On today’s show we’re talking about the discipline of performing your due diligence in underwriting and budgeting.
I had the experience earlier this week when I received a construction estimate from a major, very experienced general contractor. This particular GC does several billion dollars a year in new construction. They have a top notch team and they have top notch systems internally. The number was much higher than our budget allowed for. If the estimate was true, we didn’t have a viable project. Naturally our team leapt into action to try and understand why the numbers were so high. We scrutinized all of the assumptions. This involved examining specific line items against the benchmarks we have for similar projects. For example we had a budget estimate of $19,000 per condo apartment for plumbing. It’s not as if a condo has more sinks or toilets or pipes than a rental apartment. There is still only one sink in the kitchen, one dishwasher. Why was this line item so high? Was there a technical requirement to use copper for water and cast iron for sewer? After further review, no the plumbing pipes could be plastic and the sewer pipes could be PVC or ABS. It turns out the GC had assumed higher end finishes for the fixtures in the bathrooms, but in reality there was no justification for the cost of plumbing to be so much higher than expected.
There were several line items like this out of several hundred detailed line items. The General contractor provided their internal material take-off tool to help us understand how the estimate was put together.
A phone call ensued in which we outlined our assumptions for the level of finishes, types of windows, amenities and so on. On that basis, the GC took the feedback and a few days later they came back with a new estimate. This new estimate was slightly below out budget. The initial reaction by most of the team members was one of relief.
It’s amazing how it’s tempting to feel good when someone tells you what you want to hear. When you hear the right answer the curiosity to dig deeper often dissipates. But a good number is every bit as dangerous as a surprising number. It deserves every bit as much scrutiny as before.
It’s not because the cost of drywall went up by 10% that the project will be over budget. In my experience, there will be a fundamental assumption error in the project. That’s where the big errors creep into a budgetary estimate. It’s because a line item was zero when it should have had another number.
Even when the number is what you’re expecting, it can have mistakes. You can have a situation where two errors cancel each other out and hide the mistake.
We took the time to scrub the numbers. Here too, we found problems in the estimate. This time, the numbers were too low. That situation is just as damaging, perhaps even more damaging than the reverse situation. But I have to say it took a lot more energy to muster the motivation to scrutinize these numbers that looked so much more attractive. But as soon as we found the first problem, the motivation was there to keep digging and make sure we understood the budget estimate fully.
It takes a lot of energy to check everything for safety. It take diligence. As humans it’s exhausting to be on high alert all the time. So instead of performing due diligence on everything, most people have adopted a check for comfort as a proxy for due diligence. If they feel comfortable then they don’t bother looking any further. You don’t walk around the house checking if all the windows are closed at night. You do a simpler check. Are you comfortable? Is the house drafty? If you don’t feel a draft you don’t check the windows. A check for comfort is used instead of a check for safety.