DEMYSTIFYING THE COST OF CONSTRUCTION

How much will it cost?

You are about to remodel your home. You have never worked with a contractor before. How do you begin to navigate the process of finding a reputable contractor and a fair price?

Most people take the traditional "three bids" approach, or asking three companies to provide a price for their project. This is a common approach and may work in some cases. If nothing else it gives you a chance to interact with several contractors and get a sense of how you would work with them. It also allows you to quickly weed out people who do not seem professional, straightforward or on the ball. But three bids alone will not provide the information you need in order to be a knowledgeable and confident consumer.

What's Wrong with this Picture?

The construction business in the United States has the highest failure rate of any business enterprise. Statistics show that thirty percent of startups fail by the first year, fifty-seven percent by the second year, and within ten years between ninety and ninety-six percent close shop. What is behind these alarming statistics? Why is it that construction companies come and go so quickly?

One reason is that most people with the initiative to start their own construction business have come up through the ranks as mechanics and technicians. They generally have very little understanding of what running a profitable business entails. This knowledge comes about through deliberate education, or being mentored by someone who runs a successful construction business.

This lack of business experience shows up in the culture of "three bids." Nearly all startup contractors get caught up in cutting prices in order to win contracts instead of focusing on learning to run a successful business. The mantra of three bids initiates a race to the bottom for those contractors who practice it. The problem comes when contractors slash their prices so drastically that they don't have the funds to run efficient businesses. Sometimes they are unable to complete their projects as promised and you end up suffering.

Once a company is habituated to competitive bidding, it becomes difficult to change, especially with so much social reinforcement pushing companies into this practice. How does this affect you, the consumer?

What Do I Learn from Three Bids?

Let's take a look at the type of information you might get in the three-bid process. Chances are that when the prices come in the numbers will vary widely. Many consumers end up choosing the middle bid, possibly assuming that the lowest bid won't cover everything and the highest bid looks unreasonable. This strategy appears to make sense considering that most consumers have little experience understanding bids, and to an untrained eye, one contractor may look very much like another.

The problem is that without clear information about the details of a project and the quality of work that a contractor commits to, a consumer may find that comparing three bids by price alone is like comparing apples to oranges. Consumer must have enough detailed information to make an informed decision.

Here are a couple of questions to consider if comparing three bids:

How detailed and firm are the proposals being offered by the firms?
A known method of getting a foot in the door to win a construction contract is to offer a lower price with the intent to make up for the actual cost of production through change orders. Shortly after the project begins, unforeseen conditions appear. Soon one finds they are overwhelmed and angered by expensive and unanticipated construction costs. However, the contractor who has been around for a while should be capable of anticipating potential problems when an area of the home looks questionable, and should inform you prior to construction. The real giveaway is when multiple unforeseen conditions arise during the course of construction.

Has the contractor considered all aspects of the project?
In order to speed up, and reduce the pain, of the estimating process, a contractor may plan to make up for lack of attention to detail by throwing a little more at a familiar task with the hope it will cover for somewhere else, should the need arise. Putting together a firm price quotation for a project takes time, discipline and a lot of knowledge.

Another factor, and probably the most common, is that competing companies' markup rates will differ widely. Many contractors simply do not understand the cost of running a viable and profitable business. Operating a construction business consists of more that just showing up each day and assembling whatever a contract specifies. The cost of keeping a company’s doors open consists of many indirect expenses, i.e. overhead.

That said, what else do you really find out about a company by getting three bids? To get a better sense of how construction costs are estimated, let’s take a quick look at the construction business in general.

The Cost of Construction

The cost of any construction project can be divided into three categories: direct expenses, profit, and company overhead. Direct Expenses Direct expenses include materials, subcontractors, equipment, and labor expenses. These are the only elements that can be directly compared in the three-bid process; however it is important to have enough details to support direct comparison. For example, if detailed project specifications are available to the contractors prior to pricing, then the consumer can look at the various materials listed and compare bids. However, the consumer must use care that enough information is provided about quality of materials proposed. Many bids may look financially attractive but use lower quality materials. An Informed consumer will ask for or supply details about the materials that the contractor will use.

Subcontractor estimates should also meet the same criteria. What is the quality and professionalism of the proposed subcontractors and how good are the materials they will use?

In terms of direct costs, labor is the most difficult to compare across the board. Constructing accurate labor estimates that take in the big picture requires experience. The more complex the project, the more thought and analysis required to determine what manpower is needed to produce a well run project. Contractors often rely on computerized estimating programs, which can be invaluable, but even software programs require construction expertise in order to avoid the “garbage in-garbage out" syndrome.

Profit
In a nutshell, profit is what is left over after all the bills are paid. There is no profit standard within the construction industry. There is a myth of ten percent overhead and ten percent profit, but this does not accurately reflect the costs of overhead for any successful construction business. The ten percent profit portion of the equation is closer to the mark: research suggests that a minimum of eight percent net profit is required to begin running a viable business, with a preference of ten percent or better. A business must define its target profit rate when planning their fiscal year. But no business will survive for long if they do not realistically anticipate company overhead.

Overhead
One fallacy circulating within the construction industry is that small companies do not have much overhead. In fact, a smaller company will have higher overhead costs as a percentage of their total sales than a larger company. Overhead costs are the necessary costs associated with keeping the company's doors open. All business owners should sit down before the end of each fiscal year and begin planning next year's budget. This budget is nothing more then deciding what expense’s the company will have, and at what percent of the total budget. A budget can run from a couple dozen items to hundreds or more. The jargon may vary from business to business, but budgets essentially consist of indirect expenses and administrative expenses.

Indirect expenses
are those that are associated with construction, but are not directly attributed to any particular construction project. A short list of these items might include payroll taxes, workers compensation insurance, health, dental and accident insurance, telecommunications, training and education, warranty and repairs, small tools and supplies, and vehicles.

A list of administrative expenses will be longer, and is limited only by how individual companies see their future. A few examples of these items are: office and clerical salaries, rent, maintenance & repairs, office supplies, general liability insurance, license fees, professional services (accounting, bookkeeping, consulting), advertising and marketing.

Each business must define their overhead expenses. Running a viable construction company takes far more planning and resources than many new business owners realize.

What Is Required?

What must a construction business do to thrive? A business must arrive at a markup value that is applied to the direct cost of construction, which accounts for all overhead expenses and profit. The markup formula is total sales divided by total construction costs. This formula can provide a fairly good indication of current company financial health.

To arrive at a markup rate, a company should add their projected overhead expenses to projected net profit. That sum is then subtracted from projected total sales to arrive at projected job costs for that year. At this point, using the formula of total sales divided by total construction costs, a company can identify the markup they should apply to each project they price that year. This approach, based on analysis, makes far more sense than the ten-percent myth that has been circulating for so long that it has achieved the questionable status of legitimacy. Is there a minimum markup that a company needs in order to thrive? Yes. But only thorough planning and analysis will determine that markup.

Arriving at a Price

Gathering information for a comprehensive estimate is time consuming. Complex projects require the consultation of subcontractors who are expert in their field of work. Calculating a firm price usually requires one or more site visits. Most construction projects will involve between two and a dozen subcontractors, and it takes time and coordination to arrange site visits. Many contractors claim to give free estimates, but like an architect, designer, or engineer, a professional contractor cannot afford to simply give away time. Time required for estimating becomes categorized as an overhead expense in a company's budget projections. Instead of this time being a direct expense for a particular estimate, it becomes an indirect or overhead expense spread over the fiscal year. Some contractors and subcontractors have decided to charge directly for their estimating services. These businesses then offer all or part of this cost as a down payment to a construction contract. This method reduces or eliminates estimating as an overhead expense of the yearly budget and clients no longer pick up part of the tab for other people's estimates.

Thriving Businesses

Former president Calvin Coolidge once stated, “The chief business of the American people is business.” Businesses come and go, but those that thrive have a great deal to contribute to their communities and society in general. Small businesses are the real engines that drive the American Dream, and not only through the services or goods they provide. Their contributions to society and the community manifest themselves in many ways from providing meaningful employment to purchasing goods and services from other businesses in the community, to providing support for local charitable causes. Local and state taxes further support their communities, as well as their country.

For you, a well-run construction business offers better field personnel, better subcontractors, higher quality of materials, better-trained office personnel, and better services and follow-up.

Honest, well-run, profitable companies do not cause the type of grief we often read about in our daily papers, observe on the evening news, or hear about from friends and acquaintances. Established firms are not going to take the money and run. Because they have the resources to manage and complete a specified project in full and on time, the consumer can avoid the nightmares that grow out of disappearing contractors, shoddy workmanship, or unexpected continually mounting costs. Most important, a good contractor will be around after the project is finished to honor warranties or address any other problems that may arise.

The Final Choice

If price is your only determinant when examining bids, you may not have enough information. Contractors must provide details about the work that they are planning to provide and the advantages of purchasing their services. Business surveys have shown that informed consumers make purchasing decisions in the following order:

Trust and confidence in the provider
Quality of product or service
Reputation of provider
Efficiency of provider
Price

When a consumer does not perceive any difference in value, and all companies are assumed to be equal, they become price shoppers rather than value shoppers.

Interpreting information from three bids is a tricky process. It becomes more difficult when the method for choosing contractors is arbitrary. The levels of professionalism within this industry, as in most others, run from poor to great. If one is trying to obtain useful information from three bids, at minimum they need to be looking at three comparable companies. That can only be accomplished by doing research on those companies prior to asking for a price to construct.*

After the initial purchase, remodeling a home is probably the largest single financial outlay most people make during their lives. With an investment like this, you should feel in control of your destiny. Becoming well informed is the most powerful way to achieve this goal. Take the time to do proper research. Should you still decide to choose your contractor using a three bids process, you will have a clearer understanding of what you are attempting to interpret.

*See our brochures, How To Find The Contractor You Really Want, and Remodeling By Design-Build.