Allowances in New Home Construction Contracts – The Business Model
Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
In almost every new home construction contract that I reviewed as an accountant, I saw where the contractor would lose several thousand dollars in this area of his business. In every case, the situation was the same, there was no mutual understanding between the home buyer and the contractor. Invariably, the contractor paid out significantly more money than he took in for this part of the contract. What made the situation worse, was that the entire set of transactions were poorly documented and then accounted for incorrectly in the books. All this could have been prevented with four simple steps. First, give more emphasis to this part of the contract to gain a mutual understanding of how allowances are addressed. Secondly, authorize any amenity. Third, properly document the actual transactions and finally, issue a change order and collect the money when the buyer exceeds their allotted allowance.
This article is designed to help the contractor address the proper procedures and documentation related to allowances in a new home contract. I will first define and describe how allowances should work in a new home contract. Next, I will explain how to address the business perspective in the legal arrangement between the buyer and builder. The third section will cover procedures for dealing with allowances and finally I will explain how a contractor deals with the buyer purchasing more than the allotted amount and of course the corresponding collection process.
Allowances – Definition and Description
There are two forms of allowances. The first is the more common type and is also referred to as upgrades in the industry. The second form of an allowance is a substitution program.
Allowances as Upgrades
The primary purpose of an allowance is to provide some latitude in amenities with the construction of a new home. In effect it acts as a budget for certain areas of construction. The following are the top five monetary allowance areas of a new home construction contract:
- Kitchen Cabinets and Countertops
- Kitchen Appliances
- Bathroom Tiling
- Plumbing Fixtures
A typical construction contract lays out the respective specifications and quality of materials. With allowances, the specifications are vague or pretty much non-existent. When the home buyer desires to have a higher quality material or product as one of his amenities, he is using his allowance to offset the price associated with the upgrade. The perfect example of this is with kitchen appliances. The allowance may be $3,000 in the contract, but when the buyer goes to choose their appliances, they decide on a larger refrigerator, higher quality of brand or even a different style. When the price exceeds the $3,000 allowance, the buyer pays the difference.
Allowances in the Substitution Program
The secondary form of an allowance is as a substitution. Sometimes buyers bring their own appliances or other amenities with them. Thus, the contractor simple agrees that he will subtract this allowance value from the final price at closing. Sticking with the kitchen example above; if the buyer brings their appliances to the home, the contractor simply subtracts the $3,000 from the contract at closing.
Both forms of allowances often create more problems than they solve. One of my favorite sayings in business is ‘The devil is in the details’. This is the perfect example of why allowances create more problems than they solve. Often, there is a vast misunderstanding between the buyer and the contractor related to allowances. To understand this, let’s take a look at the business arrangement.
The Business Arrangement
Remember the primary purpose of allowances is to provide latitude to the buyer for their amenities. This is more trouble than it is worth. Right from the beginning, it is difficult for contractors bidding on a job to compare their respective bids. Some contractors will purposely bid the allowance items lower in order to keep their bid low. The following chart illustrates two different bids with a third column reflecting what the real cost will be for those allowance items.
Bid # 1 Bid #2 Realistic Allowance Value
Kitchen Appliances $3,400 $3,800 $3,750
Flooring 8,000 12,000 12,500
Cabinets/Countertops 21,000 24,000 25,000
Plumbing Fixtures 4,000 5,500 5,500
Totals $36,400 $45,300 $46,750
Contract Bid $365,000 $370,000
Bid number one is $5,000 lower than contractor number two’s bid. If all other prices are the same, then the first contractor’s bid will be lower than contractor number two and he’ll win the contract. But when it comes time to install the allowance items, the homeowner will have a rude awakening as the actual costs will mirror the standard allowance value therefore the homeowner will pay out of pocket $10,350 for their allowance items. With contractor number two, the homeowner will only pay out an additional $1,450 (the difference between the standard value of $46,750 and the bid amount of $45,300).
The only true way to equalize and compare the two bids is for the home buyer to preset the allowance amounts to standard amounts and then compare the contract bids as the following chart illustrates:
Contractor #1’s Bid Contractor #2’s Bid
Original Bid $365,000 $370,000
Reset Allowances 10,350 1,450
Both bidders increase their allowance amounts to match the standard allowance amount.
Adjusted Bids $375,350 $371,450
Notice now that contractor number two’s bid is $3,900 less than contractor number one. This is because both contractors had to include the set allowance amounts in their contract to reflect the actual expected cost of the allowance items thus allowing a true comparison of the contract value.
What contractor number one is doing is shifting the real cost onto the homeowner to increase his margin. Contractor number two is trying to be more realistic about the real cost of building this home. More buyers misunderstand this business price shifting than those with the ability to comprehend this poor business practice. This leaves the more honest contractor at a disadvantage in getting a contract.
To address this problem, the home buyer should set the value of the respective allowance sections to a dollar figure that must be used by all bidders. If the allowances are too low like those used by Bid #1, then at least all bidders use low numbers. This allows for a comparative bidding process.
Now that I have addressed the bidding issue related to contractors, there is another issue related to getting the work done. A common thread that binds all allowances no matter which form of an allowance used is the need of a sub-contractor to install these amenities. This is where the next set of troubles for allowances begins. The following is a short list of issues related to both forms of allowances related to sub-contractors:
- Quality of Materials – Many subcontractors use lower grade materials for their respective part of the contract. The allowances set in many contracts reflect this level of quality. This is usually where the problems begin. A good example is in kitchen cabinets. The allowance reflects the typical industry lower grade particle board style cabinets. The buyer desires higher grade plywood and pure wood facings.
- Timing – If a home owner brings their own amenities, delivery and installation timing become a problem adding to the cost for the contractor. Worse, are those delays associated with the installation of an amenity. Often one item triggers a second step and so on. If the amenity is delayed this creates problems for the subs and the schedule overall.
- Reconfiguration – If the item brought by the homeowner doesn’t fit the framed out location, it creates a real serious problem. Reconfiguration could involve more than just one or two subcontractors and the overall schedule.
- Access to a Qualified Sub-Contractor – Many of the higher quality amenities required certified installers. The contractor uses the same subs regularly and the odds that these subs are qualified are problematic. Now the contractor has no choice but to adjust his schedule to the timing of the certified installer.
All of the above bidding and sub-contractor issues are typical with use of allowances. I can assure the contractor, that this ends up costing money during the contract. The following are two good examples of this and the cost to the contractor:
For those of you working as contractors realize, anytime you modify a plumbing configuration in a home, the cost to do so, increases in $100 chunks. In one case, the contact called for a sauna in the home. But the system used by the sauna was an allowance issue. Well, the homeowner purchased some type of Turkish Bath/Sauna System which used foreign designed fittings and required a specialized heating/pumping system in the basement. Well, the original configuration for the basement had not allotted the space nor the plumbing void associated with getting the heated water to the second floor. By the time it was finished, the plumber had added over $3,000 to his bill associated with the specialized installation.
As always, the lady of the house becomes enamored with certain amenities. Most are attracted to higher quality countertops or cabinetry. In this contract, she wanted recessed lighting. She ordered an additional 16 recessed lamps which she paid for based on the contract. Seems innocent enough? Well, the first indicator of a problem came from the electrician. His bill added $75 for the installation and wiring of each lamp. You got it, it wasn’t in the wiring diagram. In addition, he added $45 for four new variable switches to control these lamps. Finally he added $125 for the two new circuits in the distribution panel to handle these lamps. Now, we have a total of $1,588 because naturally the state had to get its sales tax too. OK, I wasn’t expecting that, but it gets worse.
The sheetrock guy added $100 to his bills to cut the holes in the sheetrock and the contractor had to purchase two additional 8’ sheets of rock to offset the mistakes the sheetrock guy made in his cutting associated with those ceiling pieces. Well, I thought it ended here. Then the painter calls me on the phone. “Hey, you didn’t have these recessed lights in the plans. Now we have to set up scaffolding to gain access to them to tape them up!” $150 more dollars!
Get the point yet?
By the way, the final insult was that the homeowner wanted my client to pay for the extension tool used to remove and install the lamps. These lamps were installed in a cathedral ceiling. $48!
How do we avoid these cost overruns? Is there a way to get the customer to pay for the upgrades or deal with these changes?
Best Procedures and Practices for Allowances
Well, this seems to be a bad deal for the contractor all the way around, doesn’t it? First off, it is difficult to compare bids, secondly it seems that any change costs the contractor even more money. The primary purpose is to allow the customer some latitude in their amenities. What is the best way to address this whole situation? Ideally, the best tools are to 1) educate the home buyer, 2) authorize any amenity purchase, 3) document the issues related to the amenity and finally, 4) issue the change order and invoice with any abnormal amenity.
The following are these four steps broken out with descriptions of the step and processes for the contractor to follow related to each step.
Step One – Educate the Home Buyer
Prior to the bidding process, request from the home buyer their allowance requests for each of the respective areas of the contract. Be sure to identify all potential areas of concern. Naturally, as the level and quality of the home increases, the number of areas of allowance begins to expand. In your smaller basic homes, allowances are generally limited to appliances and carpeting. Sometimes, the contract may allow for some fans or some tile work. In your more semi-custom homes, you begin to get involved in hardwood and tile floors, lighting and bathroom fixtures but rarely do you get involved in cabinetry or trim work.
As the house heads towards more custom level and higher end homes, you definitely have allowances related to cabinets, countertops, bathroom fixtures (cabinets, sinks, faucets, mirror sets), expanded flooring (hardwood, laminates, carpet, tile etc.), appliances and lighting. As the prices of custom homes head towards $1,000,000 you begin to see allowances related to decking, railings, stairway, and concrete. Notice how the lot layout begins to come into play with your higher end homes.
In this step, identify all issues first. MAKE A LIST. Then have a sit down with the home buyer and review relevant matters related to the respective areas. Make a list of issues to address and review. Assign tasks to the home buyer for them to go out and do some looking at the different options for their home. Get them to look at the retail price and the potential sales price. Let me give you two examples:
- Bathroom – have a list of dimensions allowed for the cabinets and their respective tops. List the issues the home buyer needs to review in their decision model. If the width is limited, then naturally, the number of sinks etc. is limited too. In addition, explain the differences in the various faucets and the configuration of the premade vanity tops and how they affect the overall price. If the home buyer elects to have dual sinks, this adds several hundred dollars to the plumbing cost. It may affect the tile and backsplash issues. Make sure you have a detail discussion list when discussing the various allowances.
- Flooring – explain to the customer that flooring cost is mostly driven by the quality of the material. It really doesn’t make too much of a difference in labor to install carpet. Many of your lower end contracts allow for what is referred to as ‘HUD’ grade carpet. But the reality is that this is really thin material and for the tighter bonds, the cost begins to creep up quickly. This is also true as it relates to the four different levels of padding that go under the carpet. As a contractor you should educate the home buyer about the life expectancy of the various different types of flooring. If you discuss floor tiles, the price here is usually driven by the various manufacturers than the actual tile itself. Often the design pattern comes into play due to the nature of using patterns. It is important for them to understand the underlying cost driver of floors.
Have a follow-up meeting to review the various tasks completed by the home buyer. Address any obvious issues and agree to follow-up on any marginal items by looking at them as the contractor. This way, all items are essentially selected prior to the contract signature. Make a list of the items and their corresponding specifications and limitations. A good example is allowing the customer to choose a dryer for her laundry room. Well, most folks don’t understand that you have to install the power cord for the dryer (unlike most appliances, dryers do not come with a power cord installed; the buyer must install one on their own) and there are three variations out there! This sets the type of receptacle for the electrician to install and then the question is: Who installs the dryer cord? Who pays for the venting duct from the dryer to the vent duct? Notice how we are addressing a set of $60 materials issue and more than likely $50 to $100 of labor issues related to just one appliance?
To reduce misunderstandings in the long run and the corresponding costs, the contractor should have a summary worksheet of the various issues related to the different amenities. This should be handed to the home buyer and of course a signature on a summation document that describes the different documents released to the home owner related to the contract. Once the signature is on the master summation sheet, they can’t say they didn’t get the issues worksheet for the respective amenity items.
Step Two – Authorize any Amenity
This is an essential step for the contractor. It needs to be in the contract in writing stating the contractor must authorize any allowance item prior to purchase. The contract can stipulate that no unreasonable amenity request will be withheld. But the purpose here for this clause is to allow the contractor to review the homeowner’s selection beforehand and have an opportunity to address potential problems with installation. For each amenity selected, there should be a release document drafted (a simple one or two sentence form) that the contractor can note potential issues.
Step Three – Document the Amenity Purchase
When the customer selects the amenity, the form documents the item selected, the supplier, and any issues related to the selection. Sometimes the form can go with the home buyer as a prelude of a set of notes to the supplier. Many contractors use the same supplier for their amenity purchases. The home buyer has an amenity worksheet explaining the vendor, the item and restrictions including the allowance associated with the particular amenity. This way, the supplier can’t upsell the item without the customer paying for the balance beyond the allowance amount. This is important to understand. The customer should pay for the upgrade at the time of purchase with the supplier. If the allowance is $1,200 for a refrigerator and the customer selects a $1,456 model including tax, then the customer should pay the $256 difference at the store. The $1,200 bill is sent to the contractor. In addition, the restrictions for the refrigerator are on the authorization document, specifically the width and height restrictions and the water supply limitation.
The biggest culprits of all are the issues related to the sub-contractors as described above. This is why it is important for the contractor to authorize the respective purchase. What if the customer orders a refrigerator with an ice maker and the specs in the worksheet state that there is no water available in the refrigerator opening? Now we have a problem. If we use the authorization process, we can avoid this altogether or fix it via a ‘Change Order’.
Step Four – Issue a Change Order
I guarantee you that almost every amenity will require a change order of some sort. Review all my examples I provided above. The purpose of the change order is to get paid for the additional costs associated with the amenity. Using the refrigerator example above, the contractor can issue a change order after communicating with the plumber about the costs to add a water line to the refrigerator opening. The key here is to get the underlying cost and make sure you add a reasonable margin to cover your costs as a contractor. If you need help in understanding what is a reasonable margin, read my article: A Reasonable Profit in Construction.
Follow up with the home buyer and get them to pay for this change order up front, right then! Get your money. This is not unreasonable given the nature of what is happening here. Again, the home buyer put this burden on themselves. You spent time educating and helping them to work with the allotted budget. You documented the issues with each amenity so they are aware of potential problems and the associated costs. If they are willing to pay for the additional costs, then there is no problem. Don’t wait until the closing table because odds are that they will run out of money. Closing costs, moving costs and the overall cost to set up a new house will take priority over your unpaid change order. Get your money NOW!
If the situation for allowances relates to substitution, then you as the contractor need to authorize the respective substitutions. What if the oven/stove item is a gas system and there is no gas available to the neighborhood? Again, the four step process above will clear up these misunderstandings. If there is a problem, at least you as the contractor will not have to pay for this.
Remember, the primary reason allowances exist is to provide latitude to the home buyer with their amenity selections. This comes in two different formats, upgrades and substitution.
Summary – Allowances in Construction
For the contractor, the key is to educate the buyer and provide guidance to the buyer to prevent and reduce the issues related to allowances. You should authorize the amenity before the actual purchase as more than likely the amenity will generate issues during installation.Document this change and issue a change order if needed. Make sure you use appropriate markup to ensure profitability. Act on Knowledge.
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more and receiving good information, reports, charts and recommendations; join as a club member below. Start your investment portfolio today.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.