheads, but not HQ overheads);
- the damage involves supplementary work that has not been invoiced. In this case, the quantum is likely to be based on the additional price that the contractor would have charged the employer for such work (which might be set out in the contract in some cases, or might need to be calculated from relevant data); and
- the damage relates to the inability of the contractor to carry out services for another project, as the workforce was engaged in the performance of the contract in question. This scenario relates to a ‘loss of opportunity’. In such situations, the contractor could be entitled to damages that include his or her HQ overheads cost, and under certain circumstances, to the profit relating to the lost opportunity.
In our view, and with the exception of certain specific situations, HQ overhead costs can only be included as part of damages to the extent that, because of the extended execution period of the project, the contractor was not in a position to obtain and carry out other projects that would have allowed the absorption of such overhead costs. This position is similar to the one expressed by the Society of Construction Law:
In order to succeed in such a claim [i.e., adding HQ overhead and profits to the directly attributable project costs], the Contractor must demonstrate that there was other revenue and profit earning work available which, in the absence of the Employer Delay, would have been secured by the Contractor.
It therefore follows that there is no basis for a systematic and unsubstantiated inclusion of HQ overheads in damages calculations and that the contractor must be in a position to demonstrate that, but for the damaging event, it would have earned revenue from additional projects.
In this situation, and contrary to the Society of Construction Law, we do not believe a formula is necessary to determine the level of unabsorbed overheads. One should refer to the accounting data where such costs are identified, compute the ratio between the direct cost at business unit or company level (depending on the specificities of the case) and the HQ overheads, and apply the same ratio to the additional cost being claimed.
Moreover, there may be situations where the proper compensation for the contractor will not be limited to unabsorbed overheads but should include the full lost margin (HQ overheads plus profit) that the contractor could reasonably have expected to earn from additional projects that he or she was not able to bid for, multiplied by the probability of winning such contracts.
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