Construction can be a risky prospect for all parties involved.
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A lot of things can go wrong, and in construction mistakes cost money. One way to protect yourself from these mistakes is by carrying a contingency fund. In particular, there should be two contingency funds: one for the contractor, and one for the developer.
The general contractor on a project needs to carry a contingency in their budget just in case they make a mistake. For instance, let's suppose that the contractor bids out a set of plans for the project. You accept their bid and they start building. Suppose that a month into construction they realize that they accidentally left out a big ticket item (such as a conference room table that was supposed to be provided in the bid). If it's the contractor's fault they need to pay for it out of their contingency.
The contingency also protects the contractor when their subcontractors don't perform. A simple example of this is when a subcontractor leaves you at the altar. Say the general contractor bids out the plumbing work to three plumbing subcontractors. The job is awarded and the lowest cost subcontractor gets the plumbing work. Imagine if, for some reason, that subcontractor bails out on the job. The general contractor has to then hire the next best subcontractor, and absorb the extra cost involved. Contingency makes this possible.
Some changes and mistakes, however, are not the contractor's fault. For anything that was not in the initial bid from the contractor, you will have to spend developer contingency money. The most common cause of developer contingency expenditures deals with incomplete plans. As you construct a project you will start to realize things you missed. Unfortunately, the contractor won't add these for free, so the change order involved will use your contingency funds.
Some mistakes are not the contractor's fault. If any of the architects and engineers makes a critical error, you may be forced to cover it out of your contingency while you work out a solution with the architect. Sometimes this problem happens when the architect specifies a product or material incorrectly. If the contractor purchases and installs a material that is specified on the plans, they are just working according to the contract. The developer will then have to work out with the architect how to get the right material installed.
How Much Contingency Should I Carry?
Most financial institutions require that you carry a solid contingency in your budget in order to obtain financing. It is not uncommon to see a 5% contingency carried on the contractor's budget, with an additional 5% carried on the developer's side of the budget. This money is there to protect you. For the contractor, saving money under the budget could mean savings to you depending on the type of contract you signed. A common thing is to incorporate a savings clause where unused contingency and savings in other parts of the budget are split in some fashion between the developer and contractor.
The developer's contingency can be anywhere from 2-5% or more depending on a number of factors. One of the most important of these is the faith the developer has in the contractor and the plans from the architect. Obviously any savings in the developer contingency are retained by the developer.