Project time extensions and the relational impact on unabsorbed home office overhead
18th February 2021
When contractors submit a fixed-price bid on contracts, they anticipate that the revenue derived from their projects will generate enough income. This income should cover over and above the direct costs of their projects, absorbing non-project costs and providing an overall company profit. The non-project costs or “home office overhead” (HOOH) include such items as management salaries, office rent, or any other costs related to the overall operation of the company. Home office overhead is usually categorized as General and Administrative (G&A) expenses in the contractor’s financial statements.
A contractor recovers home office overhead costs by including a markup on its direct costs in its bids. Sometimes a contractor will identify a separate markup as home office overhead or G&A but is more often just part of the overall bid markup. While the original bid markup on extra work may fairly compensate a contractor for additional scope change orders, in the case of a delay with no significant additional scope, contractors often seek compensation for this unabsorbed or extended home office overhead. Put simply, these claims are for the “loss opportunity” to be able to quickly replace the delayed work with new work.
The American Association of Cost Engineers (AACE) addresses the issue of the recovery of home office overhead, “[h]ome office overhead may be added to a contractor’s bid as a percentage of direct project costs. The percentage of home office overhead is generally based on a contractor’s historical overhead rate and varies greatly from contractor to contractor depending on the type of work (e.g. general construction, electrical, etc.), the method of accounting for home office overhead costs, etc. Percentages or other formulations are often used because a more precise method for allocating overhead to specific contracts that have experienced delay is difficult to determine.”[1]
The approaches to this recovery may be under a variety of methods, depending on the terms of the contract, the project location and previous court jurisdictional rulings.
This article will describe and compare several commonly used home office overhead costs formulas used in delay situations. The following formulas will be discussed: Eichleay, Manshul, Hudson and Emden. Each formula will be described, and the respective outcome of each will be calculated and compared using the same data set of home office overhead costs.
Home Office Overhead Formulas
1. The Eichleay Formula
Allocable HOOH to Project:
(Total Company Billings over Contract Period/
Total Home Office Overhead Costs)×Total Contract Billings
Daily HOOH for Contract:
Contract Performance Period/Allocable HOOH to Project
Unabsorbed HOOH:
Daily HOOH for Contract×Delay Days
The Eichleay Formula has been the standard for many courts in the United States to calculate recovery of home office overhead. Prior to the 1940s, unless it was expressed within the contract, contractors could not recover damages related to home office costs for government delays. An article published by Amarjit Singh and Thomas Taam about the history of unabsorbed home office overhead gives insight into what laid the groundwork for the Eichleay Formula in the 1940s. The authors state that, “[i]n 1945, however, in the case of Fred R. Comb Co. v. United States ii, the Court of Claims found the government liable to the contractor for home office damages caused by delay. The court also found that the government, having breached its contract, had no right to state that a contractor will go uncompensated. This laid the foundation for the emergence of the Eichleay Formula, which set up criteria and formulae for calculating compensation due to the contractor.”[2]
The Eichleay Formula originated from the 1960 court case Eichleay Corporation v. United States iii and a decision by the Armed Services Board of Contract Appeals. In its appeal before the Board, the Eichleay Corporation proposed a formula for calculating recovery of home office overhead. The Board accepted this formula as a reasonable method for calculating the damages.[3]
Before the evolution of the Eichleay method, there have been at least two other methods, the Allegheny and Carteret methods, used for pricing home office overhead over the years in the United States. The Eichleay Formula has emerged as the most commonly used method in claims and is now the only method accepted by the federal courts on public contracts when certain conditions are met.[4]
The Eichleay Formula is as follows:
The Eichleay Formula is limited in the fact that, as it uses actual data, it can only be used properly at the very end of a project. This means if a claim were to happen while a project is still ongoing, another method would likely need to be used. Additionally, the Eichleay Formula was criticized by the courts because it: (1) presumes that when a project is delayed that the contractor was actually damaged by incurring unabsorbed home office overhead; and (2) fails to produce a reliable estimate of the damages suffered by the contractor due to the delay.[5] The federal courts also have deemed that, for a contractor to recover unabsorbed home office overhead using the Eichleay Formula, it must prove that it encountered a full stoppage of work (or were put on standby), and that it was unable to begin additional work as a result of being on standby. As a result of these criticisms, the Manshul Formula emerged in New York State.
2. The Manshul Formula
Direct Cost Incurred During Delay Period:
Actual Billings During Delay Period×(Contract Costs %/Costs + Markup %)
Home Office Overhead Recoverable:
Direct Cost Incurred During Delay Period × HOOH % per Bid
Although it is now the rule in the United States under Federal jurisdiction, state courts have not always accepted the Eichleay Formula. For example, in New York State, the courts have adopted the Manshul Formula in lieu of the Eichleay Formula. Mark Nagata of Trauner Consulting provided some background of the Manshul Formula in 2018 in his four-part contractor HOOH evaluation. Nagata states that, “[t]he Manshul Formula was established by New York State Courts in 1981. The case involved a construction project for the Dormitory Authority of the State of New York (DASNY) for La Guardia Community College, a division of the City University of New York, and the contractor was the Manshul Construction Corporation.Different from the Eichleay Formula, the Manshul Formula relied on the overhead percentage specified for changes within the contract and calculated the contractor’s home office overhead costs for the delay period in a different manner than calculating a daily home office overhead rate.” [6]
The Manshul Formula is as follows:
The biggest challenge in calculating the Manshul Formula is deeming what the correct allocable breakout for anticipated overhead truly was, unless bid documents are provided. In the past, judges have sometimes evenly split the mark-up between overhead and profit. For example, without proper bid documentation for a project with a 15% mark-up, a fair division would be 7.25% allocated for overhead and 7.25% applicable to profit, as was accepted by the courts in the appeal of Manshul Construction Corp v. DASNY (79 A.D.2d 383 (1981)). [7] In order to accurately calculate these amounts, it was necessary to back out the overhead and profit already included in the billings.
Their calculation was as follows: .0725 + (1.0725 * .0725) = .15025 (slightly over 15%). [8] When calculating the Manshul Formula, there may also be a percentage that must be taken into consideration for bond, depending on the contract. If actual financial statements are available, they can be used to determine the actual home office overhead percentage, rather than trying to estimate an even split.
3. The Hudson Formula
Home Office Overhead Recoverable:
Headquarter & Profit %/100 x Project Price/Construction Time x Delay
The Hudson Formula was first derived from Hudson’s Building and Engineering Contracts, a text authored by Alfred Arthur Hudson and Ian Norman Duncan Wallace in 1959. In the United Kingdom, the courts had initially approved the Hudson Formula as the method for calculating home office overhead costs in 1989. The Hudson Formula seeks to recover HOOH by using the original bid made by the contractor, while presupposing that the percentage used for the overhead rate is reasonable. [9]
The Hudson Formula is as follows:
The Hudson Formula has been much scrutinized for offering only an approximation of what was planned, rather than considering the actual situation. In construction, the actual situation often strays far from what was initially planned. Although it can be argued that it is reasonable to use a planned percentage allowance for home office overhead costs because it represents previous years’ allocations and shows a fair representation of current levels of overhead, courts may consider the amounts to be too excessive or unrealistic. [10] When the courts deem these costs excessive, they will then ask the Contractor to provide his actual home office overheads costs, thus discounting the Formula method all together. As a result of this, many courts have abandoned the use of the Hudson Formula, beginning with Whittal Builders Co. Ltd. V. Chester Le Street in 1987.
4. The Emden Formula
Home Office Overhead Owed:
((Total Overhead & Profit/Total Company Turnover)/100)X (Gross Contract Sum/Planned Contract Period)X Owner-Caused Delay Period
The Emden Formula was developed in response to the criticisms against the Hudson Formula. Unlike the Hudson Formula, the Emden Formula expresses the project overhead as an average percentage of the contract amount. In his technical paper, Calculation and Recovery ofHome/Head Office Overhead, James Zack calls the Emden Formula “a creature of the Canadian courts”.[11]
The Emden Formula allocates to the delayed project a portion of the contractor’s total overhead based on a historical average. “The Emden formula is based on the assumption that the contractor would be able to continue earning the same rate of overhead on another project, and the formula compensates the contractor for the loss of opportunity to do so by extending the overhead rate from the contract time to the delay period.”[12]
The Emden Formula is as follows:
The Emden Formula has been criticized for its inability to accurately portray reality. According to Paul Sandori, the formula’s prescribed combination of looking only at a project’s past performance and other work a contractor is working on at the same time can pose problems. Sandori explains that “to determine the average percentage of overhead, Emden typically looks back at the two- or three-year period preceding the contract as well as the contract time. Thus, the project overhead allocation to the delayed project is primarily based on the contractor’s performance in the past. The contractor may have so much other work during the contract time and the period of delay that only a reduced contribution would be required from the delayed project, but the result of the Emden calculation would not be significantly affected by this circumstance.” [13] For these reasons, courts cannot simply determine the average overhead rate by considering exclusively past performance, because past performance may differ greatly from future performance, and other work taking place simultaneously also could weight the overall results.
Financial Data
In order to best understand how compensation for unabsorbed home office overhead may be calculated, each formula will be calculated using the following “mock” financial data case set of GC Construction, Inc., below. Please note that ‘cd’s’ is an abbreviation for calendar days in both the mock financial data set as well as in the following formulas.
For purposes of this example, it is assumed that the Company G&A amounts include only time-related costs. In a real-world application, this cost pool should be “screened” to exclude costs that are not time related.
Individual Calculations
The following represent the home office overhead calculations for each of the formulas described above:
Please note: the appellate court calculation for the Manshul Formula includes a percentage of profit to be added onto the home office overhead amount. This has been omitted from this calculation to compare everything in a similar manner because none of the other HOOH calculations contain profit.
Below is a summary of the calculation results for each formula based on the same set of financial data and a compensable delay of 200 days:
HOME OFFICE OVERHEAD CONCLUSIONS
In conclusion, there is no standard “across-the-board,” accepted way for calculating home office overhead recovery. The various home office overhead recovery calculation methods can vary in both their formulas and outcomes. Using the data case set in the example, the most favorable option for the contractor would be the Emden Formula, allowing them to recover over $4.4M in home office overhead costs. Of course, having a different set of data could yield different results entirely.
Ultimately, deciding which formula is best for any given situation boils down to the courts and the jurisdiction in which the job is taking place. It appears that, among each of the formulas, the Eichleay Formula and the Emden Formula seem the most reliable, as each is based on actual data rather than planned or past data.
This does not negate the fact that each of these formulas still have their own limitations. For example, a limitation of the Eichleay Formula is that it can only be used at the very end of a project. As a result, if a claim were to happen while a project is still ongoing, another method would likely be used. Additionally, the Eichleay Formula has faced significant legal challenges, particularly in US Federal courts. If the matter was challenged in Federal court, its use may be prohibited unless it meets specific criteria such as a complete job shutdown, an uncertain delay, and inability to procure other outside work.
The Emden Formula has limitations because it looks at the past two or three years and does not always accurately depict what will necessarily happen in the future. In addition to the methods presented, there are more than 10 other formulas that are accepted in courts across the globe. Additionally, there are multiple variations to many of the formulas, such as the Eichleay Formula, which has two variations to the calculation shown here.
While it is difficult to offer any improvements to the formulas, variations show how they have evolved over time. It is important that contractors who believe they have suffered financial impact due to a delay or disruption be aware of their ability to recover their costs in court with the appropriate home office recovery method.
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ABOUT THE AUTHOR:
Robert A. Dieterle, Jr. has experience in the evaluation of financial damages and cost impacts claimed by contractors on construction projects. His project assignments have included industrial plants and building projects, including new construction as well as renovations to existing facilities. Mr. Dieterle has focused in the analysis and preparation of fair and reasonable estimates for delay, disruption and acceleration claims as well as calculating earned value and loss of productivity assessments. Prior to joining HKA, Mr. Dieterle was a Senior Accountant in Hill International’s corporate Finance Department. While working in the Finance group, he analyzed operating group financial performance, assisted in the preparation of company-wide budgets, prepared cash flow forecasts and prepared monthly financial packages for operations managers.
[1] Dieterle, Robert. The Eichleay Formula -Is Standby the Standard? 2008 AACE INTERNATIONAL TRANSACTIONS.
[2] Singh, Amarjit, and Thomas Taam. “Unabsorbed Overhead: Eichleay and Other Methods.” Construction Research Congress 2009, 2009, doi:10.1061/41020(339)19.
[3] Trauner, Theodore J. Construction Delays: Understanding Them Clearly, Analyzing Them Correctly. Elservier-BH, 2009.
[4]Construction Law Handbook, by Robert Frank Cushman and James J. Myers, Aspen Law & Business, 1999, pp. 1238–1238.
[5] Estis, Dennis, et al. “Delay Damages – What’s Hot, What’s Not: Making Dollars & Sense of Construction Damages.” American Bar Association, Forum on the Construction Industry, 2013, www.imageserve.com/naples2013/papers/plenary1.pdf.
[7] Harmon, Kathleen M.J., and Kathleen O. Barnes. “Bringing Home the Bacon — Overhead Calculations and the Law.” The Journal of AACE International – The Authority for Total Cost Management – Cost Engineering, vol. 54, no. 2, 2012, pp. 26–33.
[8] Appellate Division of the Supreme Court of the State of New York. (1981, March 10). MANSHUL v. DORMITORY AUTH: 79 A.D.2d 383 (1981): Ad2d3831408, https://www.leagle.com/decision/198146279ad2d3831408
[9] Harmon, Kathleen M.J., and Kathleen O. Barnes. “Bringing Home the Bacon — Overhead Calculations and the Law.” The Journal of AACE International – The Authority for Total Cost Management – Cost Engineering, vol. 54, no. 2, 2012, pp. 26–33.
[10] “Contractors Head Office Overheads Entitlement for Delays – Hudson’s Formula.” Malaysian Construction and Contract Law, 8 Feb. 2012, simplymalaysia.wordpress.com/articles/delays/contractors-head-office-overheads-entitlement-for-delays-hudsons-formula/.
[11] Zack, James. “CALCULATION AND RECOVERY OF HOME/HEAD OFFICE OVERHEAD.” INTERNATIONAL COST ENGINEERING COUNCIL 3rd World Congress on Cost Engineering, Project Management & Quantity Surveying 6th Pacific Association of Quantity Surveyors Congress, Apr. 2002
[12] Sandori, Paul. “CONTRACTOR’S HEAD OFFICE OVERHEAD — WHAT IS THE RIGHT FORMULA?” The Revay Report, vol. 22, no. 2, June 2003.
[13] Sandori, Paul. “CONTRACTOR’S HEAD OFFICE OVERHEAD — WHAT IS THE RIGHT FORMULA?” The Revay Report, vol. 22, no. 2, June 2003.
Additional Sources used for Reference:
“Claim Management.” Law Explorer, 2015, lawexplores.com/claim-management/.
Iyer, K.C., et al. “Case Study Approach Using Scenario Analysis to Analyze Unabsorbed Head Office Overheads.” World Academy of Science, Engineering and Technology International Journal of Architectural and Environmental Engineering, Vol:12, No:10, 2018, waset.org/publications/10009665/case-study-approach-using-scenario-analysis-to-analyze-unabsorbed-head-office-overheads.
Ludwig, Hon Chi Yi. “Formulae to Formulate the ‘Head Office Overheads.’” Surveyors Times, Nov. 2013, www.hkis.org.hk/en/st/ST2013/201311/2013st11_6_mem.pdf.
Ruff, Randolph. “Lump-Sum General Conditions in Cost-plus Commercial Construction Contracting.” Construction Executive | Welcome, 2018, constructionexec.com/article/lump-sum-general-conditions-in-cost-plus-commercial-construction-contracting.
Vertex. “The Eichleay Formula and Delay Claims – What You Need to Know.” VERTEX, 2018, vertexeng.com/blog/the-eichleay-formula-and-delay-claims/.
**The intent of this article is to illustrate the different formulas. The appropriate method in each case is dependent on the facts of the dispute, the contract terms, the jurisdiction and other factors.
About the Author:
Robert A. Dieterle, Jr. has experience in the evaluation of financial damages and cost impacts claimed by contractors on construction projects. His project assignments have included industrial plants and building projects, including new construction as well as renovations to existing facilities. Mr. Dieterle has focused in the analysis and preparation of fair and reasonable estimates for delay, disruption and acceleration claims as well as calculating earned value and loss of productivity assessments. Prior to joining HKA, Mr. Dieterle was a Senior Accountant in Hill International’s corporate Finance Department. While working in the Finance group, he analyzed operating group financial performance, assisted in the preparation of company-wide budgets, prepared cash flow forecasts and prepared monthly financial packages for operations managers.
There is no standard “across-the-board,” accepted way for calculating home office overhead recovery. The various home office overhead recovery calculation methods can vary in both their formulas and outcomes.”
