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The Sad Truth about Overheads and Profit Claims When a Contractor becomes entitled to reimbursement for delay to his Works it is settled law that he may recover the return that he would have achieved on other work had his resources not been detained on the Works due to the delay. Amongst other heads of claim, that includes: Head Office Overheads and Profit (HOP). The HOP element of such a claim is often a significant sum. Three formulae have been traditionally used in calculating such loss. Unfortunately all of them have suffered crucial defects in their use in practice. The Hudson Formula has long been said to be discredited due to the duplication of recovery that flows from its use; although it was approved by the courts in 1989 [J F Finnegan v Sheffield CC]. In particular, it is criticised for the assumption in it that the HOP percentage allowed in the tender was also what the Contractor's business would have achieved elsewhere during the delay. An assumption commonly found not to be true. I should point out that the assumption just mentioned is what many commentators have said is a failing in this formula compared to the Emden Formula of which more later. An examination of the eleventh edition of Hudson's Building and Engineering Contracts and the sixth and later editions of Keating on Building Contracts will show that the modern description of the Hudson Formula does not necessarily involve the tender HOP percentage. The phrase now used is 'a fair annual average' for HOP and the formula applies that to the contract sum divided by the original contract period to give the loss to apply to the reimbursable period of delay. The Emden Formula applies the average HOP that was achieved elsewhere by the Contractor's business as a whole to the reimbursable period of delay. However, like the Hudson Formula, it assumes that the average weekly contract turnover anticipated at the outset of the Works would also be true during the period of delay. Duplicated recovery is similarly inherent in the use of this formula, especially if there has been additional work that has been valued so as to include the HOP inherent in the Contractor's pricing. It seems to me that the 'modern' version of the Hudson Formula should be preferred to the Emden Formula because the latter incorporates the return on the Contractor's business as a whole without any investigation into the adjustments that should be made before doing so. Although different, the Eichleay Formula also assumes an average weekly turnover but this time it is derived from the final billings for the Works in question and the actual instead of the anticipated period to do that Works. It applies the Contractor's HOP for his whole business during that actual contract period to the proportion that the billings for the Works has to the Contractor's billings for his whole business in the same period. That gives the recovery of HOP to be achieved from the final Works. When divided by the actual contract period, less reimbursable period of delay, in days say, we get the assumed daily HOP to apply to the days of delay for which compensation is sought. It has the advantage over the foregoing formulae in that the HOP recovery inherent in the contract pricing is not duplicated in the formula's result, but otherwise the same duplications are inherent. It is possible to weed out the duplications in all these formulae but if done properly it is a time-consuming exercise for all but the simplest of projects. Indeed, an examination of the American cases involving Eichleay principles reveals that in government construction projects our cousins there are only bound to succeed using Eichleay formula type claims where the Contractor is instructed to wait with the resources for the Works on standby for an indeterminate period. In short, the detained resources are unable to produce any return. If the circumstances are such that all or some of those resources can be used on other work, either on the Works in question or elsewhere, then the American courts have tended to disallow claims at all that are based on Eichleay. That seems harsh if no reimbursement comes the way of a contractor who has been thus handicapped in obtaining the full return he might otherwise have enjoyed. Courts deciding thus have been rightly criticised by commentators for favouring the government as employer over the rights of affected contractors. Unfortunately none of the formulae will give even an approximation of the true loss of HOP in most prolongation situations. There are certain criteria that should be present before any claims on the basis of such formulae can be properly pursued. First, there needs to have been an actual loss. Typically, this might be indicated by a reduced turnover for the Contractor's business at the time of the delayed Works. Such an indication should be accompanied by evidence that invitations to tender were turned away because of the unavailability of resources for the new projects due to their being detained upon the Works during the delay. Second, the part of any delay for which compensation is due should be established. Even if a Contractor has an entitlement to more time to complete the Works it does not follow that he should be compensated for the whole period, indeed his entitlement might be extinguished altogether if he omits to use necessary contractual mechanisms to safeguard his position, dependent upon their drafting. Some of the delay period might be for non-reimbursable events, and adjustments should be made in any reimbursement calculations. Further, even if the whole delay period is attributable to reimbursable events the effects of any concurrent culpable delay by the Contractor should be adjusted in such calculations. In such situations the Contractor should be entitled to protection from delay damages of the Employer, but should not himself recover prolongation costs when his own default resulted in them being expended on Site anyway. The foregoing is difficult enough and much has been written on the necessary analytical techniques, but in this article we are concentrating upon what should happen next, which is that the formulae just mentioned should be almost universally confined to the same place as the Flat Earth Theory. This is because all the formulae rely upon averages that are quite likely to be wide of the mark compared to true figures derived by analysis. The average HOP of the Contractor's business might be generated by extremes that are nowhere near the average. The resources that were detained on the Works could well be capable of such extremes, either more or less than that average, often with a significant effect upon the outcome of the calculated loss. For example, the average of 8% for the contractor's business as a whole might actually result from a significant group of projects having a HOP recovery of 20% and other such groups having only 2%. The resources detained on the Works might in all probability be capable of 20% or 2% and not 8%. A significant difference if the Emden or Eichleay formulae are used without proper analysis of source data. As this average could well be an aggregate of many parts of the Contractor's business, then those which are inapplicable to the wasted resources for the Works should be excluded in calculating compensation. The nature of the Contractor's business and the way the components making up head office costs interrelate should be analysed in sufficient detail depending upon the cost-benefit in relation to the sum being claimed. The situation becomes absurd if the reason there has been an overrun of the Works is because of additional work, as is often the case. Leaving aside situations where the instructions for the further work have been late; if the turnover on additional work is less than the business average, and any of the formulae are used to calculate loss, then the valuation of the additional work becomes a waste of time. That is because the HOP generated by any of the formulae due to the assumed turnover will seem to be the recovery that the Contractor ought to receive during the delay. That recovery will remain the same regardless of any HOP inherent in valuing additional work. In pursuing such claims there will often be what amounts to a pretence that an adjustment for the duplicated HOP will correct the situation. For example, by working out the HOP valued in the additional work and deducting it from the total HOP calculated by formulae. But the end result is the same total prolongation claim recovery that was derived by the formulae. Very often the true situation is merely that the additional work during the delay has earned less profit than the average for the Contractor's business as a whole. But that average is simply the middle of a range of results having both higher and lower returns. There is nothing to suggest that the HOP during the delay should equate exactly to such a crude average. In short, there is every likelihood that no loss has occurred at all. Quite apart from all that, there is a crucial flaw in all these formulae. It is the usually false assumption that the resources detained on the works would achieve any particular turnover to which a HOP percentage might be applied. This is especially true for larger concerns with a variety of types of project and numerous site staff having different expertise. The resources used for a road project might not be capable of dealing with the construction of a power station if the Contractor takes on both types of work. If the latter type of work contributes highly profitably to the majority of the HOP for the Contractor's business then the resources on a delayed road project simply would not achieve the HOP derived from the average for the business as a whole. Similarly, the site resources that are actually detained due to reimbursable delay might be quite different from those employed for the majority of the Works and therefore for the average to which a HOP percentage is applied. Consider a major project with huge site resources which suffers a delay at the end when only the landscaping subcontractor, say, is on site. It follows that any calculation of the prolongation losses of a contractor, and this applies to all companies that perform site construction work, should be related to the Contractor's resources ineffectively detained on the Works because of reimbursable delay, rather than to assumptions that the HOP generated by an assumed average turnover from the business as a whole, or from the project in question, will be achieved by the detained resources. The site resources that generate turnover and therefore HOP for a contractors' business as a whole are mainly the managerial and supervisory staff employed on the various sites. Instead of concentrating upon turnover elsewhere than on the delayed project, there should be an analysis of what comprises the items making up what is often summarised as 'Cost of Sales' in the Contractor's yearly accounts. The aim being to identify those site resources. So, instead of using formulae that rely upon proportions of HOP to turnover and contract value we should be relying instead upon the proportion of HOP to the costs of resources of the kind that have been wasted by reimbursable delay. Even if it is thought that the task of a proper analysis is inappropriate in relation to the resulting outcome, the formulae should not be used. It is better to calculate any loss by applying the cost of site resources wasted on the Works to the proportion that the cost of all those site resources from the Contractor's business as a whole bear to the HOP earned by that business. The result being applied to the period of reimbursable delay. Put another way: Cost of wasted resources (WR) x HOP
for whole business = HOP due to WR
If WR extends beyond a financial year then both the RB and HOP for whole business must take in the additional financial years, or each financial year should be dealt with separately. If it is possible to identify head office resources that have been wasted due to the delay then appropriate adjustments can be made. The more specific one can be in identifying the return that each type of wasted resource would in truth generate then the more accurate will be the calculation of the true loss to the Contractor for having his resources wasted by reimbursable delay. Indeed, a further twist, but which is more difficult, is to compare the actual HOP achieved on the distressed project by its site resource with what that site resource achieved on other projects that they did before and after their involvement on the distressed project. In many international and overseas projects the Employer requires a bond from the Contractor representing a percentage of the project value. The bond providers impose limits upon the guarantees they will allow an individual contractor and this process limits the volume of work that a contractor might take on. A delay upon a bonded project means the bond is in place for longer and for the same return but for the delay. The bond is therefore one of the resources for which a loss of HOP has occurred and should be treated in the same way as other wasted resources in calculating loss of HOP due to prolongation. Similarly, a Contractor's financial gearing might be the factor limiting its ability to take on other work and the financial resources tied up in the distressed project would then be the wasted resource, particularly in the case of contractors who hire the more tangible resources needed for a project. So, the message is to abandon reliance upon the traditional formulae and instead to conduct an examination of the true effect of reimbursable delay upon the Contractor's resources. Philip Fidler FRICS FCIArb This article is also about to appear in the ICE's Management, Procurement, and Law Journal. |
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