Construction allowances are a dollar amount that you include in your contract for a particular item. There are two types of construction allowances: material allowance amounts and installed allowance amounts. They are most often used when a client hasn’t finished all their selections. A material allowance amount could be given for carpeting. An installed allowance amount could be given for countertops or cabinets, where the final selection can impact the installation time as well as the material cost.
A recent note:
“I have both of your books but haven’t seen a good plan or section on how best to work allowances with a client. Currently we show our cost as the allowance on our contracts, estimates and design agreements. What happens when they go over the allowance, or under the allowance? If they go under should we refund them cost + markup? If they go over should we apply full markup to the overage? I have ran across this problem on every project we have done and I’m still without a good solution or verbiage to include in my contracts, help would be appreciated.”
There isn’t one right way to handle construction allowance items that works for all contractors and all clients. Plan A may work for most clients, but then you meet Mrs. Oddball who seems to work at being difficult. So you derive Plan B and hope it works.
Allowances need to be clearly defined in your contract, and that includes how you’ll handle any overage or underage on the allowance amount. If you’re going to add markup to any overage, be sure to state that and the markup percent. If they come in lower than the allowance amount, you should probably credit markup as well.
Here is some possible verbiage that defines allowances:
INSTALLED ALLOWANCE: The amount of money allocated to cover the cost of both material and labor to install the specified material(s) and any applicable sales tax, overhead and profit not included. Owner understands and agrees that the final billing for an INSTALLED ALLOWANCE AMOUNT may be more or less than the figure specified in this Contract, and that any adjustments will be made on the final billing for this job.
MATERIAL ALLOWANCE: The amount of money allocated to cover the cost of material(s) and any applicable sales tax only, excluding the labor to install the specified material(s), overhead and profit not included. Owner(s) understand and agree that the MATERIAL ALLOWANCE AMOUNT may be more or less than the figure specified in this Contract, and that any adjustments will be made on the final billing for this job.
Here is other verbiage that includes markup. You can list your actual markup, but that might open a can of worms that you don’t want to deal with. It might be smarter to use an arbitrary figure like 20% or 30%. That allows you to recover some markup without leading to an argument.
INSTALLED ALLOWANCE AMOUNT: An amount designated by CONTRACTOR to approximately represent CONTRACTOR’s cost for all labor and material to install that particular item(s) and any applicable sales tax. This amount, at its final accounting, could be more or less depending on Owner’s selection(s) and/or a third party’s actual charges to CONTRACTOR. CONTRACTOR will add X% markup to the final billing for the Installed Allowance Amount.
MATERIAL ALLOWANCE AMOUNT: An amount designated by CONTRACTOR to approximately represent CONTRACTOR’s material cost for that particular item(s). This amount, at its final accounting, could be more or less depending on Owner’s selection(s) and/or a third party’s actual charges to CONTRACTOR. CONTRACTOR will add X% markup to the final billing for the Material Allowance Amount.
The contract also needs to state what happens when a client runs over or under an allowance amount:
If the cost of the Owner-selected materials exceeds the MATERIAL ALLOWANCE AMOUNT, then that amount will be added to the next progress payment or final payment. If the amount is less than the MATERIAL ALLOWANCE AMOUNT, then that amount will be subtracted from the final amount of the Contract.
If the cost of the INSTALLED ALLOWANCE AMOUNT exceeds the amount specified, then that amount will be added to the next progress payment or final payment. If the amount is less than the INSTALLED ALLOWANCE AMOUNT, then that amount will be subtracted from the final amount of the Contract.
Before they sign your contract, make sure they read the definitions. Explain what happens when they run over or under an contract allowance amount, and let them know you’ll write a change work order at the time for the change in contract price. Ask if they have any questions. If they are clear on how the allowances work, have the initial the page with these clauses to reduce the risk of arguments down the road.
There are a few more important things on allowances.
- Construction allowances should be avoided when possible. The fewer, the better. That means you need to encourage your client to make decisions on their selections before signing the contract. If you have too many allowances, it might as well be a Time and Materials or a Cost Plus contract, and you know what I think about those.
- It’s important to educate your client on what allowances are and how they work. Even if you aren’t going to have allowances in your quote, another contractor might, and what they provide for a construction allowance can skew the price significantly. If someone else is giving them a $5,000 allowance for kitchen cabinets and you’re giving them a $35,000 allowance for the same cabinets, make sure they understand they’ll probably pay $35,000 for kitchen cabinets eventually.
- Allowances need to be within a reasonable range. Setting a $4,000 allowance for appliances in a $800,000 home is just asking for a fight, and you stand a good chance of having to make up the difference out of your own pocket. Keep the unwritten law of “Good Faith and Fair Dealing” in mind. If you’ve asked enough questions, you should be able to get within 5% of their final selection.
- Clearly explain how much you’ve provided for each construction allowance area. For example, if you’re including a material allowance for carpets, let them know the allowance assumes carpeting at $50/square yard, and they’ll need 12 square yards.
- Always write a change work order when an allowance is over or under to clearly document how the final project price has changed. Do it immediately; don’t wait until the end of the job to catch up on the paperwork.
- Be sure that you have the additional or change work order procedure clearly defined in your contract, and follow it. You should be paid up front for changes of $2,500 or less, and only make changes when the customer has signed your additional or change work order. No verbal changes.
Allowances are a great way to handle selections that haven’t been made yet. They reduce the risk of underestimating the cost of getting items installed. On the flip side, they can result in arguments if the ground rules aren’t clearly established. They can also reduce your overall markup if the variance between the allowance and the actual amount is too great.
There are many ways to handle allowances; this is my thinking on the subject. I look forward to hearing from others.
Disclaimer: Nothing in this article or on our website is intended to be, or may be construed as, legal advice. I am not an attorney. You must consult an attorney before using any suggested language or any other information contained in this article or on our website to determine if it conforms to your state laws or your particular situation.
The knowledge and experience Michael Stone gained in his 60+ years in construction has helped thousands of contractors improve their businesses and their lives. He is the author of the books Markup & Profit Revisited, Profitable Sales, and Estimating Construction Profitably, and is available for one-on-one consultations.
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