What are Committed Costs in Construction Accounting?

In construction projects, managing finances can be a challenging task — but understanding committed costs can simplify the process. Committed costs refer to expenses that are guaranteed through formal agreements, such as contracts with subcontractors and vendors. Recognizing these costs early can help create a more accurate budget and avoid financial surprises. 

This article will discuss the difference between general conditions and committed costs, the advantages of committing costs early in the project cycle, and how to format cost commitment documents.

What is a committed cost?

Committed costs in construction encapsulate the project expenses that are both anticipated and contractually agreed upon, even though payment has yet to be made. These costs represent formal agreements with subcontractors or vendors, setting a clear expectation of the amount that will be paid for their services or materials. They're distinguished from the general budgeted costs, which provides a secure framework for effective budget management. 

By committing to these costs, there is a guarantee in place that ensures these expenditures are accounted for in advance, offering a level of financial predictability and control that is indispensable in construction project planning.

Differences Between Budgeted and Committed Costs

General conditions costs are expenses that result from project activities. The project team has recognized and budgeted general conditions costs. Committed costs have an agreement signed that commits to paying a vendor or contractor.

Set Costs

Both budgeted costs and committed costs indicate the amount the project team plans to spend for any particular line item, but committed costs set out the amount the project has committed to spending with a particular vendor, and it's helpful to set that out as early as possible.

Entering committed costs helps project teams get a firm grasp on actual project costs. Without them, the costs are variable and can be forgotten until they hit the books as actual costs. Seeing that cost come in after it is paid is too late to start making adjustments or forecasting out costs appropriately.

Contracts and Purchase Orders

Committed costs will move through the accounting system according to the associated contract or agreement that guarantees them. For instance, when a contractor creates an agreement with a vendor, the purchase order would go out indicating the material that will be purchased from the vendor and when. When the field team confirms the receipt of the material, the project manager knows who the vendor is and the funds allocated for that expense.

It is worth the extra step to formalize costs into committed costs, to prevent the overruns that can occur when limitations aren't put in place. For example, if an owner hires a contractor to come in and to work on a time and materials (T&M) contract, but the exact committed costs aren't well defined, costs can quickly get out of control. This is especially the case if a second contractor has to complete the work after the first contractor's failure. Locking down a contract to commit those costs can save the owner from additional charges.

What happens when prices change?

Sometimes, committed costs span multiple years of a construction project. When prices fluctuate, the prices for materials indicated in the agreement may have changed. Depending on the agreement in place, the vendor may uphold the originally stated costs or come to some cost agreement with the contractor. Otherwise, the contractor will be committed to purchasing at the current elevated costs.

The risk of material price increases are one of the reasons it can be beneficial for contractors to procure material early on rather than try to hold the vendor to a discounted rate later on. Procuring materials early also ensures the materials are there when needed. If materials lead times increase and the project team doesn't have purchase orders in place, the project risks late materials deliveries, causing project delays and leaving the team open to liquidated damages charges.

Committing costs early on has become standard practice in construction to lock in a particular price point and to keep the project manager accountable to the budget. Materials put in budget line items sometimes get missed when the actual purchase takes place, and the team doesn't consider them until they come through as a direct cost, when it appears in the budget. Having purchase orders in place makes the cost more visible so that the team can realize overruns before they occur and make adjustments.

Strong and ongoing industry relationships can help regulate price changes a lot over time. Vendors are willing to make more concessions for repeat and future customers — whether they are owners or contractors — than for somebody they don't know.

Explore data and trends for building materials prices.

Get the latest U.S. retail prices and view historical trends for common building materials.

Material Price Tracker

Formatting Committed Cost Agreements

Project teams often use AIA templates for contracts. Other times, contractors adapt AIA templates or write their own with the help of legal departments, so that they have a standard format they use on each project.

Either way, it is critical to put language in place with vendors and on purchase orders to protect the project's interests.

The contract team doesn't always have a say in the vendor's procurement terms, though, or even which vendor to use. Just like a customer doesn't get to dictate payment terms to a clothing store, materials vendors often have terms and conditions they use, and those will apply across the board. The contractor may not have a choice of vendor, either.

The owner may work only with specific vendors, and require that contractors use those vendors for the project in question. For example, a construction owner who built a number of burger franchises may use a single lighting supplier for every build.

Some vendors may want to issue separate purchase orders for each phase of a project, but it is simplest to keep a single purchase order for each vendor on a project and break out project phases using cost codes within. That way, each vendor's order is consolidated in one place so it streamlines the clicks and avoids confusion. If there are changes to volume or price, the purchase order can be modified with change orders.

Best Practices for Using Committed Costs in Construction

How and when a project team uses committed costs will depend on the size of the project, their relationships with the owner and vendors, and their standard operating procedures. However, following some basic guidelines for committed costs can help contractors make best use of this tool.

Which costs require a contract?

Each project team will have to come up with its own rules for how and when to commit their construction project expenses. There can't be a purchase order for every item on the construction project budget — the paperwork would be a nightmare if there needed to be a completed change order on a purchase order for every trip to the hardware store. There are general rules teams can use to create these guidelines.

In general, larger expenses are appropriately committed in writing so that everyone understands the final numbers the project is obligated to spend. As a baseline, any expense over $5,000 should be firmed up in a legal contract.

Similarly, any budgeted item that requires long lead times, like some materials or equipment, should be firmed up to help avoid project delays caused by unavailability.

There may be exceptions for smaller expenses if, for example, a project manager is having trouble sticking within a budget. If a PM is constantly going over budget, then the contractor can put in place not-to-exceed purchase orders to limit the expenditure on everyday expenses.

Larger projects, more formal relationships

Contractors who work with smaller materials suppliers may be used to getting by with less formal handshake agreements. As contractors grow, they will need to work with larger suppliers, who will require committed cost agreements in place.

Contractors need to grow with this because working on a larger project means they will need to use contract language with suppliers because the owner will be using some contract language with them. If smaller suppliers aren't accustomed to the committed cost relationship, they may be too small to handle a larger project.

This transition can necessitate tough conversations with vendors, and the need to disconnect with smaller vendors who can't handle the contract relationship.

Having contracts in place means everyone knows when they're getting paid, which removes the burden from the entire team. Contract language is there to protect the team and outline the rules of engagement to set expectations early, to avoid confusion and unending explanations.

When should purchase orders be created?

As soon as a contractor signs a contract with an owner and starts providing some details about the materials needed, it becomes clear who is responsible for procuring them. At that point, the contractor should begin procuring the items that fit the internal guidelines, especially larger or very specific items or where long lead times are likely to slow things down. Earlier buyout allows for more cost predictability and ensures material availability.

Building relationships

Relationships play a key role in drafting agreements for committed costs, and the give and take that makes them work plays out throughout the procurement process. Materials suppliers help estimators by providing accurate numbers for their bids, and then benefit when the estimator passes their contact on to the procurement team. Materials suppliers are happy when the order is placed and the contractor's CFO ensures the invoice is paid in good time. A strong relationship means those vendors are more likely to contribute to the contractor's next job.

The price that goes into the committed cost agreement comes about through various steps throughout the project, beginning at preconstruction. Relationships are critical to keeping costs low and maintaining project workflow.

What happens when contractors can't manage their committed costs?

Contractors sign a binding document to pay their committed costs. However, sometimes, the contracting firm can't pay those committed costs, resulting in a lien on the property. This raises red flags for project funders. Sometimes, the owner won't fund the project until that lien is removed, resulting in a significant project delay or even failure.

Good construction contracts can help contractors mitigate cash flow risks, by ensuring the contract language stipulates that the vendor will get paid when the contractor receives funding.

Why use committed costs?

Committed costs help contractors build relationships with vendors and solidify the budget and expenditures on their projects. Buying out early helps the project team forecast the job, which is especially important on projects that go on for years and years. Completing a job without commitments leaves a lot more mystery about the actual cost amount. Each company should have a standard operating procedure dictating when a commitment contract is required.

Written by