April  9, 1999



Bulletin #25: Recovering of Subcontractor Costs -- What Might Be Missing?

Over the years, ZZZ Sheet Metal had developed into a large operation working throughout the Northeastern United States. As it grew, the subcontractor concluded that moving a substantial portion of its sheet metal fabrication from the field to a centralized production facility would enhance its efficiency and cut its costs. As a result, a great deal of its fabrication work was being performed off the job sites, with the fabricated components being delivered to the sites for installation. Over twenty percent of the subcontractor’s labor force was working at the production facility. In order to accommodate its growth, ZZZ entered into a long-term lease for a 40,000 square-foot building and invested heavily in state-of-the-art fabrication equipment. Projections indicated that the facility would more than pay for itself through increased efficiencies and cost savings.

About six months after ZZZ opened its centralized production facility, it became involved in a large office/retail development as a prime subcontractor. Its work was to involve both design and installation of the air-handing system for the complex. It would be one of the largest jobs ZZZ had ever undertaken. The subcontractor had no prior experience with either the owner or the construction manager, but the project looked like a very lucrative one.

ZZZ management grew even more enthusiastic about the project when the subcontractor was presented with a contract form that would allow it to recover its costs for labor, materials, equipment, insurance, and other work-related charges, as well as a fixed amount for overhead and profit. While the subcontract contained a “not to exceed” cap, ZZZ management was confident that the project could be brought in well under the cap.

The contract form had been developed by the construction manager and looked much like a standard AIA or AGC form. Therefore, ZZZ management did not spend a lot of time focusing on the details of the contract. This was a mistake. Hidden within the 40-page contract was a definition of “labor cost” as “wages paid for labor of the contractor employed in the performance of the work at the site, while stationed in the field office, or on the road expediting the production or transportation of material and equipment.” There were separate provisions that would allow ZZZ to include the cost of employee benefits and taxes, transportation and lodging expenses, and other employee-related costs as to work on the site. However, nowhere did the contract allow ZZZ to charge for costs related to its off-site production facility.

Not yet aware of the problems with the contract language, ZZZ management was very pleased with the overall contract structure. It did not typically obtain contracts that provided an assurance of a profit. The subcontractor signed the contract and immediately expended substantial amounts on design work and in fabrication of project components at its central facility. When it submitted its first payment request, the subcontractor’s financial commitment to the project was into the middle six-figure category. Its payment request included the line items for “off-site fabrication labor,” “off-site fabrication equipment,” and “allocated fabrication facility costs.” Those costs represented a large portion of the overall payment request.

Approximately ten days later, the construction manager informed ZZZ that its off-site costs were not reimbursable under the contract. The construction manager pointed to the specific subcontract language on labor costs and the absence of any language permitting a pass-through of off-site costs. When ZZZ explained that its method of operation was beneficial in controlling costs and that the payment request included off-site cost items that would otherwise have been paid for on-site work, the construction manager agreed to negotiate for a limited allocation of labor costs attributable to the production facility, but refused to pay any of the cost of the fabrication equipment or operating costs of the facility. Since ZZZ was forced to absorb those costs as part of its overhead under the contract, the “guaranteed” profit proved to be far less than it had anticipated. The subcontractor realized that it had made an expensive mistake in not modifying the contract to fit the structure of its operation.

As the construction industry evolves away from the traditional construction model, it becomes even more important that the subcontractor verifies that the project documentation fits the structure of its business and the particular project. For the SMACNA member, the movement away from on-site fabrication requires that the subcontractor address issues as to what costs it should be able to recover in the performance of its work. For example, if an operation involves significant fabrication off-site, it could be argued that the subcontractor should be able to recover some allocated portion of:

1. the cost of owning or leasing the fabrication facility;

2. the costs of the shop equipment;

3. the wage and benefits costs of the subcontractor personnel involved in the operation of the facility;

4. the costs of utilities attributable to the fabrication work;

5. the costs of insurance; and

6. the costs of maintenance and repair necessary to the operation of the facility.

If such costs cannot be recovered on a per-project basis, the benefit of centralized production may be far less than the subcontractor assumes. However, if these costs can be allocated across projects utilizing the facility, the subcontractor may have the opportunity to turn off-site fabrication into a profitable component of its business. A slight modification to the definition of “work” may be all that is necessary to produce the desired result under any particular contract.

It can be assumed that acceptance of the allocation of all such off-site costs will not be an easy sell with general contractors or owners. However, if it can be demonstrated that the total cost of a project can be reduced due to the efficiency of off-site fabrication, such acceptance may ultimately be forthcoming.

 

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