Fixed Cost and Contract Delay

Introduction

For more than fifty years contractors, Government agencies, boards and the courts have struggled to quantify damages stemming from the continuing cost of unused capacity during contract delay and the cost of using extended capacity after a period of contract delay. And after fifty years, controversy continues over the application of the concept developed in an attempt to quantify such damages. That such a routine occurrence as contract delay should continue to cause controversy is strong evidence that there is a flaw in the concept of quantifying the damages to the contractor regarding its capacity utilization disrupted by delay of work. One problem is with the concept behind the quantification, unabsorbed overhead. In reality, economic reality, there is no such thing as delay damages resulting from unabsorbed overhead. Another problem is that the unabsorbed overhead concept introduces into the damage calculation the erroneous presumption that the original capacity allocation must be repriced. However, there are delay damages, extended overhead, standby costs, and there is delayed cash flow, but there are no unabsorbed overhead damages caused by contract delay.

Here the author examines the factual economic circumstances of a customer caused contract delay and the risk allocations attendant to fixed-price contracts and changes thereto to determine what damages the contractor actually incurs and what liability the customer has due to delay of work regarding fixed costs. Some of the arguments that have been used to sustain unabsorbed overhead claims and those used to defeat unabsorbed overhead claims are analyzed in view of risk allocation and compared to the economic realities experienced when work is delayed. Contract delays will be discussed in terms of the fixed overhead costs only. Direct costs affected by delay; standby labor, price escalation, etc., are not discussed. Also in this discussion, the impact of delayed billings regarding direct costs is not considered or it is assumed that with delayed work there is a commensurate delay in the incurrence of direct costs.

2 Unabsorbed Overhead

The term unabsorbed overhead has been used for decades in connection with contract delays to identify the nature of damages suffered by a contractor which has been delayed in performance of its work. The concept it represents is so well established that it has a precise meaning differentiating it from extended overhead, a similar and related concept of delay damages. Unabsorbed overhead has been defined in case law and contract accounting literature with clarity and unequivocal meaning. There is no doubt about what it is intended to describe although what it describes is not a delay damage but merely the consequence of an accounting exercise.

Unabsorbed overhead has been defined in contract accounting literature as, “that amount of indirect expense actually incurred which would have been allocable to the contract had the delay not occurred, and is not recovered in the revenue from any other work.” Another author has identified unabsorbed overhead in stating, “When changes cause a contractor to shut down or to idle its facilities for a period of time, fixed overhead and general administrative expenses continue to be incurred, but there will be reduced direct costs to which these expenses can be charged. The result is an ‘unabsorbed overhead’ amount which can be said to be attributable to the changes.” Unabsorbed overhead is explained in an early ASBCA case with, “If the claim is for ‘unabsorbed’ expense, it is really for a decrease in allocability to other work, which bore too great a proportion of all indirect costs because of the disruption and delay.”

There is essentially no disagreement on the meaning of unabsorbed overhead with respect to contract delay. The term describes an unrealized expectation of fixed cost allocation in the original contract period. In first Capital Electric the Board pointed out the distinction between extended and under absorbed overhead. It characterized under absorbed (unabsorbed) as a rate differential resulting from a decrease in base costs, consistent with the earlier definitions. What it did not make clear was that the rate differential could only apply to the original contract period. But this is the only conclusion that can be reached since the difference in rates can only occur between what was expected and what actually transpired. The original contract period could be the only period in which the work was expected to be completed prior to the delay. While a distinction was made between the two concepts, no definition of extended overhead was given, only a reference to the method of computing it.

The distinction between unabsorbed and extended overhead is very important to the matter of identifying and quantifying contract delay damages in terms of fixed costs. Unabsorbed overhead occurs in the original contract period. Extended overhead occurs when original work is performed in a period beyond the original contract period and can occur when a contractor is in a standby status beyond the original contract period. The terms are not synonymous and their improper use has lead to confusion and misunderstanding.

Contrary to common belief the term unabsorbed overhead was not used in the two cases concerning fixed cost delay damages that are usually cited in contract literature as two of the seminal cases, Fred R. Comb Co., v. U.S., 103 Ct.Cl. 174, (1945) and Eichleay Corp., ASBCA No. 5183, 60-2 BCA ¶ 2688, aff’d on recons’d, 61-1 BCA ¶ 2894. In both of these cases the concern expressed by the Court and Board respectively was that the contract period was prolonged and, therefore, the contract should have more fixed costs allocated to it because of the prolongation and not because of unabsorbed overhead in the original period. In Comb the Court reasoned that, “So the contractor, instead of saving the salary of that proportion of his main office staff which is attributable to the contract, is obliged, in effect, to waste it, and to spend a similar amount at the end of the contract for the extra time necessitated by the delay.” Similarly in Eichleay the Board stated, “While the overhead rate did not increase during the performance of these contracts, it is not questioned that the main office expense continued during the periods of suspension. . . . It has, however, been sufficiently demonstrated by the mere fact of prolongation of the time of performance, and the continuation of main office expenses, that more of such expenses were incurred during the period of performance than would have been except for the suspension . . .”

It is clear that the decisions in both cases addressed the extended period fixed costs, not the unabsorbed overhead in the original period. In Comb the statement that the contractor is obliged to waste the main office expense of the original period is recognition that such expense is time related and must be repeated in the subsequent period. In both cases it is clear that the computations of extended period overhead were crude approximations and that use of the original period costs in those computations was as a basis for approximating, not a requirement for repricing fixed capacity allocations in the original period.

How a clear understanding of the effect of delay on fixed costs degenerated to the confusion that followed is not clear. Possibly, the introduction of the term “unabsorbed overhead” in an early case such as Allegheny was the progenitor. Now, some use the terms extended overhead and unabsorbed overhead interchangeably as if one is equivalent to the other. Some believe one term applies to manufacturing enterprises and the other to construction companies as if the type of business can vary the concepts that are actually common to all. And then there is the infamous case of Wickham where the court declared that the crudest, most imprecise method of computing fixed cost delay damages is the only method to be used. The only thing that is clear from the record at this point is that the dance floor is covered with chewing gum and string.

3 Fixed Costs and Contract Profitability

Before pursuing a discussion of fixed cost damages, a quick review of some accounting concepts will be helpful. Accounting is not a physical science: it is an adjunct to behavioral science. Its principles are premised on concepts of property rights, legal obligations, trade customs, monetary systems, etc. While its traditional use is to measure economic gain or loss of a business enterprise in a time period, it is also used to measure and control the cost of activities. Its various uses may be governed by different sets of principles. Thus, what is an accepted basis of accounting for tax return preparation may not be suited to managerial purposes. Or cost flow assumptions used for annual financial statements may not serve any purpose for measuring the costs of specific activities. Therefore, before accepting any accounting concept blindly, it is necessary to understand its purpose and to decide whether it is apposite in the particular circumstances.

To be in business and ready to seize upon an opportunity to make a profit a contractor must have invested some resources providing a basic capacity to do business, such as a home office, a factory site, or machinery. It is this capacity that generates the fixed overhead costs. And working or not, those costs continue to accrue over time. Obtaining profitable work helps to offset those costs and if enough profitable work is obtained those costs can be more than offset. Profitability of work obtained is not determined by these costs, however. It is the profit from the work that is a contribution to cover fixed costs and provide net income for the company, not the other way around.

Products are sold or jobs are performed with the intention or expectation that an overall profit will be earned for the enterprise at the end of the designated time period. To achieve this goal the products or jobs must be profitable and of sufficient volume to cover the fixed costs of maintaining required capacity and produce some excess (profit). Thus, each product or job is expected to make some contribution to the general expenses and profit pool. That contribution can be made if the product or job is profitable, i.e., its sales value is greater than its direct (variable) costs leaving some amount of “contribution margin” to cover general expense and profit. The following chart illustrates this point.

The economic reality demonstrated in this example is that it requires equal direct costs to perform each job whether one or fifty jobs are performed. The fixed overhead is not changed because of the volume of work. Fixed costs are not costs of the work, they are costs of maintaining a fixed capacity to do work over a given period of time. The contribution margins from the several jobs are contributions toward covering the fixed costs. Thus, all the jobs are profitable and each is making a contribution toward fixed costs. If only one job were performed that job would still be profitable having made a contribution toward fixed costs.

This method of interpreting the results of business activity is referred to as “direct costing.” The direct costs only are considered when determining the profitability of the work being performed. This method of analyzing results of activity readily discloses how well management has utilized the capacity available to it in the period. It points out the cost of the capacity and the gross profit or contribution margin generated to cover capacity costs.

A different costing method commonly used is referred to as “absorption costing” and is shown in the table below. Under this method, a period’s capacity costs are added to (or absorbed by) the product costs. Its effect is to obscure the distinction between direct product cost and period cost of fixed capacity. Adding fixed capacity costs to product costs is accomplished by some allocation scheme of which there are many. In the table, Figure 2, the actual fixed overhead rate was used. While all the facts are the same as in the previous table demonstrating direct costing, the difference is that under the absorption concept if only one or ten jobs were performed those jobs were all unprofitable. If 50 jobs were performed all of those jobs were profitable. What this is saying is that the additional 40 jobs made the first ten jobs profitable. But that is not so, in reality the first ten jobs were always profitable. The 40 additional jobs made the enterprise profitable.

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