Estimating in Construction – Part V (Cost Drivers and Application Principles)
Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
The core tenet of an estimate is that each is unique. This uniqueness is driven by hard costs of construction. There are five distinct hard cost drivers in every estimate. Each cost driver has different application principles (introduced in this lesson), different sources of value and final markup formulas to determine the final estimated hard cost. The five distinct cost drivers are 1) materials, 2) subcontracted services, 3) equipment application, 4) labor and 5) intangible expenditures. Parts VI through X explain each of these cost drivers in-depth and how to properly source the value, determine final markup amounts and derive a final hard cost of construction.
Each type of cost (driver) has principles of application, i.e. thought processes an estimator must consider. Some of the principles are common among all five types of costs. Others may be unique to just that particular cost driver. This lesson introduces these five cost drivers and the various application principles involved with each driver.
Estimating – Materials
Probably the most common cost with all estimates are materials. It is rare for any project to not have materials as one of the costs of construction. However, not all materials have similar elements. In some cases, the materials are raw such as sand, gravel or fill. But in most cases, the materials are processed or composites of several raw materials. For example, lumber is a processed material; it has to be milled, dried and treated prior to delivery. Even something as simple as concrete is a composite of three or more raw resources. It is more common to purchase processed and composite materials than raw materials.
At the other end of this extreme are highly sophisticated materials such as circuit boards or compressors. Think of these materials as engineered products. Something as simple as an H beam used as a header is an engineered processed item. Take this further whereby a sophisticated system is involved such as an elevator, there are no raw materials involved when estimating the installation of an elevator. All the materials are typically a composite or even engineered components (motor, pulleys, computer, electrical switchboard, etc.).
Think of the spectrum of materials when estimating. The spectrum of materials is as follows (from simple to highly sophisticated):
The process of estimating for each level within this spectrum is different. As the material gets more sophisticated the corresponding installation is less intensive. Here is an extreme illustration of either end of the spectrum:
With raw materials, there is a different process to install the material. In most cases equipment or intense human labor is necessary to install the raw material. For example, gravel for drainage requires use of equipment to spread it a set depth over distance. This takes some time (hours of work) and equipment is expensive to use with any application.
With a circuit board, the technician follows a simple step by step procedure to install, test and energize the system.
With most estimating procedures, materials are simply sourced at cost no matter where the material falls within the spectrum of sophistication. The point here is that the estimator must take into consideration the potential additional costs associated with the other cost drivers given the level of sophistication of the respective materials involved. In effect, technical estimates are much easier to prepare than an estimate whereby the project is driven by raw materials. This seems counter intuitive, but as you read the balance of Parts V through X this will make much more sense.
Another application principle associated with materials is the nature of the project. Most projects are cost driven by materials over the other four cost drivers combined. For example, with residential construction, about 40% to 55% of the hard costs are driven by materials. The balance is customarily labor based whether in-house labor of the use of subcontractors. It is rare to find construction projects whereby the hard costs are 75% or more driven by materials. The application rule of thumb for construction projects is that materials compose greater than 25% of the hard costs of construction. With estimating, the greater the percentage of hard costs driven by materials, the more important it becomes to take into consideration the level of sophistication of the respective materials. It will have a significant bearing on the final hard cost calculation and the associated final proposed price to the client.
Part VI of this series explores sourcing of values and the different markup formulas related to the different levels of sophistication with materials.
Estimating – Subcontracted Services
The primary application principle related to subcontracted services is tied to a business principle called ‘Profit Tiers’. All estimators must acknowledge that any time a contractor engages a subcontractor that the respective subcontractor has built into their fee their own profit. Thus, the final proposal to the contractor’s client has two levels of markup. The first level is the subcontractor’s markup to cover their soft costs, overhead and profit. The second level is the contractor’s markup to cover their respective soft costs, overhead and desired profit. In effect, it is possible for the actual core hard costs related to some subcontracted services to be less than 25% of the final overall proposed amount an estimate’s prorated value associated with this particular subcontracted service. Here is a good illustration:
Concrete Tarmac/Sidewalks/Curbing for a Convenience Store Build
ABC Construction agrees to build a convenience store for their customer. Final contract proposed price is $2.4M. Of this contracted amount, the proposal valued the installation of the concrete gas pump islands, tarmac pad for the gas fueling area, aprons, curbing, sidewalks, light pole bases etc. at $251,000. ABC Construction has a 28% markup on this component of the proposal. Thus, the subcontractor agreed to install the concrete in accordance with the specifications for $196,100. Thus, if you multiply $196,100 times 28% ($54,900) and add this to the cost, the total value of this phase of construction is $251,000.
Lunar Concrete received the purchase order to perform the concrete phase of this project for $196,100. Lunar Concrete’s estimate of hard costs is $123,780 for this project. Their markup is almost 58.5% on overall hard costs. Thus, hard costs of $123,780 times 58.5% equals $72,400. Combine hard costs and markup and the final proposed price to ABC Construction is $196,180 rounded down to $196,100.
Overall, actual hard costs involved in this phase of construction is $123,780 with a final proposed value to the client of $251,000. This is a whopping 103% markup on actual hard costs of construction. In effect, $127,220 of the $251,000 covers soft costs, overhead and profit for both contractor and subcontractor combined. The actual hard costs are a mere 49.3% of the final proposed price.
As the respective underlying subcontracted service tends towards professional levels of service (engineering, architectural, surveying, diving, etc.) the more likely the underlying core hard cost decreases as a percentage of the final proposed price to the customer. This becomes more acutely ingrained when the subcontractor has to purchase their materials, supplies or auxiliary services from a tertiary level source. Think about Lunar Concrete, they had to purchase the actual concrete from a concrete ready mix company. That supplier has their own level of markup on their respective hard costs of delivering poured concrete. Think about the 3 tiers of profits in the final proposal for just this one phase of construction:
- The contractor built in its desired profit in their markup of 28%;
- Lunar Concrete has a profit within their 59% markup; AND
- The concrete supplier has markup within their respective cost to Lunar Concrete.
There is even a fourth level associated with the raw materials supplier for the concrete ready mix company. Notice the tiers of profit involved with the final proposed price.
It is important for the estimator to understand this business principle of profit tiers. It adds a dynamic to the final method or process of calculating markup on estimated hard costs of construction. In Part VII of this series, the estimator and construction management team is taught how to shift more of the profit tiers to the contractor away from the associated subs and still maintain a good contractor/subcontractor relationship.
A second application principle of subcontracted services in an estimate relates to the level of skills and certifications the respective subcontractor delivers to the contractor. The key for all contractors related to utilizing subs to perform services is why are subs used? The answer is that all work that falls outside of the in-house skill sets or availability of labor is customarily outsourced to a third party. This is quite common when licensing is involved (electricians, plumbers, HVAC, engineering, architects, surveyors, etc.). A second reason relates to highly skilled artisans needed to perform the respective step of construction. For example, cabinet makers, trim carpenters, stone masons, wrought iron work and others have skills not commonly found within the construction industry. The more experience required, the less available talent exists and the more expensive the subcontractor becomes.
Thus, all contractors should seriously consider bringing in-house certain outsourced work in order to increase overall profits. Some examples include hardscaping, landscaping, wall work (sheetrock, insulation, painting etc.), flooring and more. Part VII in this series explores this principle further and in-depth highlighting tied to the value of shifting greater profits to the contractor by using in-house labor over out sourced services.
Estimating – Equipment
Unlike the first two cost drivers, equipment utilizes one of two application principles. The first is a derivative of in-house equipment whereas the second is outsourced equipment. The hard cost calculation is different for each application.
Many contractors utilized their own in-house equipment to fulfill their obligations under contract. Excellent examples include road builders, site developers and institutional builders. For them, determining the cost of utilizing in-house equipment relies on a method of accounting called ‘pooling of costs’. Here, all costs associated with equipment usage is pooled together for each group of equipment, i.e. costs to operate and maintain cranes are pooled together and same goes for dump trucks, graders/dozers etc. All the direct costs of operating, maintaining, insuring, transporting and capitalizing the group of equipment is grouped as one lump sum value. This aggregated amount is then divided by functional physical measurement such has hours of use, or engine hours, or miles driven, or even units of lift to generate a cost per unit of measurement.
When estimating with respect to this equipment, the number of units of physical measurement is determined and then multiplied by this value per unit to determine the actual anticipated costs for the respective equipment. Estimating in Construction – Part VIII (Equipment Utilization) goes into more detail and the formulas involved for this particular application method.
Almost every contractor has to rent equipment from a third party in order to complete their work. It is rare for any contractor to have the necessary equipment available in-house to fulfill their obligations. Frequently, equipment may only have a short time duration need or is strictly used for a specific function. For example, most home builders do not own cranes to lift roof trusses or for a dredging contractor to own their own tugboats. They simply rent or subcontract this requirement to a third party.
There are two large equipment rental companies nationwide in the U.S.; Sunbelt and United Rentals follow a similar rental program. Once approved, a contractor simply requests delivery of the specialized equipment to a job site via their respective representative. The rental company has a daily, weekly or monthly charge to rent the equipment, a delivery and pick-up fee, insurance application fee and a local property tax fee in their charge schedule. A common mistake made by estimators is to limit the hard cost to just the rental fee in their estimate. For example, United Rentals charges $507 per month to rent a 3000 PSI pressure washer. In addition, they charge another $106 per month for the high pressure hose extension. To this they add $6 for personal property tax and another $11 for an environmental fee. On top of all this, they charge the state’s sales tax. In effect, many estimators miss the additional $190+ of extras because they simply followed the rental fee schedule from United Rentals.
Go back to Part IV of this series. One of the three tenets of estimating in construction is accuracy.
When estimating hard costs of outsourced equipment, a good estimator includes all of these additional fees. Better yet, an estimator negotiates long-term use discounts and incorporates these discounts in the estimate. This is explained in more detail in Part VIII of this series.
Estimating – Labor
Labor is the most complex of all the hard costs with estimating in construction. First off, each of the respective skill sets has a different rate due to the hourly wage paid to the respective field personnel. Secondly, what really convolutes the entire formula is labor taxes and benefits paid to field personnel. An estimator should have a schedule of hourly costs per skill or trade used with construction. The hourly cost is calculated and updated using an overhead application rate formula.
This overhead application formula for labor uses the pooling principle of costs associated with labor and then divides these costs by the number of available labor hours per trade per year to determine a cost per hour to have this trade or skill available in the field. The formula is quite complex but easy to understand once an estimator is walked through the respective steps to determine the cost per hour for the respective skill.
There are still other labor issues to address when calculating hard costs of construction for in-house labor. These include:
- Work Week Schedules such as 5/8 or 4/10 Work Weeks
- Prevailing Wages
- Union Compliance
- Training/Safety/OSHA Requirements
Part IX of this series goes in-depth related to labor hard costs and how to select the correct labor schedule of values to use when estimating the cost of in-house labor for a project.
Estimating – Other Hard Costs of Construction
Other hard costs of construction include:
- Debris Removal
- Facilities (Storage, Restroom, Eye Wash/Safety Stations, Hand Washing Stations, Water Coolers)
- Permitting/Compliance Inspections
- Capitalization (Interest, Financing Fees, Closing Costs)
- Governmental Compliance
Each of these costs are different, but notice a common bond. None of them result in a physical attribute of the end structure; i.e. they are not a material or skill used to produce the actual physical end product. Thus, application of their respective hard costs is individualized during the estimating process. Part X of this series goes into details to explain each of these major groups or costs and goes further to illustrate how to appropriately address the markup formula related to each. In addition, many of these hard costs may be considered an allowance within the contract with the customer.
Allowances are explained and fully covered in Part XI of this series.
Summary: Estimating In Construction (Cost Drivers)
There are five distinct groups (drivers) of costs in construction. Each cost driver has its own application method when estimating in construction. Estimators must be aware of the core economic and associated business principles for each cost driver. Below is a simple summary of the cost driver and primary application principle:
Cost Driver Application Principle
Materials Spectrum of Underlying Elements
Subcontractors Tiers of Profits
Equipment In-House Utilization (Pooling of Costs) and Outsourced (Auxiliary Costs)
In-House Labor Skill Sets and Overhead Application Rates Vary
Other Costs Each Cost is Unique in Application
Parts VI through X explain each of the cost drivers in more detail along with their respective sources of value. The final step is deciding on the markup formulas for each of the respective cost drivers. Once done with Parts VI through X of this series, Parts XI through XVIII explore allowances, change orders, and then estimating templates. The very last section of this series explains how markup works and deals with some common nuances tied to estimating. All of this is illustrated with three separate comprehensive examples at the end of this series. Act on Knowledge.