The Associated Builders and Contractors (ABC) reported that its Construction Backlog Indicator (CBI) increased to 9.67 months for the fourth quarter of 2017, the highest it had ever been. While the increase in backlog is a positive outlook for the construction industry for 2018, many will struggle to translate that into an increased bottom line due to rising material costs. These increasing costs are more of a concern for those who agreed to a long-term contract before the completion of a construction project. Below are a few ways to minimize risk associated with the fluctuations in costs from bid to project finish for a long-term contract.
Appropriate Estimates Used in Bid for Contract
Successful contractors are those that have mastered the art of developing accurate estimates during the bidding process. If you are too conservative with your estimated costs, you could lose the contract to a competitor. Conversely, if you are too aggressive with your estimated costs, you’ll win a contract that could lose money. One way to fine-tune the estimation process is to compare the estimates for all phases of a contract to the actual costs incurred for those phases throughout the agreement. This method will help you get a better understanding of what you estimated correctly and where you may have missed the mark, so you don’t continue to make those errors in future estimates. If you can perform this analysis on a monthly basis, you would be able to implement any necessary changes to your estimates on a timely basis. Even if you cannot commit the time and resources to doing this monthly, performing this analysis at the completion of the contract would still be beneficial.
Contract Pricing Structures
There are various ways contracts can be structured when determining the contract price. The two most common structures are fixed-price and cost-plus (or time-and-material) contracts. There are not too many options to reduce your risk with a fixed price contract because the contractor bears the risk if material prices were to increase significantly after the owner approves the contract. The contractor could submit a change order for the increases in material costs, but there is no guarantee the owner would approve the change order.
However, for a cost-plus contract, the price is determined by the actual costs incurred on the contract plus a percentage for overhead and profit. This type of contract shifts the risk of unexpected costs from the contractor to the owner. Because the risk shifts to the owner, these contracts typically include a guaranteed maximum contract amount to assure the owner that the final contract price is not significantly different from the bid amount; therefore, being able to estimate the cost accurately is still important.
No matter how experienced your estimators may be, there are outside forces that are impossible to predict when estimating a job. An example of this would be the recent tariffs imposed on foreign steel and aluminum. The tariffs decreased the supply of steel, and the demand is increasing (as referenced by the increased backlog above), so the cost of the material is rising. If a contractor is currently working on a job that was estimated using market steel pricing from the summer of 2017, the current price to purchase steel would be higher than what was estimated.
Consequently, an escalation clause should be included in the contract to help reduce the risk of the contractor for unforeseen events like this. The escalation clause would allow the contractor to increase the contract price if the material costs increase by more than a certain percentage. For example, the escalation clause could stipulate the owner is paying the contractor for any increases in costs relating to steel or lumber purchases if the price of the material increases by more than 5%. As with any changes you make to the language included in your contracts, it is wise to seek legal counsel to ensure the modifications made are appropriate and have the intended effect.
Contractors could see record-setting revenue in 2018; however, there needs to be an intentional focus on margin to translate this into a record-setting year of profitability as well.
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By Kevin VanPelt, CPA, Manager