What is a contingency?
A contingency offers businesses a backup or safety net in preparation for unexpected negative events. Contingencies range from procedural backups to account for unforeseen events to financial padding to protect margins in the event of price changes.
In residential construction, a contingency refers to a percentage or fixed amount of money set aside to cover unanticipated costs that may arise during a project. A contingency provides extra margin in the project budget so builders + remodelers can keep their projects profitable when new costs come up or prices change.
Why are contingencies important in residential construction?
One of the biggest challenges facing builders and remodelers is balancing income and expenses on each project to ensure their overall business cash flow stays stable. Prior to putting boots on the ground, estimators put together a prediction of what materials, labor, and subcontractor work might cost then tack on a margin percentage to ensure money comes in. These cost predictions come from subcontractor bids and vendor quotes but typically land on the preliminary budget months before work begins. In the meantime, costs change and prices fluctuate making that solid prediction just that - a wildly good guess. Unless builders and remodelers lock in prices with subcontractors and vendors, they face the risk of eating into their well thought-out margins. Builders and remodelers also face cost changes from clients on selections and allowances that could negatively impact their margins.
A contingency ensures that small, overlooked details that arise in a build do not derail a project’s financials. Builders + remodelers have many small, vital details to follow throughout every build, so every once in a while it’s normal for a builder or remodeler to overlook a hidden cost when writing up a budget. Building companies that use contingencies in their financials have a competitive edge and are able to stay profitable when responding to new costs throughout a project.
How do builders + remodelers use contingencies?
There are three different types of contingencies commonly used in construction:
- Contractor Contingency: The builder takes financial responsibility for any additional money spent on a project. This type of contingency usually requires building firms to reduce their profit margins.
- Owner Contingency: The client bears the brunt of additional costs beyond the project’s original scope. Owner contingencies are typically used in a fixed price model when a project’s scope and budget are clearly defined. In a fixed price model, money cannot be spent beyond a defined threshold.
- Design Contingency: Also held by the owner, this contingency is used for unforeseen costs during the design phase.
1. Manual Methods
Typically, builders + remodelers allocate between 5% to 10% of a project budget to a contingency. This amount should create enough breathing room for unexpected costs. Anyone tracking estimates and costs manually calculates a contingency percentage on top of all costs, before profit margins are applied. Whether they’re done on paper or calculated by hand, these methods offer familiar and accessible estimating options that get budgets and proposals in the hands of clients. Any negotiations to price or recalculations, however, require careful tracking and risk human error.
2. Spreadsheet Software
Spreadsheet softwares, like Google Sheets and Microsoft Excel, manage project financials through formulas and digital files that reduce human error and automate calculations. These spreadsheet programs require a very hands-on approach, taking several iterations to get all elements working together. Many builders + remodelers also use accounting softwares, like Xero and Quickbooks, for tracking project financials. Accounting systems excel at reporting on income and expenses going towards a pre-set contingency but are limited on applying markups. While these tools offer a digital experience that prevents the paper shuffle common with manual methods, they struggle to bring the full estimate to proposal to budget experience together.
3. Integrated Project Financial Management
Cloud-based construction management softwares, such as CoConstruct, manage all of a project’s financials in one place. A builder or remodeler lays out the estimated costs, calculates what contingency suits the project or client, then tracks the project’s budget all from one login. In just a few clicks, a builder or remodeler can write in a percentage of the total cost or a lump sum to serve as the project contingency. Tied to the project budget, these calculations transfer into real-time estimated versus actual reporting to clearly indicate where such funds get leveraged.