The key to success in construction is keeping up with the numbers. The construction industry is a cost-based business, and you need to know your numbers and mark them up to determine the price. The overall construction price, therefore, needs to be high enough to cover expenses and leave profits. For you to manage your profitability in construction, you need to manage your risks. Risk management touches all project spheres, from supervision to structuring and negotiating contracts.
A well-drafted contract builds the basis for successful projects and lasting relationships. A good contract also accounts for the scope of work, payment terms, plausible risks, and other monetary matters. In this article, we will discuss the best ways to price your construction project.
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How is a construction project priced?
Different factors such as type of design, budgetary constraints, expected risks, schedule, and project-specific difficulties affect how a company will price a project. Generally, there are two critical methods of pricing construction contracts, as we will discuss below.
Types of construction pricing
The first step in pricing a project is cost estimating, which entails calculating approximate quantities and values for the scope of work. This is where a cost estimator does the takeoffs and develops the scope of work.
After cost estimation, bids are invited for the project.
The contract is primarily priced using either the fixed price or the cost-reimbursable pricing method.
These pricing methods have their unique advantages and disadvantages. Depending on the individual requirements, the contract may vary. For example, an owner may choose a fixed-price contract because of its certainty concerning project cost.
On the other hand, the contractor might prefer a cost-reimbursable agreement to minimize the risk of reduced profit margins.
A contractor can be profitable from both contract types, but fixed contracts need more accurate cost predictions as the client will not be liable for the risks of costs exceeding the budget.
Costs + fee
The client prefers this type of contract to minimize the expenses and risks incurred on the project. In addition, these contracts do not need stringent cost estimation measures as project owners instead of contractors incur additional costs.
Generally, the cost-plus fee contracts are free of any limiting features, but if the client insists on a guaranteed maximum price, it limits the costs from exceeding the ceiling price.
One advantage of cost-plus-fee contracts is the reduced risk on the contractor. However, the client carries a heavy risk burden. This contract has other different advantages as we will discuss below:
- Lower costs: These contracts can be remarkably budget-friendly to the contractor. Decisions such as the quality of material to use are more accessible to the contractor as the expenses do not come from the contractor's pocket.
- Easier cost estimation: Estimation is more straightforward in these types of contracts. If cost estimation seems challenging, these contracts can help. A contractor needs not to worry about an inaccurate cost estimate altering the profit margins. It is already accounted for.
- Tight budgets: Regarding budget, it limits the money a contractor can spend on the project. This allows the property owner to operate on a tight budget.
The cost-plus contract has some drawbacks as the contractor needs to justify why the expenses are project-related. Below are some of the associated disadvantages of cost-plus contracts:
- Cost management problems: These contracts require additional effort to keep track of all incurred expenses. For a disorganized contractor, it might cause a lot of problems.
- Indirects costs: It is also difficult to account for indirect costs. The contractors must cover administrative expenses, and the owner is usually not happy to cover them. It is therefore pertinent to ensure the "plus" covers these costs.
- Cash flow problems: A cost-plus contract operates through reimbursements meaning the contractor has to front the costs. Keeping in mind how cash flow can be problematic in the industry, the owners can find themselves tight.
- High risk for the contractor: These contracts transfer most of the risks to the contractor. This creates a conflict of interest for the contractors and might eventually lead to higher costs for the client.
The construction industry also refers to a fixed price as a lump-sum contract.
This is where a contractor agrees to do the project for a predetermined set price. The contractor submits an overall project price instead of a bid for each expense. Lump-sum contracts are mostly applicable on projects with clearly defined scopes that are straightforward to complete.
Many projects in the federal government operate under lump-sum contracts. Since lump-sum contracts only have one overall price, the contractor needs to get the price right. The contractor needs to correctly anticipate labor costs, material costs, project schedule, and how much is required for profits and overhead costs. The contractor also needs to ensure that the owner will not bring up many change orders throughout the project's lifecycle.
Lump-sum contracts have benefits that cover both the contractor and the owner. Below are some of the most significant advantages of lump-sum contracts:
- Simplicity: These contracts are easy to draw up, understand and execute. They state the work in question and the money expected by the contractor at the end of the project. Contractors love these contracts as they allow for some flexibility to complete the project. Owners love them because they know how much the project will cost eventually.
- Higher profit margins: When contractors enter these contracts, they add some insurance into the final project price to protect them from unforeseen circumstances.
- They are easier to finance: It is harder to secure financing for other open-ended contracts. This is because there is because the lenders are generally concerned about unexpected risks and inflated labor costs. However, it is easier to secure funding for lump-sum contracts as the scope is clear under one set value.
- Less paperwork: Lump-sum contracts generally have way lesser paperwork. Owners do not need to bother with labor and material costs as payments go to the project schedule.
- It is easier to manage the budget: Lump-sum contracts have more manageable budgets, making it easier to manage the cash flow. Having a clear roadmap, the builder knows what to expect and when to expect it.
As with any other contract, lump-sum contracts have their drawbacks. Some of the major disadvantages are:
- High risk for the contractor: The contractor assumes all the risk to bring the project to completion. As much as there is an insurance fund to cover contingencies, the risks can easily surpass this fund. The contractor foots the bills if the project price exceeds the budget.
- More expensive: Owners know that the contractor assumes more risk in such contracts. Subsequently, contractors increase the contract price to cover the risks. This contract is, therefore, more expensive than other contract types.
- The projects under these contracts are rigid: Both parties need to know the scope to enter into this contract. However, when change orders occur, they are tough to incorporate into the contract. They are time-consuming and with a lot of paperwork.
- Contractors can hide profits: The paperwork is less detailed than other contract types. The contractor, therefore, has a lesser need to itemize material costs or provide supplier quotes to the owner.
Steps to find the right price
Negotiating for the right price can be tedious. In addition, both contractors and owners are wary of the implications of overruns in a project.
The best way to arrive at a feasible price is by streamlining the cost estimation process. A reasonable cost estimate cushions a builder from incurring losses and an owner from overpaying a project. Clients contemplating embarking on massive projects may even seek multiple estimates from the contractor and independent estimators.
Below we will discuss some of the steps in finding the right contract price.
Construction costs cover initial costs and future operation and maintenance costs. The prices depend on the type, location, and scope of the project. The owner targets the lowest possible costs with which they can achieve their objectives.
Some initial costs are:
- Feasibility studies
- Land acquisition
- Construction financing
- Design, furnishings
- And material testing
In most construction projects, there is also an allowance for contingencies to cover unexpected costs. They might be a lump-sum amount or computed in every single category. Contingency costs include development changes, administrative changes such as labor rates, project schedule adjustments, and third-party requirements such as acquiring new permits.
To estimate the labor costs accurately, you need to determine the base rate (hourly rate) and the labor burden. These two metrics computed together to give the labor costs.
If you have the hourly rates for the project team, the base rate will be the cumulative hourly rates.
However, these do not fully depict the labor costs.
There are other costs such as:
- Paid leave
- Training costs
- And company vehicles.
The labor burden covers these multifaceted costs. Adding the labor rate to the hourly rate for each employee gives you the total labor rate per employee. However, it would help if you also accounted for inefficiencies in labor cost calculations. Inefficiencies can be staggering, and you might find yourself constantly faced with cost overruns if you do not account for them.
The following essential costs are the material costs. Ascertaining accurate material costs is one of the objectives of proper cost estimates.
To establish reasonable material costs, you need to compute the total costs of the intended. Materials are supplied in lump-sum, while in cost-plus contracts, the costs are priced per unit.
In unit pricing of materials, we first determine the quantities of work and compute the associated prices. We then add material waste factors to ensure the project has enough material to complete and sum up the total material costs./
Make a cost estimation.
It is easier to make a successful cost estimate after you have information on labor and material costs. It would help if you used the project's scope to make a construction schedule that subdivides the work into small bits. Next is to perform a quantity takeoff and provide total material costs. Labor costs follow the materials estimates, then overheads and profits.
Apply a markup
Once a contractor has estimated all the hard costs (material and labor costs), they mark the costs to cover overheads and profits. Overheads are soft costs that are not job-specific but are necessary for the daily operations of the project. They include bookkeeping, training, insurance, and other office expenses. Profits refer to the amount left after computing both hard and soft costs. If a job is profitable, a contractor should have a decent profit after the completion of the job.
Pricing strategy tips
Pricing sounds simple, but it is far from it. Below are some tips you can use to get it right the first time.
Know your customer’s expectations
You need to ensure that you are on the same page with your customer and have them fully approve the plan. Avoid unrealistic expectations that lead to unexpected expenses as the project progresses. Ensure that you account enough money for contingencies to cater for unexpected costs during the project’s lifecycle.
Work with a team
The contractor should not make big decisions on estimation individually as there are many stakeholders involved. A team is likely to spot some expenses that you may have overlooked.
Review past projects
Reviewing past projects gives you the advantage of hindsight as you can look at records of expense lists. This drastically improves your pricing.
Hire a professional
If you cannot accurately perform your estimates, consider hiring a professional cost estimator to check your calculations and spot problems.
There are so many questions surrounding pricing in construction. Of course, the owner always wants to know how much it will cost to construct the project. Below are some of the frequently asked questions.
How much should I charge for construction?
Contractors charge 10 to 20% of the total project costs, but the price might go up to 25% of the project cost in large projects.
Can a contractor change the price?
Once a contractor accepts a quote to do a job for a given price, they cannot alter the price. The only condition where the price can change is if the scope of work changes while the project is ongoing.
What is a general contractor's hourly rate?
General contractors do not have well-defined hourly rates as the figures vary in states, cities, and countries. However, one would expect to pay a rate of anywhere between $30 to $100 per hour.
How do I calculate my hourly rate as a contractor?
First, you need to determine your annual salary. This is how much you want to get paid. After that, you need to calculate overheads. These are the total costs to operate your business. You should then choose a profit margin and add it on top of your salary and overheads. It would help if you then determined your billable hours in a year to work your hourly rate.
How much do contractors tend to mark up?
As we saw above, markup covers both overheads and profits. A contractor, therefore, needs to know the percentage that goes into overheads. Most contractors adopt a 1.5 or 50% markup so that their profit margins are about 30%, with the remaining 20% going to overheads.
Should I offer a free estimate?
For small, simple jobs, a contractor can offer free estimates. However, for big projects that involve detailed design, a contractor should not be providing free estimates.
In our current information age, we have all the necessary tools to increase the accuracy of pricing construction projects. Accurate pricing determines whether a project will be a success or not. With a proper understanding of construction estimation, it is easier to develop a more precise estimate.