If we could pick one phrase to sum up the construction industry, we’d probably choose “expect the unexpected”. When jobs don’t go according to plan, it pays to be flexible. Of course, planning ahead is a key part of this. From the moment you start putting a budget together, you should be thinking about contingency. Think of contingency in construction as a kind of insurance — something to give you a little extra financial buffer in case of emergency.
In this short guide, we’ll explain the different schools of thought on navigating contingency in construction and share our best practices.
Key Takeaways
- Construction contingency is a reserve of cash set aside to cover unknown/unknowable emergencies, like design errors, bad weather, or unanticipated material price increases.
- There’s no one ‘right’ way to manage contingency, but the important thing to remember is that your strategy should always aim to preserve profitability on a job.
- Rules on contingency will often be determined by the contract and/or owner demands. Good communication will keep everyone on the same page.
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What is Construction Contingency?
In the dynamic, always changing world of construction, being able to quickly adapt and land on your feet financially is crucial. Setting up contingency in your contracts can help you do exactly that. The point of construction contingency is to give your budget some wiggle room if costs end up being higher than you originally anticipated. When bad weather strikes or material costs suddenly skyrocket, contingency can help protect you.
Allocating Contingency
Because unexpected surprises and setbacks can happen on any job, every job should include contingency allocations. The specifics of each job and its contract type, along with how comprehensive the designs are when the contract is signed will influence the amount you allocate.
If you’re offering cost estimates during the design of a project , you’ll want to include a larger contingency (say, 10% of your budget for example). As a job’s scope continues to be refined, that percentage can be whittled down to a much smaller number, like 5% or even 3%. Ultimately, choosing the right amount to set aside often comes down to when construction actually starts, and how confident you feel in the definition of the scope. For example, let’s say you’re working with an owner to accelerate the start of a project to beat the winter weather. You know you’ll be rushed to pour the concrete foundation before the cold weather sets in, but the reviewing and coordinating the MEP trades isn’t fully complete. In that case, you’d probably want to allocate a larger contingency just to cover those unknowns.
Defining Contingency
The key with contingency is clarity. When you’re negotiating a contract with the project owner, make sure everyone is clear on what contingency can and can’t be used for. Where problems often come up is when contingency isn’t specified. For example, if pre-existing conditions are discovered on a site, you shouldn’t have to fork up your contingency to cover them – instead, a change order should be issued (and you should be paid for it) because the size of that potential impact could not be reasonably anticipated or estimated by the contractor. On the other hand, most jobs have to contend with some design inconsistencies and rough weather. A seasoned contractor should know how to account for a reasonable number of mistakes or challenging conditions based on their history of projects.
According to ConsensusDocs, here’s sample a list of example costs to be be covered explicitly by the contingency clause::
- Scope yet to be finally designed
- Missed scope or estimating errors
- Labor and material cost escalations
- Acceleration expenses
- Costs incurred to correct defective, damaged, or nonconforming work
- General conditions and overruns
- Costs associated with subcontractor defaults
Owners vs. Contractors – Why Communication is Key
Contingency is protection against risk, and as such, smart project owners will always make sure they have it. And depending on the contract type, you as the contractor might be able to allocate your own as well.
If you’re working on a guaranteed maximum price (GMP) job, for example, then a precise contingency amount – along with rules on how it should be used – should already be outlined in the contract.
There’s a bit of a debate within the industry on who should ultimately have control of contingency. Understandably, owners like to have a say in what contingency should be used for so their budgets don’t go out of control. At the same time though, jobs can quickly slow to a halt if there’s back-and-forth over whether or not to pull from contingency every time a new change order comes through.
For lump sum jobs, you must keep your bid competitive by defining the scope as much as possible before your bid is due in order to reduce any contingency that might otherwise be additional profit.
At the end of the day, the best tool you have at your disposal is communication. Building good relationships and taking the time to ensure everyone is clear on why contingency is included in a contract to begin with can go a long way in making sure you can move forward with confidence.
More Nuances in How Contingency is Handled
There’s always some nuance in how contingency gets funded and how companies show its utilization. For example, most contracts will specify if buyout savings can be routed back toward contingency.
In the case of GMP contracts in particular, it’s common to negotiate on whether change orders should come out of contingency or demand new funding.
In some cases, you might be able to agree upon a shared savings clause – a structure that outlines what happens to any contingency left over after a job is finished. These clauses are a win-win. On the owner’s side, everyone is incentivized to reduce contingency spending and work toward the completion of a successful job below budget. On your side, a shared savings clause lets you enjoy a direct financial benefit from any savings made on the job.
Managing Contingency Funds
Everyone chooses to manage contingency differently, and in our experience, we’ve talked with contractors who have strong feelings on both sides. Some contractors, especially when it comes to GMP type jobs, believe the best contingency management strategy is to keep track of the budget and move money out of contingency and into the appropriate cost line item. The advantage here being that any overruns shown in the budget are strictly for “in scope” change orders. Other contractors prefer not to touch original cost line items even if contingency is being used so that they can see which line items have diverged the most from their originally budgeted amounts regarding of whether changes are “in scope” or “out of scope” of the original contract.
Each strategy has its own pros and cons, and as we mentioned before, the strategy you go with will often be dependent on contract structure and the demands of the project owner. The most important thing to remember though, is that your contingency management strategy should ultimately help preserve your profitability on a job. The better you manage this pot of money, the more profitable a job will be.
Further Reading: Foundations of Construction Project Management for SMBs