Obviously, it’s a good idea to carefully plan every aspect of a construction project beforehand. But sometimes, a job will be started while there are still decisions to be made. When that happens, how do owners, construction managers, and contractors plan for uncertainty? The construction agreement may provide for a construction allowance. Here’s what it works.
What is a construction allowance?
When the price of materials or supplies can’t quite be determined, but a price needs to be put to paper, a construction allowance provides some flexibility. Essentially, it’s a ballpark figure that serves as the placeholder for an amount that can’t be determined quite yet. During the life of the project, presumably, the decision leading to the construction allowance will be made — and a price will be determined. With any luck, the construction allowance will be very close to the cost of the actual material or supplies needed.
In these situations, it’s common to make an educated guess at the price. Some may see this as a sort of maximum price for the particular line item or category. But it’s important to be as accurate as possible with construction allowances. Going too far over or under the construction allowance could lead to a dispute.
An example of a construction allowance
A common example of a construction allowance is when an owner has most of the specs planned out, but hasn’t decided on something simple like hardware or appliances. Because there will be some price fluctuation, it’s impossible to put an exact dollar figure on what will be used. At the same time, that price must be accounted for somehow!
When are construction allowances used?
Generally, allowances are used when there’s a guaranteed maximum price or a lump sum involved. That’s because, under these contracts, it’s important to determine a solid price at the start of the work. Whenever something more flexible like a time and materials contract is used, construction allowances don’t make as much sense.
Bottom line: Construction allowances typically attempt to add flexibility to otherwise rigid contracts. But, when used too extensively, construction allowances can create problems.
Types of Construction Allowances
There are generally two types of construction allowances: materials allowances and installation allowances.
Material allowances
This type of allowance is built into the contract price when the owner or project manager hasn’t yet selected the materials that will be used. Depending on what materials are used, costs could be very different than what a contractor, sub, or supplier expected in their initial estimate. A good example of this is with flooring.
Learn more about material financing
Building Material Loans: Contractor Options to Fund Material Purchases
Imagine budgeting your work for linoleum, but the owner eventually chooses tile floors instead. This is can cause a huge cost disparity that the contractor shouldn’t be forced to have to front. By adding a material allowance to the contract, uncertainty at the beginning of the job might not create problems later on. At the same time, waiting to contract out work until the plan is settled might be a better way of avoiding the issue.
Installation allowances
Most construction allowances will cover only materials. But what happens when the material selection changes the scope of work, too? There may not be a large gap between the price of materials, but it may involve an extra level of skill, experience or time to complete. Changes to the scope of work should allow the contractor to adjust their bid price accordingly.
When installation allowances are provided for from the start, costly misunderstandings or even disputes can be avoided. At the same time, though, more allowances could mean more opportunity for payment disputes. Any time a clear price isn’t set out, uncertainty could cause trouble.
How are allowances different from contingency funds?
Construction allowances and contingencies are lumped together pretty often. But they’re more like cousins than twins.
Allowances are known and identified at the start of the project. Meaning, allowances are anticipated from the jump – but there’s still some uncertainty as to what decision will be made re: the specific allowance. Still, the allowance provides a estimate for a placeholder until the actual price can be determined.
Meanwhile, contingencies are completely unknown. Sure, the contingency budget anticipates future problems – but those problems aren’t identified from the get-go, and they may never even come to fruition!
Read more: What is Construction Contingency? | Construction Accounting
Use construction allowances responsibly
Construction allowances can add valuable flexibility to a contract. However, they can be the source of dispute, too. Including an allowance that’s too large can heavily affect what a bid looks like. What’s more, it can also create the uncomfortable issue of what to do if the allowance was a little too generous – who gets the surplus funds? Even worse, what if the allowance is too small? Does the contractor eat the difference, or will they go to the owner or project manager or additional funding? Will they be willing to pay?
It’s a good idea to avoid using construction allowances, when possible. Obviously, they have their place – but it’s almost always preferable to enter a contract with as much certainty as possible. More allowances open up the opportunity for more disputes. Contractors should be cautious when using allowances and make sure to provide detailed work orders anytime they complete the work or purchase the chosen materials. And of course, any change that implicates the construction allowance should be approved by the client first!
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