Reassessing the Formulae for Computing the Damages Incurred Due to the Prolongation of Project

Construction contract disputes are distinctly diverse from other dispute bodies, due to their inherent technical and complex nature. They often demand urgent resolution, implicating a multitude of parties, requiring an understanding that extends beyond the rudimentary legal knowledge, dictating their unique position in the juridical sphere.

Introduction

Without a doubt, the construction industry has significantly bolstered the global economy, spurred on by substantial public and private sector investments, innovative technology, and ambitious infrastructure projects.

In the realm of project management, construction delay claims are a frequent occurrence that require swift evaluation and efficacious management. Notably, this topic elicits intense discussion and dispute due to the intricate and often conflicting directives offered on delay analysis methodologies, necessitating a thorough understanding of these various techniques.¹

The author plans to delve into the significant aspects and major claims that emanate from construction disputes, particularly due to the delay in the completion of the project. The article shall also meticulously dissect the evolution of delay claims and associated damages over time. The author shall be predominantly addressing the application of mathematical formulas, including Hudson, Emden, and Eichleay, for precise calculation of the lost profits and overhead costs. Further, the article would be critically scrutinising the recognition and acceptance of the most prevalent formula employed in shaping delay claims, signifying the fluid dynamic between legal procedures and practical application in the construction industry. Additionally, the author aims to provide a concise analysis of each formula’s application in calculating damages and loss of overhead and profits, drawing comparisons with the methodologies predominantly employed by contractors.

Major claims in construction disputes due to delay in completion of project

Construction contract disputes are distinctly diverse from other dispute bodies, due to their inherent technical and complex nature. They often demand urgent resolution, implicating a multitude of parties, requiring an understanding that extends beyond the rudimentary legal knowledge, dictating their unique position in the juridical sphere.

A claim in a construction industry is basically a formal request by one party (usually a contractor or employer) asserting an entitlement under the contract law.² As during the presentation of claims, considerable confusion arises from mistaken assumptions regarding delay, extensions of time, and financial entitlement. It is therefore imperative to recognise that a delay does not necessarily justify an extension of time, and that the granting of an extension of time does not, in itself, give rise to a right to additional payment.³ This section briefly addresses the key categories of claims arising under construction contracts due to prolongation of the contract/delay in the completion of the project, which include:

1. claims for variations;

2. claims for extension of time;

3. claims for additional payment due to prolongation;

4. claims for acceleration and disruption;

5. claims for damages under applicable law; and

6. claims for loss of profit/loss of profitability.

1. Claims for variations

As far as claims for variations are concerned, the employer generally instructs such variations, which may consequently alter the overall nature and scope of the project and that would result in delay in completion of the project. This typically refers to circumstances involving additional or reduced scope of work, modifications to the project specifications, or in some instances, adjustments to the contractual framework, such as the contract price or completion period.⁴

2. Claims for extension of time

The most frequent basis for claim submission involves requests for an extension of time (EOT) for the completion of works. Granting an EOT effectively precludes the engineer from imposing liquidated damages (LDs), or penalties for delay, as typically mandated by the contract.⁵ Furthermore, it is implicit in the award of an EOT is the contractors right to compensation for prolongation, covering the costs associated with maintaining site operations and resources for the extended project timeline.

3. Claims for additional payment due to prolongation

In construction arbitration, a prolongation claim is a broad concept encompassing a variety of claims that arise from delays to project completion. If an extension of time is granted due to circumstances beyond the contractor’s control, the contractor shall be entitled to claim additional payment for prolongation. Such payment shall include reasonable on-site and off-site overheads, including costs of maintaining the site establishment and the contractor’s head office facilities, for the period of the delay.⁶

(a) How is it different than the claim for extension of time?

A claim for an extension of time constitutes the contractor’s request for an extended completion date. Such an extension may be granted regardless of whether the delay is attributable to the contractor; if the contractor is responsible for the delay, the employer retains the right to impose liquidated damages.⁷ In contrast, a claim for additional payment due to prolongation seeks compensation for time-related costs incurred as a result of an extended contract period for which the contractor is not responsible. While prolongation costs are commonly regarded as the monetary component of a delay claim, an entitlement to loss and expense or to damages does not automatically arise from the grant of an extension of time.

4. Claims for acceleration and disruption

In construction arbitration, such claims commonly arise where the employer’s actions — or events for which the employer bears the risk — force the contractor to accelerate works to mitigate delay.⁸ These acceleration of works typically give rise to time-related additional costs, including extended work hours and overtime, increased labour deployment and associated labour costs, extra mobilisation and use of plant and equipment, and loss of productivity caused by out-of-sequence operations or by employing a greater than optimal workforce.⁹ To determine whether a claim for acceleration and disruption is warranted, the contractor must quantify the effects of disruption by comparing productivity for equivalent work during an undisputed (baseline) period with productivity during the disrupted period.¹⁰

5. Claims for damages under applicable law

If circumstances arise during performance that fall outside the contract’s scope, the contractor may need to pursue damages at law. The contractor is obligated to perform the works without obstruction. If the employer, or its agents, prevent the contractor from performing, the employer will be in breach of contract and the contractor will be entitled to recover compensation for losses caused by that breach.

6. Claims for loss of profit/loss of profitability

As far as construction contracts are concerned, unforeseen delays or extensions frequently prompt contractors to submit claims for lost profits or diminished profitability. As far as claim for loss of profit is concerned, once a breach is established, further proof of actual loss is not always required to recover loss of profit. This approach is founded on the principle that a works contract carries a reasonable expectation of profit, so demonstrating the contract’s implied profit margin may suffice to calculate lost profits arising from breach of the contract leading to unperformed obligations.¹¹

That said, loss of profitability comes into the picture where the contractor suffers from lost profits due to the prolongation of the project. The contractor bears the burden of quantifying the loss with contemporaneous documentary evidence — for example, a catalogue of prospective projects the contractor was qualified to pursue but could not because of the contract’s prolongation in order to claim the loss of profitability.¹²

Computation/quantification of the delay claims

A “delay claim” refers to a monetary claim resulting from a delayed project completion. If the authority is fully responsible for the delay, the contractor may recover the additional costs incurred.¹³ This section explains how delay claims are quantified, how common formulas are applied to calculate head office overheads/lost profits, and evaluates those formulas against relevant case laws.

1. Head office overhead costs incurred from construction agreements

Claims for Head office overheads and lost profits frequently arise in construction arbitrations concerning delay and disruption. According to the Society of Construction Law (SCL) delay and disruption protocol, Head Office overheads are defined as “incidental, business-wide costs that cannot be charged directly to production”, and includes items such as rent, rates, directors’ salaries, pension fund contributions, auditors’ fees, general insurance, etc.¹⁴ Head office overheads are largely fixed and do not vary with short-term revenue fluctuations.¹⁵ A project continues to incur these overheads even when it is not incurring direct costs. As a result, an extension of the project typically increases the contractor’s head office overheads beyond original projections.¹⁶ Such delays therefore give rise to extended or unabsorbed overheads where the contractor is unable to secure other work to absorb those fixed costs during the delay.¹⁷

2. Introduction to the formulae for computation/quantification of the delay claims

While the three formulae are theoretical mathematical constructs, each rest on factual assumptions and can produce distinct, unrelated measures of compensation or damages. Accordingly, before applying a formula, its underlying assumptions should be examined and their satisfaction established on the facts of the case.¹⁸ The three most commonly used formulae for calculating the head office overheads are as following:

(a) Hudson formula

This formula was put forward in the Hudson’s Building and Engineering Contracts, 10th Edition (1970), to calculate the profit lost by the contractor due to the delay not solely attributable to him.¹⁹ In this formula, the head office overhead percentage is taken from the contract.²⁰ The formula is stated in the following terms:

Head Office Overhead & Profit %/100) x (Contract Sum/Contract Period) x Period of Delay

Now, as we can understand from the aforementioned standard formula, it calculates an allowance for head office overheads and profit on prolongation by taking the percentage for “head office overheads and profit” from the contract (the tendered percentage) and applying it to the prolongation/extended cost base. The applicability of the Hudson formula is basically couched on three assumptions as follows:

(i) That, the contractor is not habitually or otherwise underestimating the cost when pricing.²¹

(ii) That, during the application of the formula, it is imperative to ensure that the profit element was realistic.²²

(iii) That, there should not be any fluctuation in the market conditions and that the same level of profitability would be available to her/him at the end of the contract period.²³

Despite its widespread use amongst contractors, the Hudson formula has a number of technical criticisms, which have been discussed herein.

It has been often criticised that the contract percentage that is obtained from the contract is a pricing shorthand used at the tender, and may not be equal to the contractor’s actual incremental/decremental head office overheads caused by the delay, or reflect the real profit lost. Furthermore, it is observed that this formula is not sensitive to the nature of delay, in case the projects suffer short disruption, partial slowdown, or a longer prolonged suspension wherein the overheads are affected differently, Hudson treats all of them in the same mechanical manner. Further, this formula fails massively to distinguish between the fixed and incremental costs. Pertinently, Hudson may give an inaccurate measure of lost profit, if the contractor mitigates losses, changes subcontractor arrangements, or alters overall workload, the tender percentage may not reflect the contractor’s actual lost profit.

(b) Emden formula

The Emden formula constitutes a refined iteration of the Hudson formula. The initial stage calculates the ratio of the contractor’s total overheads and profit to the company’s total revenue.²⁴ The second stage applies that ratio to the contract sum, the contract duration and the delay period to determine the weekly recoverable cost. The Emden formula is stated in the following terms:

Head office overhead & profit/100) x (Contract sum x Period of delay/Contract period

This method is more appropriate as it calculates head office overhead as a percentage of the contractor’s total business rather than of the specific contract.²⁵ In contrast to the Hudson approach, it has been widely adopted and affirmed in numerous foreign precedents.²⁶

When we look at Emden formula, it has its own lacunae, i.e. this formula requires detailed company accounts and careful allocation of the work, which is most of the times avoided by most of the contractors. Furthermore, unlike other formulae, it still assumes overheads and profit can be apportioned in proportion to revenue/time — which may not reflect fixed costs or capacity constraints.

(c) Eichleay formula

The Eichleay formula originated in 1960 by Armed Services Board of Contract Appeals.²⁷ As far as the usage of this formula is concerned, the contractor must substantiate the delay attributable to the Government and will be expected to mitigate its losses. Further, relevant foreign precedents indicate that government-caused delay is a common trigger for its application. It is used when a contractor normally cannot prove lost profits or loss of opportunity with reasonable precision, and instead seeks recovery of a share of fixed home office overheads for the suspension period.

Eichleay formula is stated in the following ways:

(i) Step 1: Contract billings/total billings for contract period * total overhead for contract period = Overhead allocable to the contract.²⁸

(ii) Step 2: Allocable overhead/Total days of the contract = Daily overhead rate.²⁹

(iii) Step 3: Daily contract overhead rate * No. of days of delay = Amount of unabsorbed overhead.³⁰

However, where the contractor can show that, notwithstanding the mitigation efforts, redeployment of workforce or plant was not feasible, the onus is on the Government to establish that no injury was suffered.³¹

Relevant judicial precedents addressing the usage of formula

Before venturing into the formulae, the reader should understand the different categories of loss arising from a delay in project completion. The first category is “additional overheads”: wherein the contractor incurs the expenses because of the delay, that results in requirement of allocation of extra overheads to the site. This loss must be proved with comprehensive contemporaneous records such as timesheets and cost accounts.³² The second category is “unabsorbed overheads”: Overheads that the contractor continues to bear because the delay prevents reassigning the head office costs to other work. This type of loss is typically quantified using formulaic methods.

Contractors have long used Hudson, Emden and Eichleay formulae to quantify delay damages; although rooted in English law, these formulae have been incorporated into and shaped by various jurisdictions.

The Hudson formula traces back to Peak v. McKinney (1970)³³, in which the Court of Appeal rejected the method and recommended relying on contractors’ accounts or other corroborative evidence to establish lost profitability; the formula, however, later received judicial support in J.F. Finnegan Ltd. v. Sheffield City Council (1988)³⁴. The Emden approach has been accepted in cases such as Norwest Holst Construction Ltd. v. Coop. Wholesale Society Ltd.³⁵, and other cases³⁶. The Emden formula emphasised on the usage of the actual cost from the contract to calculate the overhead.³⁷ Subsequent decisions of various courts of many jurisdictions have further endorsed recovery of actual head office overheads.³⁸

While the Eichleay method was developed in the United States and is predominantly used in the same jurisdiction. The Eichleay formula has been upheld in numerous US court decisions and is presently the exclusive method accepted by Federal Courts for calculating claims under public contracts.³⁹ Its application necessitates establishing a compensable delay and demonstrating that the contractor was prevented from engaging in alternative work during the contract period.⁴⁰ Furthermore, these formulae have received judicial recognition in both English⁴¹ and Canadian⁴² jurisdictions. Therefore, there are various conflicting views on whether the aforementioned formulae to be used or not, for the calculating the overhead recovery.

The following segment will examine the acceptance of these formulas within the Indian jurisdiction, particularly through the lens of judicial precedents.

Judicial precedents and acceptance of the formulae in India

In one of the earliest Indian decisions addressing the use of formulae to calculate damages in construction arbitration, the Court observed that a contractor may employ any of the three formulas to quantify damages.⁴³ Subsequently, the decision pertaining to which of the formula should be applied, in light of the facts and circumstances, falls within the arbitrator’s discretion.

Subsequently, the Supreme court in the decision of Batliboi Environmental Engineers Ltd. v. HPCL⁴⁴, observed that although all three formulas are recognised by the courts, the Hudson formula should be employed only as a last resort when the other methods are not suitable to the facts of the case. Moreover, if the Hudson formula is applied, it must be done with utmost caution. The Supreme Court most importantly has noted that the Hudson formula is not appropriate on its own — contractors need to provide sufficient supporting evidence before it can be relied upon.⁴⁵

Therefore, an examination of subsequent cases concerning the applicability of these formulae indicate that reliance on these formulae necessitates a strong evidentiary foundation. Accordingly, upon analysing the judgments of the Supreme Court and other courts, it can be reasonably concluded that the application of these formulae is unsustainable in the absence of adequate supporting evidence.

Brief analysis on alternative methods

The formulae commonly employed in construction arbitration to quantify loss of profitability have attracted growing criticisms, largely because they rest on simplifying assumptions. By failing to capture the complex realities of construction projects, these methods often yield damage assessments that are imprecise or unreliable.

As noted above, a principal objection to the Hudson formula is that it applies a contract-derived head office overhead and profit percentage that may bear little relation to the contractor’s actual overheads or lost profit during the delay. Apart from the other criticisms already mentioned, Hudson is ill-suited to small businesses: it can be used by larger contractors to inflate overhead claims and thereby place smaller firms at a disadvantage after project disruptions. On the other hand, the Emden formula, though advanced/refined version of Hudson, is criticised for its reliance on comprehensive and accurate data on a contractor’s indirect costs, contemporaneous accounting — records that smaller contractor frequently do not keep. Viewed together, both Hudson and Emden tend to operate in favour of large contractors and may result in under-compensation for smaller firms/contractors. Furthermore, the Eichleay formula is generally applicable to large-scale, high-volume projects and is of limited relevance to smaller contractors.⁴⁶ Because small firms typically sustain a proportionally greater overhead burden when projects are delayed or suspended, Eichleay often fails to compensate them adequately for those losses. Although there is no widespread judicial objection to the use of the formulas discussed, they are employed mainly as convenient tools for quantifying delay damages. Where a court permits their application, the contractor must support the formula with adequate evidence — for example, demonstrating that, but for the prolongation, the contractor could have deployed resources on another contract and earned greater profits. In practice, however, proving such lost opportunities is often difficult, which restricts the practical usefulness of formulaic methods for recovering overheads.

Considering the aforementioned discussion, following are the viable solution for eradicating the conflicting situation emanated by the three formulae:

1. One of the solutions would be to emphasise on actual costs and direct losses, mainly those resulting from idle labour or equipment. This approach emphasises on incremental costs and reduces the burden on small contractors to produce extensive financial records.⁴⁷

2. Furthermore, it is important to adopt a pragmatic method for calculating delay damages rather than focusing on court-imposed requirement of evidence. Indian courts have placed heavy emphasis on voluminous documentary proof when awarding damages. Rather than forcing small contractors to produce extensive records, Arbitral Tribunals/courts could permit them to rely on witness testimony — for example, from renowned personnel within the claimant’s organisation — about the financial effects of the delay.

3. An alternative would be to adopt a “direct costs” formula that calculates a contractor’s damages based on the actual costs incurred during the delay. Unlike Hudson, Emden and Eichleay — which depend on historical/past financial data — the direct costs approach concentrates on expenses actually borne in the delay period. Such a formula would be more transparent and easier to substantiate, particularly for small contractors, who would need only to produce records of direct costs rather than extensive, complex documentation.⁴⁸

4. The measured-mile method compares productivity before and during disruption to find out the cost of the lost productivity. It is done in the following way: Begin by calculating the productivity rate as work completed divided by time taken. To establish the baseline productivity = units completed ÷ time (days or hours) required to complete that section. Next, identify the events or conditions that caused disruption and calculate the impacted productivity for the affected period as impacted productivity = Work Units completed ÷ time taken during that period. In order to calculate productivity loss as a percentage using: [(Baseline productivity = Impacted productivity) ÷ Baseline productivity] × 100. Finally, convert the lost productivity to a monetary figure by multiplying the lost units or hours by the appropriate loaded labour cost per unit (or per hour) and, where relevant, by the number of affected days.⁴⁹

5. Another alternative method could be to use a fixed overhead percentage to calculate prolongation damages. Ideally this percentage is taken from the contractor’s audited head office overhead rate or internal accounting. In case wherever such data is lacking then it can be justified by placing a reliance on data/percentage of similar companies, industry norms, or prior arbitral awards.

Conclusion

From the above discussion, it can be concluded that the Hudson, Emden, and Eichleay formulae are not ideally suited for quantifying delay damages due to the numerous limitations and conditions associated with their application. Considering all the issues discussed, it would be prudent to develop a more balanced formula — one that not only accommodates the interests of large contractors but also addresses the challenges faced by smaller contractors who often find it difficult to recover lost profits resulting from project delays. Various alternative formulae are applied depending on the specific facts of a case. For example, the Allegheny formula — used in the construction sector — allocates costs on a contract-value (cost) basis rather than on a time basis, so it suits particular circumstance.⁵⁰ Further, the Ernstrom formula, by contrast, quantifies additional overheads where there is an apparent direct link between overhead costs and labour costs, permitting recovery for extra overheads caused by prolongation.⁵¹ Ultimately, the use of these methods in India depends on their acceptance by Indian courts and tribunals. Additionally, such formulae may even prove inappropriate or even prejudicial, as delay claims must be evaluated in accordance with the specific facts and the legal principles governing Indian law. The courts have further emphasised that any claim derived from a formula must be substantiated by contemporaneous and credible evidence. Therefore, the application of any formula for quantifying delay damages must be reasoned, consistent, and firmly grounded in evidence, while also taking into account the unique challenges faced by small contractors and micro, small, and medium enterprises (MSMEs).