Building Contracts: Fixed Price or Cost Plus?

 

The contractual agreement between a builder and client can have a great impact on the success of the project. There are two general categories of contractual agreements for residential homebuilding and remodeling. One is the Fixed Price contract and the other is the Cost Plus (sometimes known as Time and Materials).

The Fixed Price contract is the easiest to understand and is usually the most straightforward i.e., I will build this house (deck, kitchen remodel, etc.) for X amount of dollars. The cost will only change if additions or modifications are made to the agreed upon scope of work. Also there are usually allowances in Fixed Price contracts for certain items that can raise the price if the allowance is exceeded. In theory, this type of contract usually limits the financial exposure of the client.

The biggest problem I have with Fixed Price contracts is that after the contract is signed, it is in the builder’s interest to build the project as cheaply as possible putting the client and builder at odds. The less money spent building the project is profit to the builder. This risk to the client can be mitigated with a complete set of plans and specifications but rarely are plans and specs 100% complete. A third party such as an architect or construction management firm (common in larger commercial and government projects) can also reduce the possibility of the builder cutting corners. If plans and/or specifications are not complete, the possibility of unexpected change orders can arise. These unexpected change orders will usually be in addition to other change orders that the client will decide upon after construction starts. The client should understand that with a change order “there are no other bidders”. This can allow the contractor to charge whatever they want. Of course, the client will be able to reject some of these change orders but then are they really getting what they want?

The two main derivatives of a Cost Plus contract are Cost Plus a Fixed Fee or Cost Plus a Percentage. With Cost Plus Fixed Fee, the contractor’s fee is negotiated up front and the client knows the exact cost of that portion of the contract. A Cost Plus Percentage contract will have the percentage negotiated up front but the actual cost of the builder’s fee will not be known until completion of the project. A Cost Plus contract can enable the builder to focus on quality without worrying about meeting or beating a profit margin. A Cost Plus contract should not alleviate the builder from documenting changes as they arise. Of course many games can be played with Cost Plus contracts. The most common is to have a low Fixed Fee or Percentage but then have “hidden” profit in labor rates or other charges.

Most of our projects are done on a Cost Plus Fixed Fee basis. We start with a detailed budget (26 categories!) and work with the client to meet these numbers. Our accounting system is disciplined, efficient, and transparent.

In summation, there is no contractual relationship that fully protects either the client or the builder. If you are building a custom residential project, be sure to evaluate not only the contract, but also the budgetary procedures and methods the builder uses to control costs.