Nobody likes surprise expenses, but they’re all-too-common in the construction industry. Because of this, experienced subcontractors understand the importance of planning for the unexpected and including contingency funds in their budgets. A construction contingency will help you as a subcontractor prepare for (and pay for) unanticipated costs on a project. Today, we’ll discuss what a construction contingency is, how to calculate it, and when and how it will be leveraged.
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What is Construction Contingency?
Construction contingency is the money allotted for unexpected costs during construction. It is a form of risk management used to avoid cutting costs in other areas to keep the project’s schedule and quality commitments. Think of it as a kind of insurance. When something unexpected happens, like a weather delay or more materials are needed for the project than anticipated, you can use construction contingency as a backup to ensure that the craftsmanship and materials used to compensate for the delay are not jeopardized.
It should include a well-drafted method for accessing the funds, with agreed-upon terms that all project participants follow. Ideally, the funds should only be accessible to select project participants and only under specific circumstances. It should not be seen as extra cash. In fact, it is preferable not to have used the construction contingency at all because it indicates that the budget was well planned and the construction was completed efficiently.
No construction project is perfect. No matter how well you estimate a project, the construction environment is unpredictable. Of course, some causes of contingencies are preventable with better management. Whatever the source of the flaws, you should expect the unexpected.
Here are common contingency use cases in contracts:
- Harsh weather conditions
- Fluctuation in material and labor costs
- Sudden unavailability of materials
- Cost overruns
- Incomplete designs and errors in design
- Overtime or multiple shifts
- Scope gaps
- Costs due to delays
- Repairs of damaged work
- Owner-requested changes
- Design upgrades/modifications
In some cases, cost underruns in one area can compensate for cost overruns in the other, so you won’t always have to use a contingency fund.
How is Construction Contingency Calculated?
Construction contingencies are typically calculated at 5-10% of the construction budget. This percentage varies depending on the project. There are more precise methods for calculating this, such as the deterministic and probabilistic methods.
Under this method, you use 5-10% as a predetermined percentage. The formula would be:
% x Project Base Cost Estimate = Contingency
For example, if the risk probability is predetermined to be 5%, then a project with a base cost of $40,000 would yield a contingency budget of $2,000.
How would you know which percentage to use? You would need expert judgment and predetermined guidelines from individuals with sufficient experience and competency to specify a percentage of contingency. However, the Association of Advancement for Cost Engineering (AACE) explains that predetermined guidelines can be in the form of a table of contingency values.
There are several probabilistic risk assessment methods, but one of the most common is the expected monetary value. The expected monetary value of potential risks is used to quantify the impact of those risks on a project.
First, the team identifies the risks that could cause them to dip into a contingency fund. Once the risks are listed, each risk’s probability and cost impact are estimated. The expected value is then calculated by multiplying the probability of each risk occurring by the resulting cost if it happens, and then adding the results.
It can be expressed as:
Expected monetary value of risk = Probability of Risk Occurring x Impact if it occurs
The Construction Institute provides more color on how to implement this method. That said, the probabilistic method is complex and its use isn’t merited on every project. It is recommended for projects in excess of $15M, or when entering a new market, using unfamiliar tools or technology or when new project delivery methods are being utilized.
Who Can Access Construction Contingency Funds?
There are three types of contingency funds based on where the money comes from. Each has its allocations, with terms specified in a contract. Although subcontractors will only be concerned with their own contingency reserves, it doesn’t hurt to be aware of the different parties that may leverage contingency funds in the context of a construction project.
An owner can choose to provide the contingent funds to cover requests for design, schedule, resources, and personnel changes. They may prefer to use it for project improvements, such as purchasing higher quality materials that are more expensive than the previously identified material on the plans and specifications.
This contingency is typically used in GMP contracts. The owner must pay any deviation from the original bid because the changes and mistakes may not have been the contractor’s fault. An owner may also decide to make additions and modifications to the scope of work, thereby increasing the required budget.
A contractor could argue that contingent funds be set aside for unexpected circumstances or conditions that differ from those outlined in the plans and specifications on which the bid is based. At the same time, this contingency could also be the amount allocated in your anticipated price that was not accounted for in a schedule of values to prepare for any mistakes on the contractor or subcontractor’s part.
While the design and materials undergo review and value-engineering, unforeseen changes may still occur during construction. As a result, the designer can use contingency funds to accommodate changes that must be made, such as when materials become unavailable, designs change, or general upgrades are made. For example, the architect discovers that the project’s ICF has recently gone out of stock and that only a more expensive type of ICF is available and acceptable.
How to Access Construction Contingency Funds?
Certain use cases may cause disagreements during contract negotiations, so a well-drafted method for accessing contingency funds is essential in the contract.
To avoid misunderstandings, your agreement should at least include:
- The contingency amount
- A detailed process of approval
- What happens with leftover contingencies
Some contingency management policies require signature authority for the use of contingency funds to be in accordance with construction change order levels.
The authorization process for the use of risk contingency can include the following steps:
- The contractor submits a request letter for the use of the risk contingency fund to the resident engineer (RE).
- The RE will determine merit and, if merit exists, will conduct an independent cost estimate.
- However, if the RE denies merit, the RE will return the request letter to the contractor with a determination of no merit.
- If the RE agrees with the merit but not the proposed price, the RE sends a letter back to the contractor requesting a revised price proposal.
- If the RE agrees with the merits and proposed price, the RE moves on to the next step.
- The RE prepares the Risk Contingency Authorization form and the Approval Form.
- The RE obtains additional approval signatures if required.
- The RE transmits the Risk Contingency Authorization Form to the contractor.
What Are Construction Contingency Clauses?
Construction contingency disputes often end up in court, and your contract can make or break you. It should specify which items the contingency could be used for, or restricted to, such as miscellaneous items. It should also elaborate on the items under the miscellaneous category.
The clause can also include items in which the fund should not be used, such as errors in construction documents, discrepancies with building requirements, and enhancements or additions to the previously agreed-upon scope of work.
What Are Incentives for Unused Contingency?
The contingency may be reverted to the owner, shared between the owner and contractor, or serve as an incentive to the contractor, with all savings going to him. The contract should specify what happens to any unused contingencies and whether or not parties will receive incentives.
Contingency funds are imperative to cover subs during uncertainties, especially in a volatile market with unpredictable material prices and labor shortages. It’s just one of many elements that will help subs maintain strong financial health, ensuring they have enough cash on hand to keep the project moving forward. Billd, as always, is ready to be a partner to subcontractors in that respect.