Recovery of Unabsorbed Head Office Overheads in a Contract Prolongation

By Dr. Chandana Jayalath

A contractor’s overheads are normally covered by the income of the business as a whole and, where the completion of one contract is delayed, the contractor may claim to have suffered a loss arising from the diminution of the income from the contract and hence, the turnover of the business; but the general running costs of his business continue to be expended. Were it not for the delay, the contractor’s workforce would have had the opportunity of being employed on another contract, with the result that it would have contributed towards the overhead costs during the overrun period. Also, if he can show that the staff, who would otherwise have been gainfully employed, had to devote time to dealing with the disruption or delay, he may have a claim for that too.

Accordingly, a contractor may seek reimbursement of its head office costs in one of two alternative ways: as lost opportunity costs or as additional overheads actually expended as a result of the delay. An opportunity costs claim is based on the premise that because of the delay the contractor’s organization is free unable to move on to another project and earn the combined profit and head office overheads of which it is reasonably capable, i.e. the opportunity to earn elsewhere is lost.

In order to pursue a claim on the opportunity costs approach it is necessary for the contractor to prove that the overhead represents a reasonable one by reference to audited accounts for the appropriate period and that work of the same level of overhead recovery was available during the period of delay. Also, this can be proven by production of tender enquiries and publications (such as the Government Gazette) indicating the level of construction activity during the period of delay. The contractor should prove that he was actively seeking extra work during the period of delay, and by providing details of tenders which it has submitted. Difficulties can arise where economic conditions are such as to restrict the number of tendering opportunities available where the contractor was prevented from taking on further works as a result of delay.

In the case of Alfred McAlpine Homes North v. Property and Land Contractors (1995), the court affirmed that there was no objection in principle to a claim for head office overheads made on the opportunity costs approach, and further that there was no objection in principle to such a claim being calculated by reference to a formula (The author has seen more than 15 formula in computing unabsorbed overheads in a contract prolongation). It should be noted however that in this case the court in fact refused to adopt such an approach principally because it was the contractor’s working arrangement that they only ever undertook one construction project at a time and did not undertake another until the project was complete. It was therefore inappropriate to use opportunity costs as the basis of calculation.

The second method of calculating a head office overheads claim is the actual costs approach. The basis of this claim is that the prolongation has resulted in the contractor allocating more overhead expenditure to the project than was originally contemplated at the date of the contract. This is traditionally a less popular method since the records necessary to support the claim are seldom available and the amounts of money generated by this approach are generally significantly less. In the above mentioned case of Alfred McAlpine Homes North v. Property and Land Contractors (1995), and also in the Amec Building Ltd v. Cadmus Investments Co Ltd (June 1996), the courts accepted a claim for head office overheads, based on the actual costs approach but using a formula to calculate the amount attributable to the particular contract.

When a contractor makes a claim for his overheads and profit, he would normally do so under one of two different forms. Firstly, the contractor may be able to demonstrate that time and cost of specific, identified, resources at its head office had been incurred during an overrun period. In Euro Pools and Clydeside Steel Fabrications, a Scottish case from 2003, the pursuers were able to demonstrate the lost opportunity of their employees, who were diverted from other contracts, for the purpose of addressing defects in the defender’s work. They were also able to demonstrate management time spent by their director, and other engineers, relating to the attendance at meetings and the preparation thereof, and investigating the problem that had arisen through the defect. The court held that such a claim is based on the second limb in Hadley –v-Baxendale, i.e. that the losses claimed were such as might reasonably be supposed to have been in the contemplation of both parties at the time they made the contract as the probable results of the breach of it.

The other form is where the contractor argues that, in having resources locked into a site during the prolongation period, he has lost the opportunity of using those resources on other sites where they would have earned a contribution to the costs of running their head office. For this argument to be successful, a contractor must show that work was reasonably plentiful, and that, on a balance of probabilities, other work was, or would have been, available. This is sometimes referred to as unabsorbed head office overheads, in that the level of head office cost continues but the revenue stream from the particular contract shows a shortfall.

Authority for the use of formulae derives from a number of cases including Whittal Builders and Chester-le-Street District Council in which Mr Recorder Percival QC said: “What has to be calculated here is the contribution to off-site overheads and profit which the contractor might reasonably have expected to earn with these resources if not deprived of them. The percentage to be taken for overheads and profits for this purpose is not therefore the percentage allowed by the contractor in compiling the price for this particular contract, which may have been larger or smaller than his usual percentage and may or may not have been realised. It is not that percentage that one has to take for this purpose, but the average percentage earned by the contractor on his turnover as shown by the contractor’s accounts.”

These formulae are all approximations rather than assessments of actual costs, and they are all over-simplistic when compared with more accurate alternatives. In Tate & Lyle -v- Greater London Council 1981, a claim, based simply on adding a percentage of the overall cost, which is of course even more simplistic than the formulae methods was rejected on the basis that there must have been more accurate methods of assessment open to the claimant of which he had not availed himself. Each formula relies on assumptions, which may not always be appropriate, and the inclusion for an allowance for profits in some of the formulae must be separately justified.

As mentioned, various formulae have been devised the application of which is widely tested in courts of law. The essentials of a valid claim for recovery of unabsorbed overhead due to employer caused delay can be derived from reading a number of court cases. The courts insist that the contractor shall;

a. be entitled to recover when there is pure owner-caused delay. (work stoppages due to design defects, suspension caused by resolution of bid protests, slow responses to requests of information etc)

b. demonstrate a clear cause and effect relationship between the employer caused delay and a substantial reduction in the stream of income from the project, for instance a drop in turnover shown from accounts, which results from the particular delay in question, and not from extraneous causes.

c. justify that it was impracticable to take on new work during the delay period to mitigate likely damages in advance, for instance by showing invitation to tender with evidence that the reason the contractor declined was insufficient capacity. However some courts have concluded that the engineer directives to remain on standby or ready to resume on short notice preclude the contractor from seeking new work to replace lost income. However, interim disruption of work, exhaustion of contractor’s bonding capacity, uncertainty of duration of delay, equipment committed on the project are some of factors that may cause the contractor unable to mitigate damages.

d. show that that delay was not the result of directed changes or contract modifications on variation orders (which will be compensated elsewhere through application of contract rates which include overhead and profit)

The agreement on causes of delay, its extent and cost impact is questionable partly due to existence of several formulae, which give wildly varying results even when applied to the same fact setting.

It is impossible to accurately measure any under absorption of head office overheads whenever the damages become too remote and speculative. However, the contractor’s entitlement as to claim for additional overhead costs has been confirmed in case law. But the burden of proof to demonstrate such lost opportunity entirely lies with the contractor. If the contractor is unable to show evidence to support this proposition, the claim would have to be based on actual costs through contemporary records.

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