The construction sector is an industry driven by costs. From small residential buildings to sprawling industrial projects, construction pricing will always be tied to the costs required to build construction projects.
The most successful and profitable general contractors are masters at balancing cost versus profit. They deliver projects at perfectly priced bids that enable them to take on projects without the fear that a few miscalculated moves could see their profits quickly turn red.
We’re going to take a look at the various elements that affect a construction project’s price. At the end of this article, you should be able to have a firm understanding of what goes into construction pricing to help you provide the best possible value to your clients while still achieving your target margins.
Understanding The Major Factors That Affect Construction Pricing
Construction prices are primarily determined by prevailing market costs. The prices of resources such as materials, labor, and equipment all rise and fall by nature. An unprepared contractor may be exposed to unnecessary risks if they fail to take into account such price fluctuations.
When reviewing costs for an estimate, you need to make sure that the overall construction price should be high enough to cover all costs while still leaving room for profits.
Record high inflation has continued to threaten the profit margins of construction projects all over. According to data from the Bureau of Labor Statistics, construction material prices were up by 25% in 2021, and since then, the cost of construction has remained historically high.
Inflation is a critical cost factor for any general contractor. It decreases your purchasing power and increases the cost of various construction materials and labor rates. Projects spanning several years are especially vulnerable to the detrimental effects of inflation. To put things into perspective, if a construction project estimate was priced at $100 million and the current inflation rate is 8%. Failure to account for inflation during that project’s estimating phase means your project will short by $8 million.
When submitting bids, you must always consider the project timeframe and current inflation rate. One way to avoid budget creep is to ensure that your estimates are adjusted for inflation. A great way of getting this information is through the Associated General Contractors of America (AGC) annual report. The AGC releases annual reports on construction inflation to help contractors understand prevailing market conditions.
Construction is a labor-driven industry. Despite advancements in robot automation technology, much of the work on a construction site still requires human intervention. Labor costs make up anywhere from 20 to 40% of the total cost of a construction project. Failure to accurately account for and adjust labor rates can spell disaster for your project from a revenue standpoint.
Recent labor shortages have threatened the construction industry. According to the 2020 Construction Outlook Survey, 8 out of 10 construction companies have reported that they have struggled to fill in job vacancies. As a result, construction wages have also increased.
Aside from wage concerns, general contractors must also factor in the labor market’s cost of living. For example, a project in New York City will have a higher price tag as compared to the same project if it were to be constructed in Memphis, Tennessee. Labor burden, which includes insurance, benefits, training fees, and uniforms also form part of the overall wage equation that needs to be factored in.
To determine the labor burden rate, take your labor burden costs (sum of indirect costs) and gross payroll labor costs (hourly wages) and divide them by the number of production hours. Because labor rates are never set in stone, it is important to re-evaluate your labor burden at least annually to maintain its accuracy.
Cost of Materials
Out of all the elements that make up a construction project, materials are a crucial factor when pricing a construction project. Because of the natural fluctuations in material prices, estimates made months before a project starts may quickly become unprofitable if price variations aren’t factored in. All construction material prices are susceptible to volatile market conditions, especially primary materials like steel, cement, and lumber. Data gathered by the AGC shows that construction costs in 2021 rose by 20% — this could quickly put you in the red if your material takeoffs fail to account for such price fluctuations. The price of commodities also contributes to overall construction costs. For example, when oil prices go up, site transportation costs, and materials like insulation, asphalt, and roofing supplies also go up. Here are some of the things you can do to mitigate the risk of adverse material price changes.
Lock In Prices
In the process of materials procurement, negotiate with vendors to lock in the price of building materials early or cap the price with the supplier when you are creating your construction pre-bid budget. Because material prices are quite volatile, transferring the risk downstream to a supplier is a smart and proactive move. Additionally, conduct a thorough review of your past projects, and identify which materials made up the bulk of your recent purchases. If you see a consistent demand, then it may be worth buying these in bulk when prices are low.
Specify Bid Validity
Materials prices can suddenly change within a short period, and when a contract has been signed by both parties, there is no turning back. The “bid validity period” refers to the period during which a bidder keeps his or her offer legally binding. Alongside procurement timelines, it is also important to have a good understanding of how long it will take after the bid opening date until the contract is signed to calculate the bid validity period. For smaller projects, 30 to 60 days is the norm for bid validity periods. For more complex procurements, it can be up to 90 days or more, depending on how long it is estimated to take from the bid opening date until the contract is signed.
Include an Escalation Clause
An escalation clause helps protect contractors against unforeseen increases in prices of construction materials. Take the case of lumber, whose price surged 79% in Q1 of 2022 alone. Similar surges in pricing amidst global inflation and financial instability are not uncommon.
When including an escalation clause in your contract, make sure to exactly define which materials are subject to the clause, the corresponding thresholds, and indicate their prices.
Monitor Construction Industry Reports
Staying updated with the latest pricing trends helps you keep a pulse on what’s happening and help you predict future changes. Trend reports, such as the ones produced by the Associated General Contractors of America (AGC), help contractors understand the current market conditions. This report from CBRE also contains other helpful statistics and insights general contractors can leverage.
Projects such as large commercial shopping centers or multi-family buildings require more heavy equipment compared to building a townhouse in a residential area.
Procuring equipment goes beyond more than just purchasing, contractors also need to be cognizant of fees associated with these purchases such as storage, logistics, and maintenance costs. These fees eventually end up as additional mark-ups on your prices that could affect your bid estimates.
Third-party rentals are beneficial from a cash flow and operational standpoint because it stretches a contractor’s revenue stream, which in turn allows them to free up funds that can be used for other projects. Renting a piece of equipment usually costs $40-$60 for every $1,000 it costs. On the other hand, if you intend to take on a lot of heavy industrial projects, then investing in your own equipment may be a more cost-effective strategy.
Site Conditions and Location
Project site location affects the movement of labor, equipment, and materials. Difficult terrain and hard-to-reach sites further increase the costs of a construction project because more resources are spent on transporting materials to these sites.
Furthermore, poor soil conditions, wetlands, or conflicting utilities like underground pipes increase the complexity of a project resulting in a higher price tag compared to more accessible locations. It is therefore recommended that general contractors conduct thorough site surveys to understand the site logistics and to help address these risks upfront.
Construction Pricing Models
Pricing a construction project generally falls into four major categories: fixed pricing, cost-plus pricing, guaranteed maximum pricing, and unit pricing models.
Popularly known as lump sum contracts, this pricing structure sets a definite price for the job, and that amount is usually paid in increments throughout the project. Typically, this model breaks down the work into categories (plumbing, electrical, concrete, etc.) and gives each category its own value (a schedule of values) based on how much each category costs.
Unlike other pricing models, fixed pricing contracts do not reimburse the contractor for their costs; therefore, the price tendered by a contractor must cover the actual cost of the work, including profit and overhead.
A poorly defined scope can result in unexpected costs that put a contractor's profit margins in the red. Contractors should also include change order clauses in this pricing arrangement to help minimize the risk of cost overruns should there be unavoidable changes in the design or scope of work.
Advantages and Disadvantages of Fixed Pricing
Cost-plus pricing models work by reimbursing a general contractor for all the costs incurred throughout the construction project plus a predetermined fee or percentage to cover profits and overhead. Cost-plus pricing offers greater transparency by allowing owners to pay for the actual work without markups.
Cost-plus arrangements are also very beneficial for fast-tracked projects that start construction even before detailed drawings are in place. There must be clear definitions of what will be considered reimbursable expenses for the contractor and what will be considered costs for the owner to avoid disputes.
Advantages and Disadvantages of Cost-Plus Pricing
Guaranteed Maximum Pricing (GMP)
With GMP pricing models, clients agree to pay the contractor a maximum amount that covers everything necessary to proceed with the project such as materials, equipment, labor, and profits. However, if prices exceed the GMP, the contractor is responsible for absorbing any expenses beyond the contract price. If the final price is less than the guaranteed maximum, the client is not required to share the savings with the contractor. To help encourage expense efficiency, GMP arrangements usually provide incentives to the contractor if the total cost of construction comes in below the maximum price.
Advantages and Disadvantages of Guaranteed Maximum Pricing (GMP)
Unit pricing arrangements are commonly used for repetitive projects and well-defined tasks such as utility work, maintenance, and repairs. In this pricing arrangement, a contractor sets a price for each unit of work or task to be completed based on the project scope. This price already accounts for a contractor’s overhead and profit.
Advantages and Disadvantages of Unit Pricing
Competitive Bidding vs. Negotiated Contracts
An estimate helps clients understand whether the price of a project is financially feasible. After an estimate is computed by the general contractor, the price of a project is then submitted to project owners through either competitive bidding procedures or negotiated contracts.
Bidding is a process by which invited contractors prepare their best proposals and compete to win a particular contract. An architectural or engineering firm formulates detailed plans and specifications of a project based on the objectives and requirements of the owner.
In the private sector, the owner has the right to source their bidders, either through open competition or a few pre-selected contractors. However, in the public sector, the emphasis is always on the interest of the public where the lowest bid or best value bid always wins. Contractors are placed on equal footing for competition and strict parameters are in place to prevent unethical and corrupt practices.
Competitive bidding is best for cost-driven projects that prioritize meeting the owner’s budget.
Compared to competitive bidding, negotiated contracts are solely determined by the project owner based on factors such as previous working relationships, reputation, and expertise. Instead of requesting bids, project owners and a pre-selected contractor converge to negotiate the price for building the project.
Owners may value the expertise and integrity of a specific contractor whose reputation is good or who has previously worked well for them. Negotiating with a sole contractor allows for flexibility in the scope and cost of a project especially when the project requires the expertise of a specialist, and only a limited number of suppliers are known in that niche.
Pricing Construction Projects is a Cinch With the Power of AI
Estimating is one of the major steps required in determining the price of a construction project. In this step, an estimator has to perform a time-intensive takeoff to calculate the material requirements of a construction project. AI estimating software makes short work of this otherwise laborious procedure.
Togal.AI helps general contractors fulfill more bids faster by automating the takeoff stage. Takeoffs that used to take days or weeks are completed in seconds with 99% accuracy. Book a demo today, to learn how Togal.AI seamlessly integrates with your current workflow.