If you were to ask contractors what they like most about construction, they probably wouldn’t say, “I love preparing bids.”
Most contractors love being on the job site, not being cooped up in an office working on numbers. Yet contractors get the majority of their business from bidding on projects. The most successful ones have developed a winning strategy that results in the lowest bid and generates a profit for their firms.
When sureties and agents look at lump-sum construction bids, they must carefully consider the bid spread — that is, how far the winning bid is from the other bids submitted. If the spread between the winning bid and next-lowest bid is greater than 10%, further clarification is required.
10% spread can be a concern
Why is 10% the industry standard for a bid-spread red flag? Because construction profits range from 5 to 15% of the job. Surety underwriters want to understand why there is a spread. They need to be convinced the contractor will be able to turn a profit.
There may be very good reasons for a large bid spread, and most of the time the contractor will have a reasonable explanation. However, when an underwriter sees a bid spread of 10% or more, they typically ask the contractor to submit a letter answering these five questions:
- Are you comfortable with the bid, and why do you think there is a spread?
- Have you checked to see if anything was omitted from your bid? Did you bid on all the requested parts of the project?
- Were there were any mathematical errors? Perhaps a number was transposed or a zero was left off.
- What’s the profit on this job? What is your competitive advantage to earn that?
- Is there an engineer’s estimate? If so, please provide it.
This list is a general guideline, and depending on the dollar amount of the bid spread, the strength of the contractor’s balance sheet, and other factors individual to each particular case, the underwriter may have fewer questions, additional questions or sometimes no questions at all.
We weigh many contributing factors
A number of factors go into a contractor’s bid for a job, including experience, resources, pricing advantage, timing and location. All of these can affect the contractor’s bid and may result in a significantly higher or lower bid than the other bids on a project.
For example, a contractor located close to the job site may have much lower trucking costs than a bidder located 50 miles away. Perhaps the contractor has worked for the owner/architect before. He knows the project quite well and can aggressively price the work. Perhaps he has used value engineering to lower his costs. Or perhaps his closest competitor is already at capacity and has decided to bid high.
When there is a bid spread, an underwriter’s job is to engage the contractor and weigh these factors against his/her knowledge of the job and our experience with that contractor. If we still have concerns, we’ll request more frequent work-in-progress reports and visit the job site to monitor the progress. After the project has been completed, we can compare the final outcome with what the contractor estimated at the start to see how well it held up.
Other bid-spread considerations
Here are a couple of other flags we consider when it comes to bid spreads:
- Does the contractor consistently underbid jobs? It’s one thing if a contractor occasionally bids low, but it is quite another if the contractor is frequently low. Contractors who are “buying” revenue in order to generate cash flow to stay afloat are a concern.
- How does the bid spread compare with the contractor’s equity? When the bid spread is 30% or more of the company’s equity (net worth), it requires further underwriting investigation. Also, if the contractor has multiple bid spreads at the same time, there may be a negative aggregate impact on equity.
A bid spread isn’t necessarily a five-alarm fire, but it should be questioned and monitored. The good news is that we now have the technology to track bids and quickly spot patterns. Staying on top of bids and monitoring job progress is the key to a positive surety relationship. The bottom line is that as trusted advisers, we want to understand contractors’ situations and support their continued success.