Change orders are a fact of life in the construction business. While changes to a customer’s original contract can be disruptive, they also may provide opportunities to enhance profits, if they’re managed effectively. Here’s how to properly handle change orders from an accounting perspective — and how a virtual CFO can help your company take charge of the change order process.

Accounting for Change Orders

It’s common for customers to change their minds after signing a contract, but before work is completed. For instance, change orders may result from unforeseen site conditions, inaccurate specifications, customer-requested scope or design changes, unseasonable weather or materials shortages. Without proper tracking procedures, changes may lead to confusion or even conflicts with customers. Or you might inadvertently forget to charge for change orders in accordance with the contract terms.

When pricing change orders, you should factor in direct costs (such as materials, labor, equipment and redesign expenses), as well as overhead and indirect costs (such as workers’ compensation insurance and payroll service fees). Change orders can also have consequential costs that can be difficult to quantify. These are costs associated with work delays, overtime, crew reassignment and other disruptions to your normal workflow.

Contracts typically include a markup percentage for change orders. But the mark-up may not be enough to break even on change-order work. It’s important to consider the consequential costs as well as the direct costs when pricing change orders.

If properly documented and approved, change orders can generate additional revenue and increased profitability.

Remember to properly track and account!

Whenever possible, you should wait until a change order is approved in writing before beginning out-of-scope work. But contractors sometimes need to start out-of-scope work before a change order is approved to keep the job on schedule. Failure to properly track and account for the revenue and costs related with this work can have a negative impact on your financial statements.

For example, suppose your company uses the percentage-of-completion method of accounting, and you record costs attributable to a change order in total incurred job costs to date, without making a corresponding adjustment to the total contract price and total estimated contract costs. This might indicate excessive underbillings to a lender or surety provider.

Alternatively, a job’s profit could fade if you increase the total contract price based on out-of-scope work but are unable to secure change-order approval. This would also raise a red flag with your lender and other stakeholders.

How to Classify Change Orders

Change orders generally fall into the following three categories:

1. Approved change orders. For this category, it’s appropriate to adjust incurred costs, total estimated costs and the total contract price. This may increase a job’s estimated gross profits, depending on the change-order provisions in the contract.

2. Unpriced change orders. Sometimes the parties agree on the scope of work but hold off on pricing negotiations. In this situation, the accounting treatment depends on the probability that you’ll recover your costs. If recoverability is improbable, change-order costs are treated as costs of contract performance in the period that they’re incurred. So the contract price isn’t adjusted, and the estimated gross profit from the job will decrease.

If recoverability is probable, you can generally either: 1) defer the costs until the parties agree on the change in contract price, or 2) treat them as costs of contract performance in the period incurred and increase the contract price to the extent of the costs incurred. This results in no change in estimated gross profit.

When assessing the likelihood of recoverability, you must evaluate your background knowledge of the customer and your experience negotiating similar change orders. You might recognize increased revenue if it’s probable that the contract price will increase by an amount that exceeds the costs incurred — which increases the estimated gross profit from the job. But realization of that revenue should be “assured beyond a reasonable doubt.”

3. Unapproved change orders. Under the accounting rules, these are treated as claims. You should recognize additional contract revenue only if it’s probable that a claim will generate such revenue and the amount can be reliably estimated.

We Can Help

Accounting for change orders can be complicated and confusing. Our CFO outsourcing professionals can alleviate your stress by evaluating your company’s change-order process and helping improve the accuracy and usefulness of your financial statements.