In this episode of Your Business Unleashed, we’ll discuss several ways construction companies and trades price their services. Each pricing model has its benefits and pitfalls, and the choice of model depends on factors such as project type, complexity, client preferences, and market conditions.
How a construction company sets its pricing is essential to the long-term viability of the company and is one of the most critical features of bidding out jobs in a competitive market. Pricing impacts profitability, whereas billing and collection processes impact the company’s cash flows. Note that I’ll discuss billing and collection (otherwise known as revenue recognition) models in the next podcast.
Here are some common pricing models in the construction industry:
Fixed pricing is commonly used in smaller construction projects. The contractor agrees to complete project for a specified total price, which is agreed on before the project begins. Generally, the price remains fixed throughout the project, regardless of any cost overruns, leaving the risk with the contractor and not their customer.
Benefits of fixed pricing:
- Fixed pricing is the most preferred option by clients as it makes the total bill predictable and reduces their financial risks.
- Clients feel more comfortable knowing that they won’t be charged for cost overruns due to improper scoping or pricing.
- Companies that commit to a fixed price are most likely to win a contract compared to companies that do not offer fixed pricing.
- Fixed pricing simplifies project management and cost tracking for construction companies as revenue is not directly tied to costs.
Pitfalls of fixed pricing
- Companies shoulder the risk of cost-overruns if there are unforeseen changes, which can negatively impact profitability.
- Client change requests can also lead to reduced profitability and thus should always be handled separately through a change order and a new pricing scope.
- Fixed pricing requires the construction company to undergo thorough and detailed upfront planning, and scoping in order to produce detailed project specifications. This requires competent bidders and involvement from all levels of the organization in order to arrive at the correct price.
Cost-plus pricing in the construction industry ties the final selling price of a piece of work to the actual costs of completing the work plus a markup, known as a “profit margin”. This approach ensures that the company not only covers its expenses but also generates a desired level of profit, however it is one of the toughest for a client to wrap their heads around as the burden of cost-overruns rests with the client and not the company.
Benefits of cost-plus pricing:
- Cost-plus creates transparency as the company can present receipts and time sheets to justify the costs, plus an agreed-upon markup or fee.
- This method leaves the company with the flexibility to accommodate change orders and unforeseen circumstances, reducing their risk and guaranteeing their margin.
Pitfalls of cost-plus pricing:
- Clients are often concerned about cost control and may perceive it as open-ended. Thus, ender a cost-plus arrangement it is important for the construction company to provide regular financial updates to their clients.
- Contractors are responsible to control costs and therefore usually face pressure to keep costs low and accountability high in order to maintain client’s trust.
- It is important for the company to ensure that their margin is sufficient to over overhead and administrative costs. This requires up to date accounting and cost control on expenses that are ‘below the line’.
- The amount of markup that a company can provide is often limited by the competition that exists in the market, unless the company can find a way to add substantial value that others cannot (such as increased quality of work, superior reporting and transparency, and social credibility in the form of review or otherwise)
Peace rate (unit-rate) pricing:
Piece rate pricing, also known as unit-rate pricing, is a pricing model used in construction and other trades-based companies where they are paid based on the quantity or units of work, rather than a fixed hourly wage or a lump-sum contract amount. Peace rate can include materials and labour, or just labour. Peace rates tie pricing to productivity and the output of work.
Benefits of peace rate pricing:
- Clients are billed based on specific units of work completed, such as square footage, number of lights, feet of wiring, etc…
- Peace rates are ideal for jobs with repetitive tasks or standardized components where costs are uniform and predictable.
- Clients like this pricing as they have a clear understanding of how the charges will work.
Pitfalls of peace rate pricing:
- Can be less predictable for clients than lump-sum pricing as there is still a variable component (the units).
- May not work well for complex projects with multiple components, however the general contractor may seek peace pricing on specific components of a complex job.
- Scoping is important to get the pricing right as peace work requires detailed and accurate measurement in order to ensure the correct price.
There are lots of pricing models available to construction companies; some companies are very focused on what they do and offer a narrow product on a narrow pricing model, others adopt several pricing alternatives depending on the types of services they offer. It is so important for construction companies to get their pricing models right to ensure that they win contracts and set customer expectations WHILE maintaining a great profit margin, which is essential to a thriving trades-based organization.
If you haven’t already, be sure to check out our Construction and Trades industry page and download “Better Tools” our Construction Business Strategy Guide.