How to Use Allowances in Residential Construction
In a perfect world, every remodel or custom 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 that are associated with them.
But you need to provide the client with as close to accurate an estimate as possible and minimize your risk from cost overages. That's where construction allowances come in.
What are Construction Allowances
Construction allowances (or construction contract allowances, or builder 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 the risk to you - in case they choose something that is more than you've allowed in your estimate.
Most construction allowances will cover material selections the client hasn't selected yet, such as fixtures and finishings. But often the choice of materials can impact the scope of work as well, requiring either extra time by 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 projected material costs that the client hasn't chosen yet.
3. Labor and Trade Allowances
Ensures that the related installation costs are captured.
These represent contractor costs that need to be reflected in the overall budget 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.
Don't Use Too Many Allowances
While allowances are a helpful tool in creating estimates for projects with unknown costs, it's imperative to use them 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 allowances costs, which can negatively impact your profitability. And it can 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.
The Pitfalls of Using Allowances
There are a few pitfalls to watch out for when using allowances in your construction contracts.
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.
But there are several reasons why clients shouldn't be purchasing materials for their remodeling or custom home-building projects on their own, which you can read about here.
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 has 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 contractor's costs for site toilets & fencing due to project delays)
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" as a way to shed some light on the material selection costs, but they often run into an issue when it comes to clients price-shopping 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 things like flooring, light fixtures, kitchen cabinets, etc., without entering into a guarded discussion where your clients feel like they are not getting the full story.
Managing Allowance Overages and Underages
A client 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 gets billed back to the client 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 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 Mark-up
The trickier question when it comes to 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 only pays the markup on what they've actually spent, not the entire amount allotted in your 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 amount of time to the project's schedule (which 99% of the time it does), then you want to 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
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 about how to handle mark-up:
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 you have a few different things that have changed on a project, bulk them together on one change order where you can apply your markup, so it's difficult for clients to reverse-engineer the design selection costs. This is my preferred approach and the one I often recommend 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 vendors and suppliers that you're using 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 be sharing copies of receipts, and as such, 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 Minimize Client Frustration with Allowances
Allowances represent unknowns to clients, and when clients are faced with those unknowns, it can cause misunderstandings, leading to frustration and an erosion of trust.
Here are five tips to use in your pre-construction process 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 for $5/square foot and your vendor only offers one choice at that price point, your client will feel like they aren't being given a choice other than to spend more money. And 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).
Regardless of 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 along the way.
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 it 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 haven't been made yet 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 the BUILD AND PROFIT SYSTEM to help residential contractors run profitable businesses by using rock-solid financial systems to understand their numbers and a bulletproof way to estimate work so that they capture construction allowances correctly.
Click the button below to learn how the BUILD AND PROFIT SYSTEM can help ensure you use allowances correctly and effectively explain them to your clients, so you don't leave money on the table on your next project.
