Best Practices – Contractor Overhead and Profit – Why Lowest Bids Does Not Mean Best Value.

I recently came across a Blog posting on the website www.markupandprofit.com where the author Michael Stone discusses the difference between a contractor’s markup and profit.  Mr. Stone wrote the article to appeal to contractors, but he acknowledges that some of his readers are property owners.  He closes his article with an appeal to Owner’s to avoid selecting contractors based on lowest cost.

Mr. Stone is a seasoned builder with decades of experience.  He and his wife started their business and launched their  website in 1999.  In addition to a host of services, Stone offers consulting to help contractors build and develop their businesses.

Mr. Stone’s blog includes several other valuable insights you might want to go and check out.

To continue the conversation Stone began and to reinforce the notion that lowest cost is not always best choice, I wanted to discuss the various costs a contractor incurs when they take on a project.

With the recent decline of Carillion (in the UK) and other notable construction firms teetering on insolvency, I think it is important for us to understand how contractors generate revenue.  A basic understanding of this will help us ensure that in our quest to secure the best possible price, we are not doing so at the contractor’s expense.

Overhead

Overhead costs vary greatly, so it is important to determine up front what should be considered overhead and what should not.

In it’s most basic sense, overhead costs are all of the costs associated with the contractor’s business operations.  These are not profits that go into the contractor’s pocket, these are expenses the contractor has just to keep the business operating.  I think of rents (or mortgages) for their office, utility bills, insurances, taxes, salaries for office staff (not directly billable to a project) and the cost of benefits for the office staff.

For the most part these costs are fixed and they should be spread out across multiple projects throughout a company’s fiscal year.  While these costs do not bring any value to the Owner they are nonetheless costs that the contractor must recover to keep his business alive.

Stone estimates that Overhead costs may be as high as 54%, but of course this depends greatly on the scale of the project and the size of the contractor’s operations.  It should be noted that the largest construction firms in the world report their overhead costs to be less than 1% of total revenue.

General Conditions of Construction

Unlike other businesses that only need to address the overhead costs associated with business operations, contractors also face another form of overhead in the form of General Conditions of Construction.

These costs are a layer of overhead generated by field operations.  These costs include; field offices, the salaries and benefits of dedicated personnel assigned to the project, project specific insurances, and miscellaneous costs that are incurred by the field staff.

These costs are also fixed for the duration of the project, but unlike overhead costs that get spread out over multiple projects, these costs are wholly and entirely attributable to a single project.

We commonly see these costs quoted somewhere in the range of 15% to 20% of the cost of work, but this too is highly variable depending on how large your project is and what requirements you include in your General Conditions.  I prefer to solicit these costs as monthly or weekly fixed rate because we can more effectively manage these costs without depriving the contractor of actually incurred expenses.

Profit

Every business needs to make profit.  Without profit organizations would simply fold up and shut down.  Up to this point, all of the costs we have discussed are expenses of the General Contractor.  None of the those costs are actually contributing to the profitability of the company.

Profit should be added to every single expense that we just reviewed.

Today we are accustomed to seeing contractors charging 10% profit.  Anytime we see 15% or 20% we are alarmed and immediately think we are being taken advantage of, but is that true?

In their 2017 earnings report, AECOM (one of the world’s largest construction companies) reported gross earnings of 3.7%.  In the same period, Jacobs a similarly sized competitor of AECOM posted earnings before taxes of 3.9%.

These firms are some of the most sophisticated in the world.  They have teams of MBA’s working for them, yet they cannot seem to make profits higher than 4%.

Having handled many bids from each of these firms I can tell you that their construction quotes typically reflect profits of 10% to 15%.

This tells me that these firms are under tremendous competitive pressures.  So much so, that more than 6% of their “profit” goes towards covering overhead costs.

Closing

So in deference to Mr. Stone, I echo the notion that lowest cost does not equal best value.  We in procurement must understand the costs of doing business and ensure that our award recommendations are made for healthy, fiscally strong  contractors.  We must not allow ourselves to be tempted to look only at the bottom line price.

We need to understand the contractor’s costs and be mindful that we lose all our leverage after the work starts.  All things being equal, the cost of a project will generally be the same.  Minor bid variations of 10% to 15% are common but bids that come in lower must be carefully reviewed.  Low-ball contractor’s win bids with the intention of making up losses through change orders.  These change orders will come at a time when you will be most vulnerable and have the least leverage.

So what has been your experience?  Have you awarded low bid contractors?  Did they perform as expected?  Did you deal with lots of change orders?  Tell me your stories.

Thanks for reading.  If you enjoyed this content, please feel free to browse my previous articles and please like, share, comment, and subscribe.  This helps promote my content and is greatly appreciated.

 

 

 

 

 

 

 

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