Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
Well developed, accurate and timely estimates are the best tool ensuring profitability in the construction industry. No other internal control mechanism is as valuable to the contractor as the estimate. Good estimating systems in construction provide the management team with the necessary confidence to make long-term decisions benefiting all parties involved with the company. Customers receive a higher quality structure with less warranty requirements, employees get a sense of security with their tenure, and vendors/subcontractors acquire desirable relationships with their contractor assuring delivery of best practices for their respective trades. Simple put, good estimates deliver profits to the contractor.
The idea behind estimating is to provide as accurate as possible a hard cost of construction dollar value for a project. This is the primary concept behind estimating. But estimating does much more than provide an accurate cost value, it also provides a basis to evaluate construction performance and market changes. These concepts are explained in the first section below. Even with these core concepts, there are certain universally accepted rules that can’t be broken; referred to as tenets. Estimating has certain tenets that must be followed or the outcomes will cause repercussions for the contractor; specifically financial failure. With knowledge of the concepts and tenets, contractors incorporate certain principles to improve the accuracy of the estimates. Often these principles are industry driven and not universal as tenets are with estimating. The end result is a reliable and trustworthy set of values resulting in a standard to compare operational and financial performance against once the project is completed.
This lesson covers concepts, tenets and principles of estimating. Parts I, II and III explored how estimates use hard costs of construction. These hard costs are compare to actual direct costs of construction to determine discrepancies. Using a multi-step process, the construction management team can evaluate both operational and financial performance right down to the specifics within each phase of construction. Using the knowledge learned, the team can make corrections to both operations and estimating to continuously improve overall construction performance and ultimately bottom line profits. It all starts with understanding the concepts of estimating.
One of the three primary characteristics of success is perseverance. Perseverance is defined as persistently working towards an achievement even during failure. It is easy to evaluate financial failure, if there is less money in the bank account than when one started on the endeavor, most likely you have failed in your endeavor. You have a financial tool to measure success. However, there is no third party resource such as a bank statement to gauge operational success. It must be internally generated. Estimates serve as the internal standard to compare against for operational success. Fortunately, estimates also provide a financial outcome comparative directly relatable to operational success.
In effect, estimates are a contractor’s standard of performance. The management team creates a standard of excellence and when the project is over; they compare the outcome against their standard. The team can evaluate operational and financial performance against this standard. The team learns from its mistakes and incorporates lessons learned from the results and makes continuous improvements to their estimates, i.e. continuously updates the standards, the internally generated third party resource to evaluate success. Thus, the primary concept of an estimate is that it is the proposed STANDARD for the respective project. Performance is compared against this standard.
Estimates are always generated using anticipated hard costs, which are direct costs of construction. All other costs are excluded from estimates, specifically soft costs of construction. Soft costs are those indirect costs of construction and include:
- Employee Benefits
- Tooling/Safety Gear
- Most Insurance Coverage
- Project Management (There is an exception to this with larger long-term projects.)
The most common tool of measurement of performance is in the form of dollars. Other tools of performance management include units of materials, labor hours and equipment utility. Thus estimates have a high reliance on dollar amounts, but they also are used to measure units of production. Therefore, estimates are standards not just in the form of dollars but in the form of physical measurements too.
A key second concept of estimating is accuracy. Accurate values set a higher quality standard for comparison to outcomes. The more accurate, the greater the reliance the entire management team has with this internally generated standard. High reliance allows all members of the team to have faith in the outcome of the project, both operationally and financially. This high level of confidence allows the team to make decisions for the entire company that benefits the company’s overall success. Many long-term decisions are keyed to faith in financial outcomes. Think about the purchase of fixed assets, providing additional benefits to employees or pursuing new and larger projects. All of these decisions negate any ‘Going Concern’ issues (Going Concern is a business concept whereby the continuous operation of the company is in doubt due to one or more factors).
A third concept behind estimating ties to market changes or conditions. During construction, market forces can change the final outcome significantly. First, delays could exist due to a sudden shortage of certain materials or skill sets of laborers. But the most common market change is the price of certain materials. Back in the early 2000’s, there was a sudden spike in the price for tin and suddenly it was not only difficult to find ventilation systems, but the price for ventilation systems spiked. The drawback to estimates is that it is a reflection of the current market price or market condition for certain materials and labor. Good estimates allow for better measurements of these market changes upon evaluation at completion. If properly done, the outcome will identify market changes allowing for future estimates to be adjusted. Better yet, some contractors used this knowledge and adjusted their contracts to include a market conditions clause for any contract that extends beyond 90 days in duration. This clause is commonly referred to as an Escalation Clause.
From September 2018 through August of 2019, the price of cement increase 2.2%. For concrete contractors involved in long-term projects or projects with a significant portion of the value tied to concrete, costs soared and profits dropped dramatically. In many cases, this 2.2% increase caused greater than 7% decreases in profitability for the contractor.
The escalation clause allows the contractor to directly pass the cost increase to the customer.
Overall, estimates are internally generated standard of operational and financial performance for the contractor. It is used to gauge production, performance and financial results. Evaluation of actual outcomes against the estimated amounts allows the management team to make improvements in operations and adjustments to future estimates. Estimates act a a gauge to evaluate success.
Estimates are internally generated standards of operational and financial performance in construction.
Tenets of Estimating
Tenets are universally accepted or unbreakable rules. There are no conditions, circumstances or other criteria that can force deviation from the rule. Think of tenets as comparable to laws of physics; they simply can’t be broken. With estimates, there are three tenets that exist. First, all estimates are unique. No two are alike. Secondly, they must be accurate in order to be effective. Finally, timeliness is required in order for an estimate to generate any value to the contractor. The following three subsections explain these tenets in more detail.
Every project in construction is unique. No two are alike. There are literally hundreds of variables that impact the generation of an estimate. The following is a short list of the multitude of variables:
- Statement of Work
- Engineering Requirements
- Site Conditions
- Geographical Weather Conditions
- Availability of Materials/Labor/Talent
- Outcomes Required
Given the variables that can impact an estimate, each estimate is unique. Therefore, anytime criteria requires a unique output, the time input to prepare the estimate is extensive to take into consideration all these variables. With construction estimating, the key is to prepare a list of the most impactful criteria. The lists will be different depending on the nature of the construction company. A new home contractor’s list of essential considerations to generate an estimate will be significantly different than a bridge builder or a tower fabricator.
For your company, the entire team should spend an hour and brain storm about this list of variables that can greatly impact the outcome of estimates. Then list them in priority and create a check-off worksheet for an estimator to ensure that all these variables were considered. These variables should be a part of the pre-existing conditions questionnaire that is a part of every estimate.
Estimates Must be Accurate
All economic sectors, industries and government authorities use standards to ensure effective delivery of their products or services. Estimates are in-house generated standards as to the hard cost of construction. Accuracy of the values is essential in order to evaluate operational and financial performance. Estimates must be accurate. Any deviation can significantly impact bottom line profits. This example illustrates the impact improperly prepared estimates can have on the bottom line.
XYZ Construction Inc.
XYZ fabricates and erects cold storage facilities. This includes engineering and electrical work. Due to the extensive engineering requirements, XYZ’s engineering department is classified as an indirect (soft) cost of construction. Thus, contribution margins from project must exceed 55% to offset the expensive indirect and overhead costs for this company. Here is XYZ’s 2019 income statement in summary format:
XYZ Construction Inc.
Year Ending December 31, 2019
Revenues $19,408,300 100%
Direct Costs of Construction 8,976,700 46%
Indirect Costs of Construction 5,007,600 26%
Overhead 2,861,900 15%
Taxes 666,200 3%
Net Profit $1,895,900 10%
The estimator for Project #190218 calculated hard costs of construction at $1,393,400. Mark-up on hard costs was determined to be 123% which is the company’s overall average mark-up*. Thus XYZ submitted a proposal which was accepted for $3,096,500. The project was completed by year end 2019 and included in the above financial report. Management agreed that this particular project had no abnormal criteria and thus this project was allocated it’s respective share of indirect, overhead and income taxes based on its revenues generated. Actual costs of construction came in $118,000 greater than estimated. Review of the operational outcome identified a failure with the estimate to take into consideration proper drainage of water when the freezers were in defrost mode. The necessary structural changes generated over $112,000 of cost overruns.
The following job profitability comparison report compares the financial results and the corresponding impact on the net profit assuming the difference in the estimate and the proposal’s dollar value would have been accepted by the customer.
XYZ Construction Inc.
Job # 190218 Comparison Profitability Report
Year Ending 2019
Actual With Accurate Estimate Notes
Revenues $3,096,500 $3,358,700 A
Costs 1,511,400 1,511,400
Direct Job Profit 1,585,100 1,847,300
Allocated Share of Indirect 798,900 855,000 B,C
Allocated Share of Overhead 456,500 488,500
Allocated Share of Income Taxes 106,300 174,500 D
Job #192018 Net Profit Contribution $223,400 $329,300
A) Estimated hard costs are divided by .45 to generate the proposal value, i.e. a 55% job margin is expected from projects.
B) Indirect costs are allocated to each job as a ratio of the project’s revenue to total revenue. In this case, 15.95% ($3.1M of job revenue/$19.4M in total revenue) of indirect costs are assigned to this project.
C) Since the project’s adjusted revenue increases $262,200 due to the change in costs for drainage, total revenue during 2019 would equal $19,670,500; therefore the allocated share percentage increases slightly to 17.07% ($3.4M/$19.7M).
D) Taxes are adjusted for additional operational profit from the increase in direct job profit and as such, the effective tax assigned to this project increases in greater proportion than indirect and overhead costs.
An increase of $118,000 with the estimate’s hard costs generates an additional $105,900 of direct profit. This is a 47% increase in profits from a 9.2% increase in accuracy with the estimate.
This tenet of accuracy exists in all fields of construction.
Estimates Must Be Timely
The third tenet and just as important as the first two is that estimates must be timely. Preparation of an accurate estimate takes many hours and in some cases, days to prepare. Timely preparation is necessary to allow the management team to discuss and endorse the estimate. Without all parties getting onboard with the estimate’s end result, there will be finger pointing during the evaluation process. Thus, all contractors should develop a schedule of actions with all estimates in order to timely deliver the end proposal to the customer.
A reasonable schedule of actions will follow a timeline similar in nature as the following:
- Receipt of Request for Proposal (RFP) or Statement of Work (SOW) or some form of initiation prompts the need for an estimate.
- Management reviews the receipt and notes any significant discrepancies from the company’s mission. Management must approve proceeding with generating an estimate.
- An Estimator is assigned the responsibility of generating the necessary documentation.
- Estimator puts together a set of tasks and gathers all information including points of contact, plans, list of materials, scope of work, etc.
- A pre-existing conditions questionnaire is filled out (commonly done during the site visit/walk-through).
- Any required subcontracting quotes are communicated with vendors and deadlines are documented to the vendors.
- Estimator finishes gathering all data including subcontractor quotes.
- Estimator prepares initial estimate for discussion with management team.
- Management team provides input and discussion.
- Final estimate is completed and approved by management.
Once the final estimate is completed and approved, the proposal can be then prepared and forwarded to the potential customer along with a preliminary contract or a letter of understanding between the parties. Often the customer will balk at the proposed price and request an understanding as the underlying reasoning for the values provided. There is some back and forth between the parties. With many negotiations back and forth, the customer will change the conditions or scope of work in order to reduce the proposed price. The better contractors educate the customer as to the underlying drivers of price variances to get the customer onboard and create a sense of trust.
Almost all construction contracts are driven by a sense of trust between the parties. This trust stems from good communications and the ability of the contractor to convey the various cost drivers of construction. Without timely preparation of an estimate, contractors cannot substantiate their position related to underlying costs during this negotiation period. Timeliness is required to achieve trust between both parties in a contract.
Principles are defined as rules or guidelines tailored to the respective industry. Unlike tenets, there are factors that can impact, change or completely ignore the respective principles. For example, inspection of site conditions is applicable to most construction contracts, but not necessarily for all contractors. Think about prefabricated construction or tradesmen, it isn’t necessary to inspect or verify site conditions, the lay of the land isn’t their responsibility. Thus, principles are not universally applicable whereas tenets are universal. Notice how principles are more refined in nature than tenets and often, principles are customized to the respective contractor.
Every contractor should create their own list of the top 20 or more principles as a check off list when the management discusses the respective estimates during the validation process (explained in a later lesson in this series). The following are some of the higher level principles used with estimating in construction.
Only Use Hard Costs of Construction with Estimating
With Parts I through III, it was stated that estimates are limited to hard costs only. This is true with more than 75% of all estimates generated. However, some estimates do require inclusion of soft costs. Many larger governmental and institutional construction contracts do require inclusion of soft costs in the formula. This is required with many contracts in California. There, both the government and labor unions require validation of payroll benefits and implementation of prevailing wages for all government issued contracts. Many federal contracts require an allocation model tied to some units of production for all soft and overhead costs of construction.
The more advanced lessons in this series explain how to incorporate these different allocation models with estimating in construction. But in general, all estimates should be created using only hard costs of construction. If the reader wants more clarity about hard and soft costs, read: Hard and Soft Costs of Construction.
Utilize a Pre-Existing Conditions Questionnaire Prior to Preparation of an Estimate
One of the core business principles used by all is the principle – Gain an Understanding of the Work Environment. This key business principle forces the management team to understand the various forces that impact productivity or can create adverse outcomes if not considered as function of the process. This is essential when creating an estimate. This business principle is simple for contractors, one simply wants to understand what is involved during construction. The easiest and most direct tool is site inspection. Many estimators fail to take into consideration all the respective variables associated with construction that can and will add to the overall costs of construction. For example, some neighborhoods require a contractor’s or performance bond. Some homeowner associations require the contractor to pay a fee, often significant in dollar amount, to contribute towards the initial association capital outlays.
The best tool to use is a pre-existing conditions questionnaire customized for the contractor’s line of business. For example, with remodelers, the questionnaire includes questions about access not only to the neighborhood, but to the building/home too. Other questions include gate codes, key locations and even grading of toilet flushes. Grading of toilet flushes? Yes, low or slow flushes indicate either poor suction, water pressure or improper equipment; during remodeling these systems may need replacement and this adds to the overall cost of construction. Thus a well developed and extensive questionnaire leads the estimator to a more accurate estimate. It isn’t simply a matter of acquiring the knowledge, it is acting on that knowledge that produces greater profits.
Incorporate the County and Local Code
Every estimate should have a check list of the required inspections and engineering certifications during construction. These inspections and certifications have associated hard costs and preconditions. Every good estimator looks for the abnormal inspection or certification requirement. Getting caught without the respective inspection and failing to account for the requirement often costs hundreds of dollars. For state or authority inspections, fees can run into the thousands or tens of thousands of dollars. Go beyond just the local county, include any community required inspections and their fees too.
Acquire Multiple Vendor Quotes for Materials and Trades
Multiple vendor quotes, whether subcontractor or supplier, in necessary to generate an accurate estimate of hard costs. The more vendor quotes, the more reliable the estimate. The most common mistake made by estimators is delaying the delivery of needs, scope of work etc. to potential vendors. This doesn’t give them adequate time to respond with a clear and definitive value(s). One of the early steps in preparing estimates is to create the respective vendor quote packages and get them delivered to qualified vendors. A good estimator follows up via e-mails, texts and phone calls to ensure timely responses.
Many suppliers will generate the respective take-offs needed to determine the correct materials list for either the entire project for their respective scope or for a particular phase of construction. This particular principle is explained in more detail and several suggestions in a future lesson. For the purpose of this lesson, a core principle of estimating is to acquire multiple quotes from the contractor’s resources.
Communicate with the Client Any Discrepancies And/Or Validate Customized Requests
One of the most neglected principles of estimating is failure to read the scope of work in detail and review the plans. Good estimators will read the scope of work several times over different days to generate a list of questions to ask during the site walk-through. In addition, any specialized construction requirements are noted and pertinent issues are documented. For example, a retaining wall may require additional engineering work or soil testing to determine proper drainage. If this isn’t included in the plans, ask why? If there are custom orders for particular purposes, validate the requests. For example, if wrought iron decorative fence is included in the plans, does the wrought iron have to be powder coated or will a traditional paint job be acceptable? Remember, often the architect, engineer or client are not aware of the options available in the market.
Ensure Receipt of Amendments to the Statement of Work/Request for Proposal
Many large corporations and government driven requests for construction work are continuously modified. Most federal and state jobs use a website to continuously update any changes during the proposal period. Most contractors sign up to automatically receive the amendments. However, every estimator should validate all changes several days prior to completion of the final estimate. Many of these changes are a direct result of other contractor questions and communications related to the respected project (see prior example of a common principle with estimating in construction).
Confirm Grade and Availability of Materials
Another necessary step in preparing an estimate is confirming the quality of the materials indicated in the plans or scope of work. Clients often request via the plans or write-ups the highest quality grade of materials creating an absolute position. In some cases, this high grade of materials doesn’t exist or isn’t available. For example, some grades of materials are strictly regulated by the federal government and available to certified federal contractors due to restricted applications, i.e. military use. Other grades of materials just simple don’t exist. This requires research and communication back to the client about substitution with quality of materials. In some cases, the lead time for certain materials or components require revision of the timeline or some form of start/stop function for a contractor. If this is the case, then additional costs are incurred to remobilize or to maintain equipment on-site. For example, some electrical transformers require upwards of a year to design/fabricate for the customer. Your average person isn’t aware of this time lag from order date to actual installation. This creates several potential costly requirements such as additional rental time for containers/fencing/security related to the site. In rare cases, it could require an additional permit application. The key to this principle is research work by the estimator. Research takes time and requires tremendous volume of communications to affirm grade and availability of materials.
All throughout the estimating process, a good estimator will mark-up plans with notes, keys to certain requirements and even add e-mail contacts/times and corresponding communication responses. The goal is to have a fully marked up set of plans validating research, communications, issues and keys to other documents. This allows the management team to discuss any pertinent discrepancies during the evaluation stage (Parts I – III in this series). The end goal is improving the overall estimate’s accuracy and of course ensuring proper procedures were followed.
Create a Check List of Required Skill Sets
With more complex construction projects such as road construction, ship building, manufacturing equipment and commercial facilities it is a requirement to generate a list of required skills needed to complete the respective tasks. In some cases, very few individuals hold the respective certifications or licenses. A simple example are crane operators. Once certain lift heights are required, additional certification is required for the crane crew. Furthermore, OSHA standards and certifications should be included in this spreadsheet in order to assure compliance not only with the client’s project but with state and federal authorities.
Summary – Concepts, Tenets and Principles of Estimating in Construction
Standards of both operational and financial performance exist in almost every industry. The construction sector of our economy uses an in-house generated standard called an estimate. Thus, the primary concept of an estimate is that it is the proposed STANDARD for the respective project. Performance is compared against this standard. The more accurate the estimate the better the overall contribution the standard makes towards the company’s performance. This standard is also used to assess market conditions and changes during the construction period.
There are three tenets of estimating. First and most important is that every estimate is unique. Thus, each estimate’s preparation requires thoughtful and skilled techniques. The more experienced estimators have learned to take their time to increase overall accuracy, the second tenet of estimating. Finally, estimate preparation must be timely or its credibility is in doubt. Waiting till the last minute to put it together reduces its overall validity and will cause repercussions throughout the entire construction period, ultimately ending up in financial ruin.
Throughout the estimating process, estimators rely on core principles that are common to their respected industry. Some principles are almost 100% applicable to all construction industries and include using hard costs as the primary value indicator. Other principles include:
- Preparing a Pre-Existing Conditions Document
- Acquiring Multiple Vendor Quotes
- Constant Communications
- Research Codes/Materials and Skill Sets Needed to Complete the Project
These concepts, tenets and principles are a pyramid of rules with estimating. Design your company’s estimating process around this pyramid of rules. Act on Knowledge.
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