Where do contractors hide profit?

Where do contractors hide profit?
By Luis Gile
December 2015

The title of this article suggest that's all contractors are out to hide profits, but I want to make sure that you don't take away that impression because it's simply not true.   The majority of contractors are honest and hard working.  They are running a business and every business is entitled to make a profit.   Unfortunately, there are instances where a contractors "double dips" (charges profit on top of profit) or deliberately hides profit in their invoicing.  In some cases these infractions, are the result of common but incorrect business practices.  Other times it may be intentional.  Either way, my goal for this article is to identify for you some of the potential pitfalls and call your attention to the places where this is most likely to occur.  

Number One:  General Conditions

The General Conditions of Construction is one of the most common places for double dips to happen.  This is also the place where additional charges are improperly applied when a construction change order is necessary.  The key to avoiding this is to make sure that you completely understand and have defined what general conditions include.  This MUST be done up front.  Before you even request the bids.  In other words, you need to tell the contractor what you expect the general conditions costs to include.  This will ensure that when you receive all of your bids (hopefully you have solicited at least 4), each of the bidders have quoted their price in the same way.

Number Two:  Self Performed Work

Self performed work refers to any trade or construction work that the General Contractor performs with his own workforce (as opposed to sub-contracting the work to another company).  In residential construction many of the companies that operate as general contractors began their businesses as trade contractors.  Some may have been carpenters, plumbers, or even electricians, but as they grew and started to get more and more work they evolved into a General Contractor.  This is good because it is a sign that they are very capable and if you understand this, it could be an opportunity for cost savings.  Unfortunately, most homeowners don't know to ask and actually end up paying the general contractor twice as much profit for the portions of work that the GC self-performs.  Don't be afraid to ask about which portions of the work the GC will self-perform and make sure to ask what the profit margins are for both the GC portion of the work and the trade work.  Keep in mind that each trade contract will include profit that the trade contractor needs to make for his business.  If your GC is self performing a portion of the trade work himself, then you should be able to either negotiate a lower profit margin or no profit margin at all for the work he is self performing.

Number Three:  Rental Equipment

Construction Equipment such as bulldozers, backhoes, cranes, lifts, and dump-trucks are commonly used on construction projects.  Most of the time, sub-contractors will provide their own equipment and include the costs of the equipment in their price.  Other times, the GC might rent equipment from an equipment rental company, these costs are invariably passed along to the Owner as rental equipment costs.  Rental equipment costs could either be included as part of the cost of the work or as part of the general conditions.  In some cases, the GC might own his own construction equipment and he may charge the owner a rental fee for using that equipment for the project.  Construction equipment is expensive to own and maintain and contractors are entitled to charge fees to cover their costs.  However, the cost of maintaining equipment should not be the same as the cost for renting equipment.  Costs for GC owned equipment should be treated the same as self performed work.  Don't be afraid to ask who will be providing equipment for your project.  If the GC will be providing some of his own equipment, ask him to quote you his rates and make sure you understand how he will be applying profit to those rates.  

Number 4:  Change Orders

It may seem pretty obvious that change orders are a great place for profit to be hidden, but you may not know how profit is hidden in change orders and how to avoid overpaying for change orders.  The most common way that GC's overcharge on change orders, is to add general condition costs to every change order.  If you have properly defined what is included in the general conditions costs, then you should be able to discern when a change order should include general condition costs and when it should not.  To ensure that you are not overpaying for change orders, make sure you negotiate change order rates as part of your overall price negotiations.  Ask for change order rates as a percentage mark-up.  These rate can be applied to change orders by multiplying the costs of the change by the percentage markup to establish the GC's profit.  Also, if you know in advance that a certain portion of the scope is subject to change,  the best way to avoid overpaying for a change is to solicit alternate pricing.  Alternate pricing can be used to price alternative solutions for almost any part of the scope of work.  By soliciting this cost up front during the bid you are ensuring that you have competitive pricing for this alternative scope.

The various cost elements that make up the cost of a construction project can be very complex.  You have multiple contractors and lots of moving parts to track.  Being clear and deliberate about every cost element is the best way to ensure that you are getting a fair price.  Be fair to your General Contractor.  He should not be expected to eat costs or perform more work than you are not willing to pay for.  Keep in mind that he is running a business and he is entitled to earn a fair profit margin on everything he does for you.  Conversely, you are entitled to know and to negotiate just how much of a profit margin you are willing to pay.  Address all of these issues early on and you will have a much more successful project.