It cannot be overstated the importance of obtaining a comprehensive and detailed scope of work and estimate of repairs before you hire a contractor to rebuild. These documents should be provided to you by your adjuster and any contractors bidding on the reconstruction project. The final estimate, agreed to by your insurance company will provide the funding to rebuild or repair the damages. Once you receive a copy of your adjuster's estimate, take time to go through it to be sure it is complete and represents accurate allowances for items of like kind and quality of what existed prior to the damage occurrence. Compare any estimates provided by contractors against the adjuster's estimate to verify its accuracy. The most accurate scope of work and repair estimate should be used to reach an agreed cost of repairs or settlement amount. This will be one of the most important steps in the recovery process.
The Master Scope of Work
In most cases, more than one party will provide estimates for the repairs. To simplify the bidding process, one contractor (who is familiar with the type of damages your property has sustained) should be selected to create a "master scope of work". The scope of work should accurately reflect all necessary repairs and associated tasks in a detailed line by line format that includes dimensions, measurements, and explanations. The scope of work should be made available to you, the adjuster, and other contractors, so the scope can be reviewed and any necessary changes be made. Once the scope of work has been agreed to, all the parties can provide estimates based on an identical scope of work assuring the consumer that comparable work is being bid. If not, you could have two or three contractors with completely different opinions providing estimates that can differ significantly. The master scope of work will help expedite the settlement process and make the adjuster's job easier. In cases where the estimating process requires multiple site visits and many hours of work, you may consider paying a contractor an hourly fee as compensation for their effort.
A proper scope of work should include obvious elements such as framing, drywall, stucco, roofing, doors, windows, cabinets, painting, flooring, etc. as well as the often overlooked items such as supervision, temporary services, content manipulation (moving your personal items and furnishings), finish hardware, etc. The following is an example of what a detailed scope of work and estimate may look like.
The Preliminary Scope of Work Supplement
If you are unsure the estimate provided by the adjuster covers all of the repairs or tasks needed or that certain items may be priced too low, you can request a contractor provide you with a preliminary scope of work supplement. Contractors who are familiar with this process take the adjuster's estimate and review the damaged areas of your property. The contractor will list any items or tasks that do not appear on the adjusters estimate or that do appear, but may be priced too low or miss identified. The contractor will then provide an estimate that reflects only those items in question or the necessary increased cost. Once received, the adjuster can make the necessary additions or adjustments to their estimate. Individual construction trades, for example roofing, plaster, framing, electrical, plumbing, flooring, painting, etc. should not be priced lower than what the cost will be to perform the work for that specific trade including a proper mark up to cover the contractors overhead and profit. One underestimated trade can cause a significant financial loss to the entire project.
Post Contract Supplemental Estimates
Supplemental estimates are common practice in the insurance restoration industry. In many cases, after you are provided with an estimate from your adjuster, there will be additional costs discovered that were not included in the original estimate. These items may include hidden damages discovered after demolition, permit fees, engineering fees, price increases, or items that were left as pending or open. It is always a wise practice to establish as complete a scope of work and estimate with your adjusters' approval before you sign a contract. This way you will know how much you have to work with and whether or not there is enough coverage in your policy to cover the cost of the repairs. Any additional work needed, that may have been overlooked or costs that were not already approved, will require the adjusters approval prior to proceeding.
By law, a contractor cannot process, present, or negotiate a claim of insurance or act as an insurance adjuster. But, they can argue in defense of their scope of work and associated costs in their estimate.
Contractor Overhead and Profit and What It Means To You
This is one area that is often overlooked and widely misunderstood. As you go through the repair cost-estimating process, you will receive estimates from your adjuster as well as from contractors. At the end of these estimates you will find a summary page that may show commonly used factors of 10 percent for overhead and 10 percent for profit. These factors are crucial components of the cost of repairs and need to be understood. Contractors' general overhead costs are comprised of any and all costs associated with operating the business that are not specific to any particular project. These operating expenses include costs like salaries for the company staff, leasing office or warehouse space, office equipment, vehicle expenses, fuel, liability insurances, equipment purchases and maintenance, utilities, advertising, marketing, legal and accounting fees, education and training, bad debt and costs of collections, etc. Company overhead is calculated by figuring the percent of these operating expenses to the total jobs sold, completed, and collected (Gross Sales). The consensus of smaller to mid sized restoration companies is that the average overhead costs run between 30 and 40 percent of the gross sales. This is far greater than the 10 percent factor that is commonly used by most insurance companies. For example if ABC Restoration completed $1,000,000 in work in a year and paid $300,000 in operating costs, the company overhead would have been 30 percent. This means that it costs the company 30 percent of the total sales to stay in business.
Overhead does not remain constant and can increase dramatically as sales volume changes, costs increase, cash flow is hindered, etc. Overhead increases as sales or job size increases. It does not go down or stay the same.
Profit (or in this case, net profit) is the amount of money that remains after all costs for labor, material, and overhead have been paid. Net profit is what is used by the company to grow, invest, provide incentives and benefits, make improvements, and provide service on call backs if something goes wrong on the finished job.
Price Mark Up Example Broken Down
Here is a simple breakdown for a general contracting company that carries an overhead burden of 30 percent. This will show what the company needs to charge (or mark up) to cover this overhead and still make 10 percent for profit. We will use a project that is estimated to cost $100,000 in labor and materials. At first glance you might think that 40 percent of this job cost (or $40,000) is the amount that will cover the contractors 30 percent overhead and 10 percent profit. This would lead you to conclude that that the contractors' final bid should be $140,000 but it doesn't work and here's why: Overhead and profit are based on total sales, NOT job costs. If you assume $40,000 for gross profit and add it to a job cost of $100,000 you arrive at a figure of $140,000. Since overhead is based on total (gross) sales, now take 30 percent of the sale price to determine overhead and you get $42,000 (.30 times $140,000). Subtract that overhead from the job cost and you have $98,000 remaining. In this example the contractor cannot cover all of his overhead costs, let alone realize any net profit. Do you want to know how much a job that costs the contractor $100,000 needs to be marked up to cover a 40 percent gross profit margin on total sales? It is almost 67 percent. That's right, a job that costs $100,000 will have to be marked up nearly $67,000 to cover a contractor's gross profit (30 percent overhead plus 10 percent net profit) which is equal to 40 percent of the gross sale.
Example Job Cost Mark Up Table
The following table shows how a job cost must be marked up by a contractor to attain different percentages of gross· profit. Gross profit contains both net profit and a percentage to cover the contractors' overhead. Overhead is simply the cost of operating a business. No two contractors will have identical overhead, nor does overhead remain constant. The definition of job cost or, in this case hard cost, is the actual cost of labor and materials to perform a given task before any mark up is added to cover a contractors' overhead and profit. In this example, we will use $100 as the actual cost of materials and labor to perform a construction related task. The overhead column shows a percentage of mark up over actual costs that may be charged by different contractors based on their varying overhead burdens. This is normally stated as a percentage of total sales. The profit column shows a contractors profit margin remaining constant at 10 percent of total sales. The mark up equation column shows the math used to achieve a numerical factor to calculate the correct mark up.
Here is how the mark up equation works: The first number in the equation is the job hard cost (actual contractor cost without any mark up or profit added). The second number in the equation represents the percentage left over after the overhead and profit are removed. This is the amount needed to complete the work. The third number represents the decimal figure calculated after the hard cost is divided by the percentage needed to complete the work. The amount charged column is the job hard cost multiplied by this figure. It reflects what the contractor will need to charge a customer to cover the company overhead and achieve the desired 10 percent net profit.
As an exercise, let's use 30 percent for overhead and 10 percent as a profit goal. From the table we see that the total job cost should be $166.67. The following numbers can then be calculated:
By this example you can clearly see that if a contractor is not careful to estimate the costs to cover his overhead and profit correctly, they won't be in business for very long. This issue alone may be the leading cause of why most construction companies go out of business within 10 years.
Be Careful Using Sub Contractor Bids
In some cases, you may be asked by your adjuster to provide sub-contractor estimates to support the costs of a given trade. These trades may include roofing, stucco, framing, electrical, plumbing, painting, flooring, etc. This may be okay as long as the general contractor who will be performing the work is allowed to mark up those bids to cover the overhead and profit. In some cases, the adjuster may only allow sub-contractor bids to be marked up 10 percent for overhead and 10 percent for profit. This practice will not work and will actually cause a considerable financial loss to most contractors. As we have previously concluded, general contractors' overhead costs alone will far exceed 10 percent of the job cost.
NOTE: The following example shows what happens in cases where an adjuster offers to give 20 percent over an actual subcontractor bid to allow for the contractors' overhead and profit. In reality, the adjuster is only allowing 16.67 percent as the mark up. We will use $100 as the subcontractor bid amount and $120.00 as the final allowance to prove this point.
As you can see by the above table, if a contractor needed 30 percent to cover the overhead and needs 10 percent allowed for net profit, a 16.67 percent markup will constitute a significant loss to the contractor if he agrees to perform the work for this amount.
This example reveals that the cost of the work stays the same, but the amount the contractor makes gets reduced. This will usually result in the contractor having to cut corners or figure some other way to make up the lost revenue needed to cover the overhead and profit.
If a homeowner hires a contractor who has failed to properly estimate and mark up their job costs, the contractor will soon realize they underpriced the job. This may result in the contractor not being able to complete the work and/or pay suppliers. This can cause the contractor to resort to using proceeds from new contracts to pay off old debt incurred from previous projects. This scenario of "robbing Peter to pay Paul" exposes the homeowner to mechanic's liens, serious financial problems, and the possibility of the contractor abandoning the job. Be very wary of "low-ball" estimates. This issue of underestimating job costs and not adding enough to cover overhead costs and make a reasonable profit will ultimately cause the contractor to go out of business.
For more information regarding mark up and profit, you can obtain the book Mark Up and Profit a Contractors Guide, written by Michael C. Stone of Construction Programs & Results, Camas, Washington.