Fee Erosion Challenges and Solutions for General Contractors

General Contractors in commercial construction navigate one of the tightest profit margins in the business world. Project fees can range from a mere 1% on the low end to 6% on the high end. With economic headwinds continuing to challenge the industry, securing the next job is often an uncertain exercise, and safeguarding against fee erosion on current projects has become paramount.

There are many reasons fees can erode, but we are going to focus on three key areas General Contractors can’t get wrong: 

1. Creating Solid GMP Budgets
2. Effectively Managing General Conditions
3. Reducing Change Order Risk 

Let’s look at how managing these critical project elements can provide GCs a triple-play of protection to the bottom line.

How to Create a Solid GMP Construction Budget

In a Guaranteed Maximum Price (GMP) contract, the General Contractor must guarantee the cost of the project based on the current design. When the GC must commit to a GMP, the design is often not finalized. To comfortably guarantee the project's cost, the GC must build contingencies and allowances to cover anticipated changes or unknowns.

Building a GMP Budget for a General Contractor takes a lot of expertise and skill, but the basic components can be broken down into four simple categories. 

1. General Conditions
2. Subcontracts
3. Allowances and Contingencies
4. Fees

General Conditions are the costs the GC will incur during construction that won’t become part of the finished product handed over to the owner. These costs support job site operations, including fencing, trailers, equipment, utilities, and staff costs for project managers and supervisors. Estimating General Conditions is typically straightforward, based on direct forecasted project costs multiplied by the months to complete the work. If more General Conditions are required than estimated, the GC must absorb the costs, ultimately cutting the project fee. 

Subcontracts directly result from a GC “buying out” the project scope with hard bid estimates from Trade Partners. To avoid fee erosion, the GC must ensure the bids cover the entire scope of work without any gaps. Like the overarching GMP, subcontracts are locked in once bids are awarded and are not adjusted other than through a Change Order process.

If a portion of the work is not included in a Subcontractor contract, the GC will need to draw on contingency if the contract allows them to, or it will begin to erode their fee.

Allowances and Contingencies are what the GC uses to cover expected or unexpected changes across a project lifecycle. Contingencies are typically used to cover unforeseen design changes and errors or minor additional scope requests from the owner, while Allowances include specific things like overtime, paint touch-up, additional detailing, trade damage, etc., common to all projects. 

The latter is where most of the fee erosion risk lies for a GC. To build reliable Allowances and Contingencies into the GMP, General Contractors need to be able to estimate the number and dollar value of expected changes. Historical Change Order data is crucial for this, but as we shall see, gathering this information accurately can be challenging to impossible with the industry's current methods. 

Fees The final piece of the estimate is the fee. This is usually a competitive bid or a straight negotiation with the client and represents the money the GC will make on the project. In today’s world, for private work, GC fees typically range from 1% on the low end up to 6% or more on the higher end. 

On a $1 million dollar project, a fee of 3% means the GCs fee is $30,000. If a $10,000 cost cannot be covered in an allowance it represents risk for a third of their fee. 

A lackluster GMP estimate has the potential to wreak havoc on fees. Botched General Condition estimates can outrun the budget quickly. If subcontracts contain scope gaps, the GC is left juggling costs, either dipping into Contingencies (if the contract allows) or consuming portions of the fee. Most critically, if allowances fall short of covering expected Change Order costs, the GC is faced with the grim choice of dipping into their fee bucket, asking for additional budget from the Owner, or having a (possibly contentious) negotiation with a Subcontractor.

How to Better Manage General Conditions on a Jobsite

Once the GMP is set and the project begins, managing General Conditions on the job site can be improved with consistent, quality forecasting. Typically an accounting department will post direct costs to a project budgeting system on a weekly or monthly basis, making General Condition costs relatively straightforward to see and forecast. 

To forecast General Conditions, the General Contractor project manager (PM) will: 

1. Review costs that have been posted to the project
2. Determine the balance of money left in the budget
3. Determine the average amount of money posted each month
4. Calculate the number of months remaining in the project
5. Multiply the months remaining by the average cost per month
6. The resulting amount will be the cost to complete and can be compared to what is left in the budget

By doing this simple exercise, a PM can forecast if they have enough money in General Conditions to cover direct costs for the remainder of the project. 

When a project incurs significant changes beyond the original scope and schedule, a GC should always negotiate with the Owner for additional General Conditions to cover the changes. Falling behind schedule may also consume the General Conditions budget and result in fee erosion if a GC needs to hire more labor to catch up.

If a project has more Change Orders than expected, GCs will often bring on additional Project Managers or Project Engineers just to review and process the documentation. This added overhead eats into General Conditions and can cause overruns. It is critical that if changes add days to the schedule, the GC includes additional money to cover their own General Conditions.

How to Keep Ahead of Change Orders

The biggest cause of fee erosion is commonly mismanaged Change Orders. The math is simple: Change Orders usually make up 15% or more of the total project cost on an average commercial construction project, and fees are only 1-6%. In GMP projects, the fee is based on the total project cost, already including contingency and allowances. So when a GC approves a Subcontractor COR and reconciles an allowance, they do not make any additional fee. Change Orders only represent risk unless the project scope expands above and beyond the original GMP.

To understand the risk of fee erosion, it helps to break Change Orders down into three categories:

1. Forward Priced Change Orders (Design change pricing exercises)
2. Field Directed Extra Work Change Orders (T&M Tickets)
3. Subcontractor Initiated Change Orders

Forward Priced Change Orders typically result from design evolution or new changes initiated by the Owner or Architect. For example, if the GMP was awarded on the 50% Construction Drawings, there will be a pricing exercise when the 100% CDs are issued. Every design change beyond that is handled as a bulletin, addendum, or ASI, typically issued by the architect. 

This can occur frequently on modern projects, with the General Contractor (GC) needing to send design changes to multiple Specialty Contractors. The GC must then review each response for validity of scope, labor rates, quantities, taxes, overhead, and more. This process can be incredibly time-consuming, particularly on projects with numerous design changes and Specialty Contractors, resulting in extensive administrative work.

The process of sending out design changes and soliciting cost impacts is similar to a mini-bid process each time. During this process, the GC faces fee erosion risks in multiple ways:

1. Difficulty predicting project management hours for these exercises often results in exceeding overhead as teams work extra hours.
2. The time lag to visibility means teams cannot make proactive decisions.
3. Bottlenecks in decision-making can lead to schedule impacts and delay claims.
4. Each time the design changes the GC must buy out the scope of the change accurately. Any miss in scope, schedule, or cost could further erode the fee or require negotiation with the client.

Field Directed Extra Work is a standard industry process whereby Specialty Contractors proceed on out-of-contract work directed by the General Contractor and track the labor, material, and equipment quantities through Time and Material (T&M) Tickets approved by the on-site superintendent. However, if this work isn't documented and submitted accurately and on time, it can lead to fee erosion as T&M Ticket costs accumulate unseen. Manual processing often introduces delays, making cost forecasting challenging and possibly leading to significant unexpected costs for the GC.

In the worst-case scenarios, T&M Tickets can stack up for months, and a GC can be presented with hundreds of thousands of dollars in cost at the end of a project. At that time, there’s often no opportunity to cover the cost from Allowances or to present it to the Owner for sign-off, so the Subcontractor either eats the cost or is paid from the GC’s contingency or fee. 

Subcontractor Initiated Change Orders are changes initiated by a Specialty Contractor for out of scope items such as RFIs or submittal responses that contain changes, weather delays, backcharges, etc. Because GCs do not always solicit these changes, they are almost always submitted via email and carry the risk of being missed or not captured until weeks or months later. Project Managers once again need to determine validity and verify costs. Because the processes are so manual, the processing time often lags, again creating a blind spot for General Contractors and making forecasting challenging. 

Clearstory is the only product purpose-built to capture Change Order Risk from all three of these sources in real-time for General Contractors. It eliminates the need to ask for updated Change Order logs because our cloud-based, Universal COR log updates in real time for all stakeholders, creating trust and transparency. Plus, Clearstory eliminates carbon copy T&M Tickets, manually created T&M logs, email threads and redlines on Change Order reviews, and pricing exercises done through disjointed email threads, providing a single, simple, digital, real-time view of all Change Order risk.

Ready to Learn More?

If you are a GC who deals with any of these Change Orders challenges, our team would love the opportunity to meet for a quick session and explore how we can help reduce fee erosion. Book a demo today.