How to Use Allowances in Residential Construction
In a perfect world, every remodel or new home build starts with a solid estimate outlining the project's entire cost.
But we don't live in a perfect world, and construction projects are often started before all the final costs are included, especially for design elements like fixtures and finishes, and the labor costs associated with them.
However, you need to provide the client with as close to an accurate estimate as possible and minimize your risk from cost overages. That's where construction allowances come in.
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What are Construction Allowances
Construction allowances are dollar amounts you include as the estimated cost for items not finalized at the beginning of the project when the construction contract is signed.
Since you don't know the exact final price of those items at the project onset, using an allowance means you can direct the client on how much they have available to spend on those items while minimizing your risk in case they choose something that is more than you've allowed in your estimate.
Most construction allowances will cover material selections the client has yet to make, such as fixtures and finishings. But the choice of materials can often impact the scope of work as well, requiring extra time from your own team, a trade partner you've already hired, or a new trade partner with a different skill set.
We typically break down allowances into three categories:
1. Base Building Material Allowances
Enables you to accurately charge clients for materials that fluctuate in price daily, like lumber.
2. Finishes and Fixtures Allowances
Captures design selections that the client hasn't chosen yet.
3. Labor and Trade Allowances
Ensures that the related installation costs are captured.
All of these represent project costs that need to be reflected in the overall budget and contract price, and accounted for in your estimate so they don't come off your bottom line. If the client chooses to go above the maximum allowance price, the difference should be accounted for via a change order.
The Importance of Clear Allowance Definitions in Construction Contracts
Because you’re starting remodel or new custom home build with so many unknowns, you need to have allowances in place. But their purpose is to fill in those unknowns with realistic placeholders so that clients can have a sense of how much they are spending, and you have a direction to start with. That’s why it's important to ensure you define allowances clearly in your contracts so everyone is on the same page.
Homeowners often struggle to understand allowances and how they work. Builders and remodelers also struggle to explain them properly, so there is ambiguity about the entire allowance process, which can lead to stress and eroded trust.
Define Allowances Clearly to Avoid Confusion
It’s important to clearly define allowances in your construction contracts to keep things transparent and avoid problems during the project.
Avoids Misunderstandings: Allowances are placeholders for items your client hasn’t picked yet, like flooring, lighting, or cabinets. If you don’t clearly explain what’s included, the client might expect high-end materials when you’ve budgeted for something basic. That can cause frustration later on.
Keeps the Budget on Track: When your allowances are clear, the client knows exactly how much is covered. If they choose something more expensive, they’ll expect to pay the difference.. This avoids awkward money conversations mid-project.
Builds Trust: Clear allowances show your client that you’re being upfront about costs. They help avoid the feeling that you’re hiding fees or padding the budget, which goes a long way toward building trust.
Prevents Delays: If your allowances aren’t specific, you’ll likely spend time clarifying details while the job is already underway. That can lead to unnecessary delays and stress for both you and your client.
Use Specific Contract Language Examples
Include specific contract language that clearly outlines the different allowance categories, like flooring, fixtures, or cabinets. Be sure to state the exact spending limits for each allowance so your client knows the budget for those items.
You’ll also want to thoroughly explain your change order process so your clients know what happens if they pick products or materials that exceed their allowance. Your change order process is how you’ll handle the extra costs, get approvals, and document any changes. Including this language helps you avoid confusion and keeps everyone on the same page if adjustments come up.
When you lay out allowances clearly, it helps set expectations and avoid surprises. Your client knows what’s covered and what might cost extra, which builds trust and keeps the conversation open. It also makes it easier to deal with changes and keep the project moving.
How to Estimate the Right Allowance Amounts
Contractors often underestimate allowances, leading to client frustration and budget overruns. They need to understand how to set realistic allowances to avoid client disputes and taking the project over budget.
Three Factors to Consider When Setting Allowance Amounts
When setting allowance amounts, it’s important to consider a few key factors carefully. These will help you create realistic and clear budgets, making it easier for you and your clients to stay on the same page throughout the project.
Current market prices for materials
Make sure your allowance amounts reflect current market prices, not estimates from past projects or outdated supplier quotes. Material costs can change quickly, especially for items like lumber, tile, or fixtures.
When you use up-to-date pricing, you give your clients a more accurate picture of what their selections will cost. This helps prevent budget issues later and shows that you’re being transparent and realistic from the start.
Realistic labor costs based on job complexity
Labor costs can vary depending on how complex or custom the work is, so it’s important to factor that into your allowance amounts. Even if the material is the same, a basic tile install will cost less than a detailed herringbone pattern.
Be sure to consider the skill level, time, and coordination required for each allowance category. Setting realistic labor costs helps you avoid underpricing and ensures the client understands the true scope of what’s involved.
Supplier/vendor pricing fluctuations
Prices from suppliers and vendors can shift due to availability, demand, or changes in manufacturing costs. When setting allowance amounts, keep in mind that what something costs today might not be the same a few weeks from now. It’s a good idea to communicate to your client that pricing is based on what’s current at the time of estimating. This helps manage expectations and gives you some flexibility if prices increase before selections are finalized.
The Pitfalls of Using Allowances
There are a few pitfalls to watch out for when using allowances in your construction contracts.
Setting Allowances Too Low
Setting allowances too low might help your initial bid look more competitive, but it often leads to bigger problems later. For example, if you underestimate the cost of something like tile, your client may get frustrated when they realize their preferred option is way over budget. This can create tension, delay decisions, and erode trust.
Low allowances also set unrealistic expectations. Your client may think they can get higher-end finishes for less, only to be surprised when it’s time to make selections. That sticker shock can make it feel like the project is going off track, even if everything else is running smoothly.
To avoid this, base your allowances on what clients typically choose for the level of finish and style they’re expecting. If a category, like lighting or countertops, has a wide cost range, give a realistic mid-range estimate or include a clear price range in the contract. This helps guide their decisions without locking them into one option.
Let clients know that the allowance is a placeholder, not a limit. Be clear about what happens if they choose something outside of that amount and how changes will be approved and billed. This way, you’ll set clear expectations and help avoid surprises later on.
Having open conversations early about what things really cost is key. Walk clients through a few examples and show them the kind of selections that fit within the allowance. This helps them feel informed and in control, and it positions you as a trusted advisor rather than just a contractor managing numbers.
Being honest and realistic upfront might make your proposal look a little higher, but it can also save you from difficult conversations and unhappy clients down the road.
Using Too Many Allowances
While allowances are helpful tools in creating estimates for projects with unknown costs, they must be used wisely and not as a replacement for a solid upfront pre-construction process.
Including too many allowances in your estimate increases the risk of missing changes in allowance costs, which can negatively impact your profitability. It can also be unsettling to clients because it overwhelms them with decisions (and gives them more opportunity to price-check and question your processes).
Using fewer allowances in your overall budget helps ensure that while you include placeholders for the absolute unknowns, you're not jeopardizing your profitability before the work begins.
Client Misinterpretation
Homeowners will often misinterpret how they are supposed to be used and try to work them to their financial advantage.
They may see an allowance as a way to save money by purchasing materials on their own or hiring their father-in-law to install those materials to avoid the builder's markup.
However, there are several reasons why clients should not purchase materials for their remodeling or custom home-building projects on their own, which you can read about here.
Confusion Between Allowances vs. Contingencies
Allowances and contingencies often get used interchangeably, but in reality, they're more like cousins than twins.
And it's important to define them for your clients and identify how they will be used.
An allowance is a known and anticipated upcoming cost identified at the beginning of a project. There's uncertainty about the estimated cost, but it's budgeted for as a placeholder until the final price is determined.
A contingency is an amount of money that you recommend a client have access to in order to cover construction items that will become change orders, such as:
Unexpected site conditions
Client decisions or changes
Engineer or inspector requirements
Other costs (like contractors' costs for site toilets & fencing due to project delays)
Learn more about contingencies and how to manage them here.
Can Cause Project Delays
Starting a remodel or custom home building project with a laundry list of allowances means that we aren't properly prepared to execute.
And that means everyone will feel this pain in future schedule delays.
The entire purpose of a paid pre-construction process is to work through the design, the costing, and the schedule to get as many of the decisions made as possible so you can limit the unknowns. This results in a timeline that reflects the scope of work and reduces friction with your clients downstream.
Why You Should Use Cash Allowances
If you are a cost-plus remodeler or custom home builder, costs are very transparent because the client sees all the line items and knows exactly what they are paying for. So, if a selection is higher than the material allowance amount, it's a straightforward conversation.
But in the fixed cost world, it gets a bit trickier because your markup (the contribution to your overhead and your net profit) is built into the lump sum final price you have in your contract.
To ease the confusion, some fixed-cost general contractors will use "Lump sum + Allowances" to clarify the material selection costs. However, they often encounter issues when clients price-shop specific items based on those builder allowances.
The key to doing this successfully is to use "cash allowances," which means listing the exact cost of the specific items in an "Allowance Schedule" without your markup added.
We do this because clients will fact-check and question your pricing vs. Amazon or Home Depot's website, and we don't want to fracture their trust early in the process and have them question everything else along the way.
This allows you to have dollar-for-dollar conversations about flooring, light fixtures, kitchen cabinets, etc., without entering into a guarded discussion that makes your clients feel like they are not getting the full story.
Managing Allowance Overages and Underages
A client's overage on a material allowance amount is no different than a client changing part of the scope of work. It's an extra cost and time, and the client is billed back via a change order (more on this shortly).
But what happens when the client underspends on their allowances? Should you credit the difference back on a future invoice?
"In cost-plus work, the clients only pay for the labor performed, the materials consumed, and the trade partners hired on their behalf."
So if they don't spend the full amount of any allowance, they only pay what they spend.
Conversely, in fixed-cost work, it becomes a bit trickier.
If you haven't shared the allowances with your clients as discussed above, the underage is much less transparent, so it's your call whether to advise them. When I encountered this scenario in my career, we did not credit the client back because it was likely helping to make up a shortfall somewhere else on the project, such as internal labor.
If you've shared the allowances with your clients, they will likely ask you to credit them, and it's important to be prepared with how you'll handle these (and this should be written into your construction contract!).
A good practice, regardless of whether you are fixed-cost or cost-plus, is to keep a running list of allowances spent for the construction project to track overages/underages before you issue change orders or credit back unused portions. Unless it's apparent that the overages will definitely exceed the underages, and in this case, be sure to use change orders early and often.
For example, a client might overspend on one particular item, in which case you would want to inform them, but perhaps hold off on submitting a change order until the remaining allowance items are chosen.
It could very well turn out that the remaining items come in under the allowance threshold, negating the overspending on that one item. In that case, issuing a change order for one item and a credit for the others just creates more work for you and complicates things for your client.
However, you handle it, it's critical that you share this strategy with your clients upfront so they understand that if they overspend in the early selections, they might be over budget until the balance of allowance decisions are made.
Allowances and Markup
The trickier question regarding overages is whether or not you add (or credit) your markup to that difference. This is particularly relevant for design material selections, but not as much for added labor and/or trade partner costs, which are easier to deal with.
Cost Plus
As a cost-plus builder, the client pays the markup only on what they've actually spent, not the entire amount allotted in the construction budget.
But if they spend over their allotted amount, whether or not you charge the markup on that overage can be up for debate.
When it comes to pricing and markup, it's imperative to remember that we all have a cap on the amount of working time (i.e., throughput) we have in a year. Allowance overages mean additional costs and likely extra time you must spend on the project instead of on other revenue-generating opportunities (like the next project).
If you don't add your markup to those additional costs, you're diluting the contribution to your overhead and net profit in the current fiscal year, leaving you short and not earning what you deserve.
So, if the change in work or scope will add any time to the project's schedule (which it does 99% of the time), you should charge the markup.
But sometimes, the more expensive product might have the same lead and installation times, and your clients might wonder why you're essentially making more for what they perceive as no additional work.
This is always a good time to remind them of the steps involved in managing the project and how even simple changes can add significant time and energy on your part, such as:
Defining the scope of the work and/or the changes in materials
Confirm the final price and availability of the product
Preparing the change order request for the client
Securing their approval and communicating the approved changes to all involved
Updating schedules and financials
…and many more internal steps
Fixed Cost
As a fixed-cost builder, if you've taken the time upfront during your pre-construction process to select almost all of the design finishes, then the markup you've applied to those allowances should provide the right contribution to your overhead and net profit based on your annual project volume.
So, in cases where design selection allowances are exceeded, consider these three tactics for handling markup:
1. Your contribution to overhead and net profit is likely covered.
If there are only a couple of small actual cost changes for design selections, you might consider not adding your markup to help keep the peace with your clients.
2. Think of using a scaled-down markup for design selections only.
For cash allowances on design selections, use a lower markup than your normal one and make it visible to your clients in the change order you write up for their approval.
3. Bulk changes in scope together in a change order.
If a project has changed a few different things, bulk them together on one change order where you can apply your markup. This makes it difficult for clients to reverse-engineer the design selection costs. I prefer this approach and often recommend it to fixed-cost clients.
Overall, it's best to do what makes you most comfortable and connects to whichever pricing model you use.
Material Allowances and Builder Discounts
Whether you're fixed-cost or cost-plus, you're most likely receiving discounts from the vendors and suppliers you use on each project.
And whether or not you pass on that discount to your client is entirely at your discretion. Some argue this is an ethical debate as you're making your margin on top of a retail price, but I would argue you're doing the same thing by marking up your team's labor (or trade partners' costs).
Keep in mind that the margin on retail pricing is another way to bring additional revenue into your company to contribute to overhead and net profit.
In other words, there's no right or wrong answer to this one.
As a cost-plus builder, the conversation can be difficult if you're sharing copies of project costs, such as invoices from your suppliers, as the client has full transparency into each cost.
As a fixed-cost builder, you should not share copies of receipts, so the choice is a bit easier because there is less transparency.
As a cost-plus builder myself, I would pass on that discount to my clients because the client is still paying less overall. And you're still marking up the cost and receiving contributions to your overhead and net profit.
How to Communicate Allowances Effectively to Clients
Allowances represent unknowns to clients, and when clients are faced with those unknowns, it can cause misunderstandings, leading to frustration and eroded trust.
Here are five tips to use to help minimize client frustration when working with allowance items:
1. Use Your Pre-Construction Process Effectively
Fewer choices mean fewer chances of overwhelming clients with decisions and lower the likelihood of you missing changes in allowance costs.
Slowing down your pre-construction process is a good idea because it allows you to get more definition from your clients so you can understand their needs and wants, set more realistic construction allowance ranges, and use fewer allowances overall.
2. Be Realistic With Allowance Amounts
Lowering allowance amounts to win a bid only results in surprise costs later on for the client. Set realistic allowances that reflect actual costs they will have to pay, and ensure that the allowance you set offers clients more than one choice.
For example, if you set a flooring allowance of $8/square foot and there are limited options at that price point, your client will feel like they aren't being given a choice other than to spend more money. They'll also be worried about this cascading throughout the project when making final selections on everything else.
3. Use Cash Allowances
One of the biggest pain points residential home builders feel is having to justify their pricing after clients price-check online (because we know they will).
Whether you are fixed-cost or cost-plus, speak in dollar-for-dollar terms regarding allowances to avoid fracturing client trust early in the process and having clients question everything else.
4. Decide On Discounts Upfront
Determine if you will (or won't) pass along discounts to your clients.
If you aren't passing along the discount and you're fixed cost, then you don't need to do anything else. But if you're cost-plus, consider not sharing the invoices from the suppliers with your clients, because this will allow them to challenge you on this.
If you are going to provide the additional discount(s) you receive, discuss them with clients during the pre-construction process, so they know what to expect.
Passing on supplier and vendor discounts is entirely at your discretion and should align with what you feel works best as a fixed-cost or cost-plus builder.
5. Explain How Allowance Overages And Underages Work
Decide how you'll handle overages and underages, and write this into your contract. Make sure to explain to clients what happens if they spend more or less and how you will deal with it.
Using a ledger to keep a running list of allowances spent lets you see where the overall bill nets out before you issue change orders or credit back unused portions.
The Bottom Line on Allowances
Allowances are a great way to handle selections that have yet to be made or account for an undetermined scope of work, as they reduce the impact of underestimating the costs associated with either of these scenarios.
But they only work if your process for using them is rock-solid. That means ensuring they are clearly defined in your construction contract and explaining them to your clients in your pre-construction process so that you avoid tough conversations later on in the project.
Maintaining profitability on your remodeling and custom home-building jobs relies on these three things:
A solid pre-construction process
Properly estimating projects
Keeping score and proactively dealing with changes
I created BUILDWISE to help residential contractors manage their financials accurately so they can be profitable on all their jobs. Using BUILDWISE helps ensure you aren’t missing job costs by giving you one platform to track everything from estimates to change orders to expense management. And it’s the only financial management software for contractors that is designed to work with both fixed-cost and cost-plus pricing models.
