Explaining Contingencies, Variances, and Change Orders
As professional builders, we know that unexpected things will happen in any building project, no matter how much upfront planning is done. 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.
Very often, builders will use a ‘contingency fund’ in their contract documents and carry it as a line item in the budget. A contingency fund is a specific amount of money, usually a percentage of the contract sum, that is set aside in case unexpected costs arise during construction.
But explaining that fund to clients, and getting them onboard with it, 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 construction contingencies should be used for, and what they think it’s for.
That is, assuming you can get them to agree to one at all.
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 contract price. We use change orders in the construction industry to ensure that we aren’t diluting our profits by covering extra construction 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)
All of these situations can increase the total cost of the project. When these unforeseen costs occur, such as increases in material prices or additional labor costs, they need to be passed on to the client in the form of a change order. You should outline these change orders early and often in your sales and preconstruction process so that your clients become familiar 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 contractor, you need to clearly define that additional costs on a remodeling project that 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 cost estimates during the planning phase of a project and the actual costs during construction. If you’re a cost-plus remodeler, then those costs are still billable to the client (plus your mark-up) according to your signed contract.
But how do you decide which costs warrant a change order and which ones 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 additional administrative work for you.
One strategy to avoid that scenario is to set a variance threshold, which establishes a certain dollar amount in which 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 was right, and you secured the trade partner and kept in contact with them about 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, that might be a minor variance which doesn’t require going to the client for an approved change order.
However, if that new cost is $8,000 more than the original trade, you’re now faced with a major variance - one that should be change ordered for the client to accept.
Using Variance Thresholds
An effective tactic to manage variances on a project (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:
Original estimate
Change orders
Actual costs to date
Variance
Remaining to be billed
It’s important that variances and variance log processes are talked about 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.
Fixed Cost Projects & Contingency Funds
So, how do you manage variances and additional costs if you’re a fixed-cost remodeler?
Typically, in the fixed-cost world, if an additional cost is incurred that doesn’t meet the criteria for a change order, it’s assumed that the builder would “eat the cost” because that increased cost is a result of something they did, not because of a change in the project.
But that’s the fastest way to dilute your profit – or lose money on a job, and that’s not why you got into the industry. So how do we manage these costs?
This is where the above-mentioned contingency funds come into play, which some builders opt to carry in their construction budgets.
While that solution isn’t ideal for cost-plus remodelers, it does work for fixed-cost builders because it allows us to pay for additional costs outside of our control without diluting our 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.
But, if you’re going to use a contingency fund in your fixed-cost accounting, 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 processes
Here’s Why the Line Between Contingency and Change Orders Can Get Blurry
Drawing down from a contingency fund is the most common way to handle additional costs that fall outside the scope of a change order. But, if you’re typically carrying a contingency fund in your budget, you might be using it to cover costs that really should be change orders - and that should be increasing the overall project budget.
The line between contingencies and change orders often gets blurry because contingency funds are essentially a miscellaneous pool of money waiting to be used. And both clients and design partners 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 more extra charges have been covered by the contingency fund), 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 for something that a few weeks earlier they were told was a ‘contingency’ item. Psychologically they don’t feel responsible for paying for it, and you’re in a situation where you feel the need to eat that cost to keep the peace.
Another Way to Replace Contingency Funds
If you’re a fixed-cost builder, there’s another way you can treat budget overages while avoiding the awkward contingency fund conversation with clients by building into each category of your estimate.
For example, if you know the flooring for a remodel is going to cost $25k, 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 original contract and that the client doesn’t know about.
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 are 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.
At the end of the day, 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.
