Explaining Contingencies, Variances, and Change Orders
As professional builders, we know that unexpected things will happen in any building project, no matter how much planning you do upfront. And those unexpected things result in additional time and cost to the project.
Figuring out where the money comes from to fund those costs can be a tricky conversation.
For many builders, that often means using a 'contingency fund' and carrying it as a line item in the budget. A contingency fund is a specific amount of money, usually a percentage of the total cost set aside in case extra costs arise during construction that doesn't qualify as a change order.
But explaining that fund to clients and getting them on board can get messy and complicated.
Because if a client knows there are additional funds for the project, they will think it's theirs to spend, blurring the lines between what a contingency is and what they think it's for.
It gets even messier if you include a contingency - but only spend some of it, and your client wants you to refund the difference.
This is why we need to reframe the conversation and change how we handle extra project costs during construction.
Introduce Your Clients to Change Orders
A change order is an amendment to a construction contract that outlines changes in the project's scope, duration, and price. We use change orders to ensure that we aren't diluting our profits by covering extra costs that aren't our responsibility.
They're necessary to ensure you capture any changes or modifications during a remodeling project and, most importantly, get paid for them.
The most common reasons for cost changes during a residential construction project are overages that occur because of:
Site conditions
Inspector or engineer requirements
Client requests
Additions or changes to scope (based on one of the above three criteria)
When these costs occur, they should be presented to the client as a change order, which you should outline early and often in your sales and preconstruction process to familiarize your clients with them.
But what about additional costs that fall outside the scope of a change order?
Cost-Plus: If it's not a Change Order, it's a Variance
If you're a cost-plus remodeler, you need to clearly define that additional costs on a remodeling project which aren't a result of design or regulatory changes still need to be accounted for in the overall budget and assigned financial responsibility.
One way to do this is by using a variance.
A variance is the difference between the estimated costs 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.
But how do you decide which costs warrant a change order and which are a variance? Is every additional cost considered a change order?
It can be, but it could create a "death by a thousand cuts" scenario that will likely frustrate your client and add considerable administrative work for you.
One strategy to avoid that scenario is to set a variance threshold, where you choose a certain dollar amount as a cap. Everything above it is considered a change order, and everything below it is a variance.
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 fit your budget, and you secured the trade partner and kept them updated about the start date. Now it's time for the installation, and the drywaller has ghosted you.
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, it could be considered a "minor variance" that doesn't require issuing a change order to the client.
However, if that new cost is $8,000 more than the original trade, you're now faced with a "major variance" that should be a change order for the client to accept.
Using Variance Thresholds
An effective tool to manage project variances (and avoid issuing change orders for every additional cost) is to use a variance log.
The variance log captures all the major and minor overages on a project that are not a result of design or regulatory changes (those would be automatic change orders).
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
It's important that variances and variance reporting are discussed early and often in your upfront sales and preconstruction process 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.
Fixed Cost Projects & Contingency Funds
Tracking costs in a transparent model like cost-plus seems easy, but how do you manage variances and additional costs if you're a fixed-cost remodeler?
In a fixed-cost model, it's often assumed that the builder will "eat the cost" for additional charges that don't meet the criteria for a change order because it was a result of something they didn't account for in their estimate, not because of a change in the project.
But that's the fastest way to dilute or completely evaporate your profit, and that's not why you got into the industry. So how do we manage these costs?
This is where contingency funds come into play, which some builders opt to carry in their construction budgets, allowing them to pay for additional costs outside their control without diluting their profit margin.
A contingency line item in your budget allows you to account for unexpected situations or reasonable errors on the jobsite that shouldn't be your responsibility to pay for.
Two Ways to Use Contingency Funds in Fixed Cost Projects
There are two ways to build a contingency fund into your project estimates to ensure that you are covered for additional costs.
The first option is to set one round number as a line item in the budget based on a percentage of the project cost. But determining that number can be challenging.
The second option is to build additional funds into each category of your estimate instead of one round number.
For example, if you know the electrician's scope will cost $25k, but you always see additional costs pile on, then build $32k into the price to ensure you've got a "buffer" to cover yourself, just in case. You may not end up using it on that specific part of the build, but another part might go over budget, and this way, you're protected.
I call this the "Bucket Theory," and it's a way to ensure you're buffering every category in your estimate against potential overages without the need for uncomfortable client conversations around "contingencies."
Then treat overages from changes in the scope, site conditions, inspector/engineer requirements, and owner additions as change orders so that you don't open the door to using the 'contingency' you built into the contract and that the client doesn't know about.
Or, if you still prefer having one line item on your estimate for contingency, you can add the padded totals for each category and use that amount as your contingency number.
Do You Share This With The Client
If you're using a contingency fund as a fixed-cost remodeler, I recommend not sharing that information with your client.
But, if you choose to disclose it to the client (and design partners), then you need to ensure you're protecting your gross profit by:
Defining what the fund is
Outlining the difference between change order and contingency items (with examples)
Getting your client onboard by talking about contingency early and often in your sales and preconstruction process
There's a flaw with this approach, however. Because contingency funds are essentially a miscellaneous pool of money waiting to be used, the line between what is a contingency and what is a change order often gets blurry. If clients and design partners know there's a contingency fund, they can become tempted to spend it, leaving you in a lurch if you need to access those funds for an emergency situation.
For example, let's say you're working on a project with a $30k contingency fund, and there's a $6k additional cost because of a change in the design. If you sat down with the architect and the client, they're both going to push for that charge to be paid by the contingency fund, even though design changes are typically passed on to the client to pay for via a change order.
Not only does this make the conversation very awkward at the time, but flash forward to a few weeks later when more of these conversations have happened (and the contingency fund has covered more extra charges), and it's now drawn down to zero.
Suddenly, similar extra costs must be presented to the client as change orders. But the client has gotten comfortable using the contingency fund and can't reconcile why they are paying more for something they were told was a contingency item a few weeks earlier. Psychologically they don't feel responsible for paying for it, and you're in a situation where you might feel the need to eat that cost to keep the peace.
There is another issue with drawing down a contingency fund instead of presenting the client with change orders. While doing that makes it easier for you to avoid those conversations (and easier for the client to avoid facing an increasing budget), you're jeopardizing your profit by not using change orders correctly in your remodeling business.
Variances and Change Orders Are Not a Replacement for a Good Sales Process
The best offense is always a good defense, and that's where your upfront processes come in. At the end of the day, your sales and preconstruction process's main goal is to estimate the project as closely as possible to the finishing price.
And while tactics like variances, variance logs, and change orders help account for situations where costs exceed the estimate, they aren't a blank cheque. You still need to be accountable and transparent to clients about the financial details of their remodel and aim to minimize additional costs where possible.
It all comes down to setting the right alignments at the start of the client relationship. Building a solid estimate that properly aligns the scope of the work with the right cost - and properly communicating the process for changes during the project - are key elements to managing your client's expectations and ensuring a smoother outcome.
I created the BUILD AND PROFIT SYSTEM to help remodelers and custom home builders like you run profitable businesses by implementing rock-solid systems that help ensure you aren't bearing the financial burden for all the possible variances and changes that can happen on a jobsite.
Learn how the BUILD AND PROFIT SYSTEM can help you protect your bottom line and effectively manage clients' expectations.
