Residential construction is booming.The sales of newly built, single-family homes rose in August to their highest peak since 2006. While some are building or moving into newly built houses, others are looking to make improvements to existing homes. The boom in new builds and remodels has led to a higher demand for building materials, in particular, lumber.
Increased demand is compounded by production disruptions in lumber mills because of COVID-19 concerns, resulting in supply shortages. In some markets, the price of lumber has increased by more than 80% since mid-April.
Today, lumber is harder to get and more expensive than ever.
So, what now? How can you make sure that you keep your business on solid ground despite the turbulence of increased lumber prices?
Here are four short-term solutions you can use to combat your lumber woes:
1. Use a Contingency.
A contingency is an added percentage (or fixed amount) of the contract value that has been set aside for unexpected or unpredictable changes to your costs. Contingencies create a buffer for your profit margins and decrease the chance of uncomfortable client conversations (and bank issues) because of increasing the base price later in the process. In addition to reducing your exposure to financial risk, you can take advantage of a new selling point -- a price reduction for your clients if not all of the contingency is needed.
2. Treat lumber as an allowance item.
Just like you might reserve a budget for clients to pick plumbing or lighting fixtures, you can make lumber costs an allowance item, and use the current lumber price in your market as the allowance amount.
That way, your client will be responsible for any actuals that exceed the allowance, which shifts the risk created by market-dependent costs from you, to your client.
Your allowance should be written without an Escalation Clause (see below) , so that clients can’t walk away from a project because of price fluctuations. This allows you to have price transparency on lumber without having a fully open-book project.
3. Leverage an Escalation Clause to account for material price changes.
An Escalation Clause is a contractual provision that spells out the terms for increasing the price of a project under certain conditions. In addition, it explains the rights both parties have in responding to the escalation. It can provide a cap on your risk if the clients continue with the project and doesn’t require you to raise the price of the project at the outset. It can be combined with a contingency to provide full price protection to you and peace of mind to the client.
4. Use an Open Book or Cost-Plus financial structure.
Using this structure ensures that ALL costs on the project are transparent to the client. The client knows the estimated budget, but is responsible for paying whatever the actual costs are, plus an agreed upon % profit markup or fixed profit amount. This structure shifts risks associated with market-dependent material pricing to the client. It also provides profit protection on every part of the project, not just on lumber. In this scenario, you would want to write your contract in a way that your client would not have an escape clause. This financial structure will not require you to raise the price of the project at the outset and can be a selling differentiator for clients who seek greater financial transparency. Everything is in the open, no hidden costs.
These practices have been implemented with great success by a number of our customers. Pick a plan that works best for your business or try a few of the suggestions together. Having a plan (and a back up plan) is the best way to tackle what this year has thrown at us. We’ll be here to help navigate the ever changing winds of 2020.