The Construction Buyout Process: How to Protect your Profit Margin
What is your company’s desired profit margin? Determining this figure is critical as it impacts long-term viability and growth. Once a firm establishes its desired profit margin, the challenge shifts to how to earn the rate. The challenge is greater for general contractors (GCs) since construction is inherently risky. Conducting a disciplined, effective construction buyout process helps GCs safeguard their profit margin.
The Construction Buyout Process Explained
The construction buyout process occurs after preconstruction and before construction commences, following project award.
At this point in the project lifecycle, the owner has awarded the project to the GC. They need to buyout the project, i.e., secure agreements with subcontractors and procure the necessary materials and services.
As part of the bidding process, the GC develops an estimate of costs. During the construction buyout process, the estimates become commitments, and costs are locked in.
Therefore, the GC hires subcontractors and selects vendors. Contracts/agreements are formalized.
If material and service prices exceed estimates, the GC will earn less than anticipated and miss their desired profit margin. On the flip side, if prices are lower than expected, the GC will earn beyond its profit margin. Of course, this may change during construction.
Most GCs go through this process within the first 30–60 days of project mobilization.
Once the buyout process is complete, the GC has selected its team for the construction project.
Here are a few steps that GCs can take to protect their profit margin during the construction buyout process.
It Begins Before You Start
Although the buyout process occurs after you’ve secured the job, you lay the groundwork for protecting profit margin during the bidding process.
How so?
The construction buyout process is based on the estimate that you, the GC, create during the project bidding phase. Therefore, the more accurate and thorough your original estimate, the greater the chance that you can protect their profit margin.
How can you create a reasonably accurate estimate of costs during the bidding process? It starts with having a thorough understanding of the project scope and the construction process.
If you miss step one, you’ll inevitably fall or be behind the proverbial eight-ball in step two. It doesn’t matter how great your negotiating team is or how many bids you secure from subcontractors if your original estimates were off or the team didn’t recognize the project scope.
Consider that you use your estimates to bid on the project. You’ve reviewed the scope, determined which trades you’ll need for the project, and approximated how many hours each will spend on it.
A misunderstanding of the scope may mean you need more hours than initially anticipated for some subs, or you may have missed a sub type altogether. If this is the case, your labor costs will inevitably rise.
Perhaps you misread the market. You anticipated that an X-type subcontractor would cost $175 per hour. Then the estimates come in, and it becomes apparent that the market rate for X sub is 25% higher than your estimate. That’s also a strike against your profit margin.
Consider using estimating software to ensure you get step one right. Go into the buyout process in a strong position and protect your profit margin.
Start Early
Does your team feel a rush of excitement when you win a new job? Great, celebrate. Or perhaps your team is busy keeping up with current projects.
Either way, the team may not jump into the construction buyout process right away.
Mistake.
The time to move forward is ASAP. The goal should be to lock in prices pronto. All waiting does is add uncertainty about pricing.
There are many market lessons businesses can learn from the shutdowns and COVID-19. One lesson is the high volatility of material prices and labor rates. Price volatility and procurement issues continue in some areas. The unpredictability means prices can change significantly from day to day.
Therefore, you should move towards subcontractor selection and vendor agreements as soon as possible. By locking in prices early, your team can determine whether they are on track to meet the firm’s desired profit margin.
A delayed start to the construction buyout process can lead to a scramble to find subs, leaving you in a desperate position. You’re in reactive mode and may end up overpaying because of it.
Another downside of delaying the construction buyout process is that it can delay the project start. Besides cutting into the profit margin, a slow project start could annoy owners and sour relationships.
Widen the Sub/Vendor Pool and Improve Negotiations
You have your ‘go-to’ crew. You’ve worked with this team multiple times, and they’ve come through in the past. Great!
However, if you limit the subs and vendors you work with to a select group, it impinges on your ability to negotiate.
By widening the pool of subs and vendors you work with, you gain greater leverage in negotiations. When a sub/vendor knows they’re going to get the job, they have little incentive to negotiate. Instead, you fall back on this is the way we’ve always done it. The limitation is a recipe for poor contract terms.
Yet each job is different. Therefore, each contract should be too.
The ability to negotiate during the construction buyout process is vital to protect your profit margin. The negotiating stage is where you can gain buyout savings.
A vast vendor/sub pool helps skilled negotiators navigate the process and secure the best deal for your GC firm. Your ‘go-to’ sub vendor/sub can’t simply presume they’ll get the contract. The vendors/subs are forced to negotiate.
Note that negotiations should not be limited to pricing. Value-added services, risk, scheduling, and other factors that affect profit margins are also on the table. The more creative a negotiator is and the more they have to offer/ask for, the better their chances are of improving the terms.
Select Subs Based on Multiple Criteria
You know your desired profit margin, but of course, more would be better. So, choose the sub that offers the lowest price. Simple.
Not so much. Choosing subs by price alone is short-sighted. After all, a low bid is meaningless if the sub is not capable of adequately performing the job.
Other factors (beyond price) that you should consider when vetting subs include:
- Experience
- Reliability
- Workforce
- Financial stability
- Ability to perform the task.
A more qualified professional sub is faster and better than the alternative. This results in less rework, schedule delays, fewer change orders, and overhead burn. Their higher productivity rate can help save your profit margin.
One step to getting a sub who can get the job done effectively is to create a clear, complete scope of work. Scope clarity starts with you, the GC. If you’re not clear on the scope, the challenge of finding the right sub is magnified. Consider how you can hire the best company for the job if you’re not sure what the job is.
The lack of clarity in the contract also impacts profit margins. If the scope changes during the construction buyout process (or during construction) and more work is required, profit margins get diminished.
So, hiring the best contractor —not necessarily the one who offers the best price —and providing them with a clearly defined scope can help you protect your profit margin.
Of course, surprises will occur during construction. However, improved performance during the construction buyout process puts your firm in a strong position to maintain its desired profit margin despite inevitable changes during construction.
Looking for software to help your GC firm navigate the construction buyout process and other construction phases?
Check out RedTeam.
