Construction Contingencies for Remodelers and Builders
As builders, we understand that unexpected issues can arise in any project, no matter how well we plan ahead. These surprises often lead to extra time and cost.
Finding the money to cover these extra costs can be a tough conversation if you haven’t planned ahead and built a safety net through client education or within your project estimate.
In the residential construction world, that safety net is known as a “construction contingency.”
Simply put, a contingency is extra money that either your client is aware of and has access to, or built directly into your project budget to cover unexpected costs. This ensures the project can adapt to changes without bleeding the builder's profit margin.
But how it’s handled differs based on whether you’re a fixed-fee or cost-plus builder.
For fixed-cost builders, contingencies are built into the overall project cost by the builder, usually as a percentage of the contract sum. And because the client only sees a bottom-line lump sum amount on a fixed-cost estimate, they don’t know the contingency is there. And it’s a good idea to keep it that way because once they know it’s there, they’ll try to get their changes covered by it, thereby bleeding your profit.
In the cost-plus pricing world, it’s best practice not to build a contingency category into the project estimate but instead, advise and educate clients on why they need to have access to at least 10% of the estimated cost for contingency. And when things come up like site conditions, you’ll issue a change order for this cost which is technically covered by their contingency.
What Is a Contingency in Residential Construction?
Simply put, a construction contingency is used to protect a project budget and reduce financial risk for the builder by ensuring they don’t have to use funds that would normally go to overhead and profit contributions to cover other unexpected additional costs.
That being said, it’s important to understand that not all unexpected costs on a remodeling or custom home-building project are covered under a contingency. In fact, most additional costs should be passed along to the client to pay for in the form of a change order or variance.
Contingencies, whether for fixed cost or cost-plus contracts, are put into place to cover a very specific list of unexpected expenses that can arise, such as:
Projects taking longer than expected
Slight increases in material cost
Miscalculations on material take-offs
Increases in trade pricing vs. what was originally budgeted for
What a Contingency Does NOT Cover
There are many reasons why a residential construction project can accrue extra costs, and generally, those shouldn’t be your responsibility as a general contractor. That means not using your contingency to cover additional expenses for items like:
Issues discovered during demolition, like latent site conditions
Engineer or inspector requirements
Client allowance overspends
Changes in project scope, whether client-initiated or by designers/architects
When these unforeseen costs occur, they are passed along to a client as a change order.
Contingencies, Change Orders, and Variances: What’s the Difference?
In essence, contingencies, change orders, and variances all work the same way: to cover unexpected cost overruns during a renovation or new construction project. But each plays a different role in the overall project budget, and understanding when to use each one and how to explain them to your client, is key to ensuring that each remodeling or custom building job remains profitable.
Because very often, if a client knows - or thinks there are additional funds for their remodel, they will think it’s theirs to spend. This blurs the lines between what construction contingencies should actually be used for and can create tension between homeowners and builders.
Here’s a quick breakdown of the differences between them:
Construction Contingencies are best used with fixed price contracts as funds set aside for unforeseen costs and risks that arise during the project, like when something simply takes longer to self-perform
Change Orders are an amendment to a construction contract that outlines changes in the project’s scope, duration, and contract price. In either fixed-cost or cost-plus building, you’ll pass final price for these changes along to your client through a change order document.
Variances are the difference between the cost estimates during the planning phase of a project and the actual costs during construction. If you’re a cost-plus remodeler, those costs are still billable to the client (plus your markup) according to your signed contract.
By clearly distinguishing between these terms, you can ensure that each fund is used for its intended purpose and avoid confusion. Learn more about the differences between contingencies, variances, and allowances here.
Common Myths About Construction Contingencies
Depending on where you do your research, you might hear about different types of construction contingencies, such as design contingencies, owner contingencies, and contractor contingencies.
Very often, they’re described like this:
Design Contingency Allocated for design changes or updates.
Owner Contingency Held by the client for unforeseen changes.
Contractor Contingency Managed by the contractor to cover unexpected construction costs.
The internet will have you believe that these are different types of contingencies when, in fact, they are simply a good way to get confused and confuse your clients.
The truth is, there aren’t different types of contingencies, just different ways to handle them depending on whether you run a fixed-cost or cost-plus residential construction business.
For example, a design contingency, which some might believe should be held to cover changes in design, falls under the criteria for a change order. Because if a client, or their designer, is making changes to the project design, that’s a cost they need to pay for.
Don’t fall for this trap. Ignore the misinformation, and follow a simple process for managing additional costs on your jobs.
Bottomline: A homeowner needs to have X% above and beyond the contract value as a contingency, as determined by the builder.
How to Use Construction Contingencies in Fixed-Cost and Cost-Plus Construction
Whether you're a fixed-cost or cost-plus builder, accounting for contingencies in a residential construction business differs. The approach to setting aside contingency funds, managing unexpected expenses, and communicating costs to clients will vary based on your pricing model.
Contingencies for Fixed-Cost Builders
As a fixed-cost builder, a construction contingency is something that you’ll build into your overall project budget to ensure that funds are available to cover a range of unforeseen costs that aren’t considered a change order but also shouldn’t come out of your contributions to overhead and profit (aka your Gross Profit).
Because fixed-price contracts include a single bottom line total for the entire project scope, the client doesn’t see the amount required as a contingency as a separate item.
Typically, the contingency is a percentage of the total sum of the project and can be handled one of two ways: as a line item in the budget or built-in to each category.
For example, let’s say that the project budget includes hiring a trade partner to install floor tiles in a bathroom remodel. But the final bill from that partner includes an extra day’s work because part of the tile delivery was delayed. Those extra labor costs would be covered by the contingency that was built into the estimate and not from your gross profit.
Cost-Plus Construction Contingencies
If you use a cost-plus business model, you’re using a transparent, open book pricing process that charges clients actual costs for every component of their remodel or build, plus a mark-up.
Handling contingencies as a cost-plus builder is a little more complicated because it involves having a direct conversation with clients about having additional funds available instead of having these funds built into the estimate.
One way to do this is by using a variance threshold, which can be broken into major and minor variances.
How Variances Work
Let’s say you’ve quoted a remodel and got an estimate for drywall at the start of the project. The price was right, and you secured the trade partner and kept in contact with them about the start date. Now, it’s time for the installation, and the drywaller has disappeared.
So, you hire a new trade, and the cost for installation is higher than your original estimate.
If that new trade’s cost is $800 more than the original quote, that might be a minor variance that doesn’t require going to the client for an approved change order but can be covered by the variance threshold discussed in the preconstruction phase.
However, in the same example, let’s say the cost is $3500 more for the replacement drywaller. In this example, this would be considered a major variance, and you should write up a change order and have your clients sign it. You’ll thank me at the end of the job when they pay their final bill because they approved the overage.
How to Manage Variances
An effective tactic to manage minor variances on a project (and avoid issuing change orders for every additional cost) is to use a variance log. The variance log typically captures all minor overages on a project that are not a result of design or regulatory changes, as those would be automatic change orders.
It can be as simple as a spreadsheet to track overages in cost group categories of construction that you share with your client at each invoicing cycle.
For those that have a developed accounting system, this is known as the Cost to Completion Report, and it shows you the following:
Original estimate
Change orders
Actual costs to date
Variance
Remaining to be billed
If you’re unsure how to handle this, Buildwise Financial Software is for you.
Variances and variance log processes must be discussed early and often in your upfront sales and preconstruction processes to ensure they are top of mind with clients because it’s always near the end of a remodeling project when the original estimated amount is surpassed that client amnesia sets in.
How to Calculate a Construction Contingency
Industry standards generally recommend assigning 5-15% of the total project budget for contingencies, though this can vary depending on several factors.
Factors Influencing the Size of the Contingency
Project Complexity: The more complex the project, the higher the likelihood of unexpected issues. For example, a custom home with intricate designs may require a more significant contingency than a straightforward remodel. Complex projects often have more variables, leading to more surprises during construction.
Historical Data and Past Experiences: If you've worked on similar projects previously, you can use that experience to estimate how much of a contingency is needed. For example, if previous projects in the same area faced unexpected weather delays or site condition issues, you might set aside a larger contingency based on those experiences.
Economic Conditions: Economic factors, like material price fluctuations or labor shortages, can also impact the size of the contingency. In times of economic uncertainty, allocating a higher percentage is wise to guard against unexpected cost increases.
Methods for Determining the Appropriate Contingencies
There are a couple of ways to calculate how much contingency you should set aside:
Percentage-Based Method: This is the most common method, where you calculate a percentage of the total project budget—usually between 5% to 15%. A simple formula for this would be:
Contingency Amount = Total Project Budget × Contingency Percentage
For example, if your project budget is $200,000 and you choose a 10% contingency, the contingency amount would be $20,000.
Risk Assessment Models: For more complex or higher-risk projects, some contractors use a more detailed approach, such as a risk assessment model. This involves analyzing potential risks—like site conditions, design changes, or material price increases—and assigning a specific cost to each.
The sum of these risks forms the contingency amount. This method is more time-consuming but can be more accurate, especially for large or complicated projects.
How to Calculate Contingency Costs in Construction Projects
To calculate the contingency costs in a construction project, follow these steps:
Estimate the Total Project Budget: Start by determining the total cost of the project, including labor, materials, trade partners, and any other expected expenses.
Select a Contingency Percentage: Based on the project’s complexity, past experiences, and current economic conditions, decide on a reasonable contingency percentage (usually between 5% and 15%).
Calculate the Contingency Amount: Multiply the total project budget by the chosen contingency percentage to determine the contingency fund.
For example, if you have a $500,000 project and decide on a 10% contingency, the calculation would be:
Contingency Amount= $500,000 × 0.10 = $50,000
This means you should set aside $50,000 as a contingency for your project.
Considering these factors and methods, you can calculate an appropriate construction contingency that helps protect your project from unexpected costs while ensuring smooth progress.
Best Practices for Managing Construction Contingencies
Successfully managing construction contingencies ensures that the funds are used appropriately and that the project stays on track financially and operationally.
Here are some best practices to effectively track and manage contingency funds throughout the project lifecycle.
Tracking and Managing Contingency Funds Effectively
It is essential to accurately track expenses throughout the project to ensure variances are identified and are either assigned to change orders or contingency.
For more information on managing how to track expenses in real-time, check out Buildwise.
Documentation, Reporting, and Communication
In fixed-cost building, you won’t be reporting contingency amounts to clients as it will create massive confusion, leading to frustration with your client. You will likely be assigning excess costs to the cost group that they belong to with the goal of not having the sum of all overages exceed the contingency line item you built into your budget.
In cost-plus building, you should manage contingencies by providing regular budget updates at each invoicing cycle. Ensure that you identify minor vs major variances and complete change orders when the variance is major. Remember to advise clients early and often that they need to have X% of the project total available for additional costs, which are inevitable on any construction project.
Common Mistakes to Avoid with Construction Contingencies
Managing construction contingencies effectively is key to avoiding client frustration and stress. Here are some common mistakes to watch out for when handling your project’s contingency funds.
Underestimating or Overestimating Contingency Amounts
One of the biggest mistakes in fixed-cost building is underestimating or overestimating the contingency needed. Underestimating can leave you without enough funds to cover unexpected issues, which bleeds your profit. While overestimating can unnecessarily inflate the project cost and reduce your ability to sell the job as your starting price might be much higher than competitors.
A good rule of thumb is to base the contingency amount on the project’s complexity and potential risks, typically ranging from 5% to 15% of the total project budget.
Misusing Contingency Funds
Contingency funds are meant for unforeseen problems, not planned upgrades or changes. Using contingency money for expenses that should be change orders is a quick way to reduce your profits. Builders often do this to avoid approaching clients with change orders as some think they are a bad thing when, in fact, they are merely a financial instrument to communicate added scope to a project. And it ensures that the cost of that added scope is not yours to bear.
Failing to Adjust the Contingency as the Project Evolves
As a project progresses, new challenges may arise that weren’t anticipated in the initial budget.
In a fixed-cost contract, you’ll need to create a change order if the costs being added are a result of site conditions, client requests, inspector/code issues, acts of god, or other natural disasters/extreme weather circumstances, etc.
And the same goes for cost plus building.
Regularly reviewing the project’s status and addressing the budget is necessary to ensure you aren’t paying for someone else’s home.
The Bottom Line on Construction Contingencies
Construction projects rarely cost what the initial estimate says. And in fixed-cost building, this can result in drained profits and tension with your clients. While on the other hand, cost-plus building clients might feel the costs are spiraling out of control compared with the initial estimate.
Whether it's a kitchen renovation, home addition, or custom home build, setting aside the right amount of contingency in your fixed cost estimate allows for smoother project progression and financial stability. The key is to calculate the appropriate percentage, typically 5-10% of the total budget, and manage it carefully throughout the project.
And for cost plus, having the conversation about contingency funds with your clients early and often will keep them in check when the costs start to climb for unforeseen expenses.
With a clear understanding of contingencies, their proper management, and the right software to assist, you can ensure your project moves forward smoothly, minimizing disruptions and keeping the budget in check.
Buildwise is a financial management tool created for builders by a builder that helps you understand your real-time financial picture on all your building or remodeling projects. Its expense management module lets you upload and track all job costs instantly, so you’re never waiting to find out if a job is profitable.
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