The Contractor Subcontractor Relationship – An Understanding
Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
With construction, no other mutual bond has such a high dependency on each other as the contractor subcontractor relationship. If the relationship is developed properly and with a mutual understanding, it can be very successful. If poorly created and lacking cohesion, the relationship devolves into a tit for tat fight and often ends up in the legal system costing the contractor excessive sums of money to correct.
This article introduces both parties to the relationship and identifies the guides you towards the next article in this series which covers the proper steps to take in order to create a successful contractor subcontractor relationship. To appreciate this unique bond, both parties must first understand why they need each other. Secondly, the two parties need to appreciate the nature of the risk reward aspect of their relationship. This is often the contentious part of the contractor subcontractor relationship and it is the most likely reason the two parties divorce each other in their relationship. Finally, there is a proper way to create the contractor subcontractor relationship and this section points the reader in the right direction. Other articles on this site go into more detail related to these steps and I encourage you to read them.
Contractor Subcontractor Relationship – The Bonds That Tie Them Together
There is one driving force in construction, the end user wants it now! Therefore, there is a sense of urgency in getting the project completed. To exacerbate this sense of urgency is the cost of money, i.e. interest to service the debt while the project is getting built. It is common for interest to exceed 3%, and sometimes hit 5% of the entire budget related to a construction project. Often, this interest is borne by the contractor and not the end user. Even if the end user bears this interest burden, the relationship between the end user and contractor is strained by the impetus to get it done.
Since time is of the essence, driven by interest, a contractor must decide the best method to get the physical work done. In-house employees will work assuming he has adequate staffing, but often this isn’t the case. Only larger more robust contractors can maintain a level of laborers to get the work done as there are often slow periods of work or sudden demands necessitating adjustments to the worker pool. To augment this, contractors will engage subcontractors to provide the necessary personnel to get the work done. Other reasons include:
- Skills – with construction, certain skill sets are restricted by their very nature and it is often difficult to find and keep these skill sets within the pool of employees of the contractor. For example, tiling is really an art and a highly defined skill requiring years of experience to acquire and maintain; thus many contractors subcontract out this particular skill. Others include, framing, masonry, trim carpenters, and stamped concrete.
- Certification – many of the various aspects of construction require licensed or certified individuals to perform this work. Surveyors, engineers, electricians, mechanical installers, plumbers and arborists are perfect examples.
- Capitalization – another reason a contractor doesn’t have certain types of employees relates to cost to provide the necessary tools to get the job done. Site developers have heavy equipment costing millions of dollars to acquire. Scaffolding for siding work or exterior trim, production line equipment to make cabinets or containers just to remove debris are other examples of areas with construction customarily subbed out due to the costs to have this ability.
- Limited Scope – another reason to engage subcontractors relates to the limited nature of the particular function for the contract. Those steps that are highly restrictive or uncommon customarily use subcontractors to complete so as not to delay or encumber the contractor. Examples include well diggers, septic tank/drainage filed installation and fencing.
All the above are the most common reasons to hire subs to get the work done expeditiously. Yes, a contractor can hire, train and maintain his/her own personnel to perform these steps, but that contractor would have to have a large volume of contracts (backlog) in order to justify the costs associated with the respective functions as noted above.
From the subcontractors perspective, it is generally the opposite reason to exist. He/she needs volume of work to justify the costs of maintaining their respective skills, certification, capitalization or limited nature of what they do. The best resource is a vast pool of general contractors to provide the necessary workload to cover these costs and restrictions. It is as if the relationship between the contractor and subcontractor is symbiotic in nature. They need each other in order to survive and achieve success. What causes a contentious relationship between the contractor and subcontractor is of course the reward for the work done and the associated risks involved.
Risk Reward With the Contractor Subcontractor Relationship
There is only so much profit in a contract. Thus, the question is, who gets this profit. Naturally, both the contractor and subcontractor want the profit associated with the subcontractor’s part of the contract. On the other side of the equation is the risk aspect of getting the work done. There are a multitude of risks involved including weather, engineering, site conditions and timing. Thus, there is give and take between the two parties and this is part of the contractor subcontractor relationship that both parties need to understand and accept the basic give and takes. Let’s start out with profit.
A typical project contract will have around 25 to 30% of profit built in to cover the contractor’s overhead and the final net profit. Thus the contract’s profit far exceeds the contractor’s net profit as a function of the contractor’s overhead issues. For a contractor, overhead issues are mostly insurance, logistics, office administration and employee benefits driven. The contractor’s actual net profit from his business is driven mostly by the respective sub industry of construction (commercial, residential, or industrial) the company functions within and their respective access to resources to get the work done.
The subcontractor is of course one of those resources to get the work done. Of the 25 to 30% project profit, what is the allocation between the two parties? The answer is it ‘depends’.
Notice that the profit is divided into two subsections, overhead and net profit. One of the two parties must provide the proper insurance, logistics and employee benefits to those performing each of the components of a contract. Thus, if the subcontractor provides the insurance, logistics and provides their employees with benefits, this part of the contract’s profit should shift to the subcontractor. This is what normally happens in most contractor subcontractor relationships. The contractor may retain one or two percent of this part of the project overhead of the project profit related for the administration of this part of the contract; but in general most of the overhead built into the contract’s profit is shifted to the subcontractor for their part of the overall contract. Here is a simple illustration:
Form Construction has a $17,000,000 contract to build a high rise condo complex. The exterior of the building is made of both stone and glass. The entire contract has a 16% overhead on direct costs (direct costs estimated at $13,250,000) and an additional 10.6% profit on costs and overhead combined. The contractor estimates the stone part of the direct costs is 6.5% or $861,250. Form Construction wants to hire Able Stone to do the work, Able submits their bid for $950,000 with the following breakdown of costs, overhead and profit:
Costs – $663,500
Overhead @ 23% 152,600
Form Construction’s bid assumes overhead covers insurance, logistics, employee benefits, safety, and administration related to the core costs. Able Stone agrees to cover its employee benefits, all logistics related to their part of the contract and provides the necessary insurance and bonding for the project. Form construction estimates the total overhead earned for the stone component of the construction is $137,800. Therefore the stone component of the contract will generate the following for Form Construction:
Stone Costs $861,250
Stone Overhead 137,800
Profit @10.6% of all costs 105,900
Total for Stone $1,104,950
It just so happens that the stone component of the project is exactly 6.5% of the entire contract matching the estimate (and this is exactly how it is suppose to work out). The subcontractor is agreeing to do this part for $950,000 leaving Form Construction with a project profit (which is Form’s share of overhead and net profit) of $154,950 for this part of the overall contract. Form’s net profit required from this part of the contract is $105,900 leaving $49,050 for Form’s share of the overhead costs related to this part of the contract. Therefore, Form Construction is getting 36% of their estimated overhead costs for this part of the contract. This should easily cover the administration costs related to this part of the contract as the other elements of overhead were shifted to Able Stone per their agreement with each other.
Look at the analysis used above, the focus was on the overhead aspect of the contract and subcontractor relationship. The contractor shifted this overhead responsibility to his subcontractor thus shifting some of the overhead value to his final net profit from this project. In this case, Form Construction did well. Often, it is the subcontractor that acquires some of the net profit into their pocket. Assume Able Stone agreed to do this part of the contract for $1,000,000 and not $950,000. Able Stone shifted all of the overhead aspect plus $950 of the net profit of the contract into their pocket. Thus Form Construction’s net profit would be reduced. This is referred to as ‘Profit Shifting’ in business and it is important for all parties to understand this basic business principle.
Would Form Construction allow this to happen? Should they?
Well, actually, it may not be a bad idea especially if Form Construction is shifting a lot of risk to Able Stone.
Every contract has risks involved. Most of these risks are mitigated with insurance. Examples of risks shifted to insurance carriers include work injury, required under worker’s compensation law; equipment accidents, covered by a garage or equipment policy; theft, covered through general liability; and performance, covered under a bond. Some risks can not be covered by insurance and include weather, site conditions and logistics.
Many contractors will shift as much risk to their subcontractors as possible to minimize the associated costs related to delays or inherited issues of these uncovered risks. For example, site conditions are customarily shifted to the subcontractor as often the contractor hands the site over to the subcontractor during their allocated time period to get their part of the construction completed. The subcontractor may inherit conditions that are not conducive to getting work done. Issues may include barriers, dismantling existing set-ups for other trades and then resetting them after getting the work done or the need to build temporary structures to enhance or accelerate their part of the contract. Other issues may include logistics of getting materials and manpower to the site especially if the site is remotely located.
Continuing with the Form Construction example above, let’s see how and why Form Construction shifted risk to Able Stone.
Form Construction agrees to build a high rise condominium complex for $17,000,000. In their contract with the customer, Form Construction agreed to taking on the engineering aspects of the project contingent on issuing change orders related to any engineering requirements advocated by a professional engineer. In its subcontract with Able Stone, Form Construction required Able Stone to get an engineering report and an engineer to sign off on this part of the contract and that this engineer’s error and omissions insurance will cover any liability or costs to correct flaws. Able Stone agrees.
During the installation of the stone, Able Stone engages a professional engineer to sign off on the work. The engineer discovers a flaw with the plans. Due to the complex’s location, there is a possibility of earth movement and thus the engineer demands the base stones be mounted on top and tied into an expanded foundation. Able Stone discovers that this new development necessitates an additional cost to Able Stone of $100,000.
In the profit shifting example above, Able’s total profit on their contract for $1,000,000 was $183,900. The additional costs will reduce their profit to $83,900. Form Construction’s agreement to allow Able to charge $1,000,000 and not $950,000 was a good deal because they shifted risk to Able Stone and thus Form Construction did not have to absorb the additional $100,000 of costs.
How can this whole situation be avoided in order for both parties to benefit from the relationship?
Creation of a Great Contractor Subcontractor Relationship
The key to a great contractor subcontractor relationship is to have a good contract, one that both parties understand well. The key is to sit down and have a discussion of expectations and issues related to the project BEFORE signing the contract, not afterwards. There is another article on this site that covers the negotiations process and the respective articles in an agreement between a contractor and subcontractor.
Continuing with the above Form Construction relationship with their subcontractor Able Stone, notice that in the contract Form Construction has with their customer that they are responsible for engineering. Form Construction passed this element of the contract onto Able Stone. However, take note that the main contract allows Form Construction to issue a change order for the physical modifications or compliance related to engineering. Form Construction should relate or pass this ability to Able Stone in order for Able to get compensation for the additional $100,000 of costs related to the engineer’s requirement to tie the stone to the foundation. In effect, the end customer pays for any engineering modifications for the project and not the contractor or the subcontractor.
Now both parties are satisfied and both parties make a reasonable profit related to their respective part of the contract. 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, go to the Membership Program page under Value Investing section in the header above.
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 member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
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.