Cost Plus vs. Fixed Price Contracts

Allied offers both Cost Plus and Fixed price contracts and many times when I first pose the question to clients which they would prefer, they indicate that Fixed price would be their preference. That is, until I explain the pros and cons of each format. Then, almost entirely, both residential and commercial clients change their preference to Cost Plus. So what is the difference and why choose one over the other. The answer is specific to the individual and depends on many factors I help our clients evaluate. Boiled down to a fundamental level, however, a cost-plus scenario gives the Client the best product at the lowest cost - every time. Fixed priced contracts always leave someone (contractor or client or both) on the short end of the stick - and here is why.

Many people initially like the Fixed Price concept until I let them in on how a reputable contracting company will generate a fixed price (and if after reading this makes you feel uneasy, think about how a disreputable company might generate and estimate). Here is that process:

The Estimate

As detailed an estimate as possible will be generated. Basing things on square footage costs or at a commodity level is something only production developers and builders can do. Custom builders and "one-off builds" have to be estimated down to the stick and brick as best as possible. But given that a home probably has more than 10,000 different parts and pieces to it, estimating it to the dollar is literally impossible and anyone who tells you differently is simply misleading you. If you are really good you can usually get very close (within 0.5-1% on the materials of a new build) but the labor is the wild card. Weather, ability of available staff, whether or not the carpenters young baby kept them awake all night the night before - all play a part in the cost of a job. Until machines build our homes, humans will be the wild card and humans are imprecise instruments and they will always provide variability.

The Margin

Every good contracting company projects its sales and sets a margin for those sales. The margin is what a company charges beyond the actual costs of the product to cover their overhead and profit on the job (see my blog on the difference between margin and markup). Every owner should know what the company's overhead is and what percentage of their sales that overhead represents to make sure that the overhead is covered by their margin. In addition, every for-profit company needs to make a profit which also needs to be covered by the margin. Some company will use the same margin for all jobs and others will adjust their margin depending on the type of job they are doing. That all has to do with their pricing strategies and desired profit levels.

The Cushion

That all sounds good so far, but here is the rub for you, the client. Every job has risk and company's mitigate risk in their pricing strategies. Usually if multiple people price a job, the lowest cost has not mitigated the risk properly. A well run company (meaning it makes a consistent profit on its work) mitigates its risk by either raising the margin on a riskier job, or adding a cushion to make sure they don't lose money or earn a lower margin. What that means to the client is if all goes well, they end up paying more for the job than it really cost the contractor to produce the job at their typical margin. This dynamic creates a self-inflicted pressure on a contractor to produce the job as cheaply as possible because if they do, there is more profit for them. That, almost exclusively, isn't a good dynamic for a client.

So once the estimate has been generated and a contract offered, it still may seem like a good idea to chose the fixed price contract. It might be worth paying more for a fixed price just to have the peace of mind that that is all you'll pay - except that is rarely how fixed price contracts play out. All fixed price contracts have Change Order provisions and rarely do custom projects not change course, at least slightly, during the course of construction. Change Orders are a contractual addition, subtraction, or change of scope and require time to estimate, and sign off from both sides which can slow production. The contractor also has far more leverage in pricing change orders because they already have the job and that position allows them to charge more or less whatever they would like for that change order. Why? Because most fixed price contracts do not disclose costs, margin etc.. they just give a price. And when the toilet drain needs to be moved, they can price that change order at almost any cost. Change orders are often rushed through to keep progress moving on a project and unfortunately many contractors use this situation to their advantage. In fact, this is a common tactic particular in the commercial contracting world where contractors will bid a job low to get it and then use the change order process to eventually make their money. It is a perverse dynamic that unfortunately has evolved and pervades in that world. It also creates a relationship between builder and client that pits interests in opposition to each other, as opposed to being aligned.

In the end rarely, if ever, will the secure protection of a fixed number actually materialize and you'll end up paying more for the project then you thought. To be fair on small simple jobs or massive complicated job with the right circumstances, fixed price contracts can make sense, but in general, they don't offer the protection that most people are seeking. The sad thing is most contractors know exactly how this process plays out but will never let on that they do - they have been there hundreds of times before and you haven't and its in their interest to use the situation to their advantage.

How is this process different for Cost Plus and what is Cost Plus? Cost Plus has a "Cost" which is the sticks, bricks, and labor that makes up a job. The Plus is the Margin that covers overhead and profit. In this format as the "Cost" changes, so does the "Plus". Creating an estimate for the Cost Plus Contract is exactly the same - create as accurate an estimate as possible, and then feed that cost into the margin structure for the company. At Allied we are able to use a lower margin when working in a Cost Plus format because our risk is mitigated nor do we need to add a cushion to protect our margin from the "incalculables". What is critical, however, is that the estimate is honest and that we establish a level of transparency and subsequent trust with the client to protect their interests as well as ours.

Always beware of someone who says "trust me" - because if you need to ask for it, you shouldn't be. Trust is demonstrated with actions and transparency, not blindly through allegiance. Cost Plus contracts require transparency as a safeguard to the client and require many hours of establishing a base level of trust through client meetings and interaction. I work particularly hard at breaking down the inherent distrust most people have of contractors. We unfortunately, as profession, don't have the greatest level of established integrity. By providing transparency and discussing the good and the bad of the process, I work with clients to help them understand why the contracting world is the way it is, and help arm them with information on how to navigate it with skill and understanding. When working in a cost plus format we disclose not only the cost but also the margin. Every item that goes into your job lands on an invoice and you will ultimately know where, down to the penny, your money has gone to. While most people would like their projects to be less expensive, there is a satisfaction and comfort knowing that they know where and to whom their money has gone.

So as a builder, why would I limit my profits by using a cost plus format and disclosing costs to clients? Because it's not always about the profits. There is more in life than profit. While many people may think construction is about "sticks and bricks", it isn't. It's about people and relationships. Taking care of the people on both sides of the financial arrangement is critical to fostering those relationships. When people feel allegiance toward each other they are far less likely of taking advantage of the other party. By creating a situation where both parties are responsible to each other rather than in opposition you create a dynamic that is much safer in a relationship where hundreds of thousands of dollars can change hands. That creates trust through actions, not appeals, and it is the type of trust that can be relied on. That is valuable to both parties in terms of the pocket book and peace of mind. Ask anyone who has done a major building project about the negatives, and I'd bet everyone will answer cost and stress. While cost can't be eliminated - only limited and managed - stress is caused by the relationship. Strong relationships with mutual responsibility are fare more capable of handling stress than relationships in opposition. This is why contracting is about people and not just bricks.

Here are some of the benefits of a Cost Plus Contract.

Flexibility

Imagine we are building an addition on your home and we encounter a rotten beam that needs replacement. That would qualify as an unforeseen condition which is a typical clause to protect a builder from having to eat the cost of fixing something they could never have know was there. In a fixed price contract that would require a physical change order form to be filled out, estimated and signed off by both builder and client. That takes time, could slow things down and possibly cause a chain reaction of delays in a project. A good builder knows that over the course of a year they lose say 5-10 production days of labor waiting for clients to sign off on change orders and they would build that into their labor costs to make sure that while their crew is cleaning the shop while waiting for you to sign the change order, they aren't paying for that out of their pocket. That leads to increased costs for you - indirectly and in a hidden cost you would never know about.

In a Cost plus contract that same rotten beam can be fixed almost immediately with a phone call to you and a verbal authorization. In 5 minutes a new beam can be on its way and that flexibility is often very beneficial to finishing on time and on budget. Similarly, if you want to make a layout change once we have torn a wall out or change the faucet choice, it is a simple conversation that accomplishes those changes. In a fixed price contract any change should be accounted for with a contractual change order because the original contract will have specified the layout or the faucet and the change in those costs needs to be signed of one. With Cost Plus, your understanding and approval of the change in costs is all that is required. Transparency protects the client from erroneous charges, and the builder’s interests are protected because the client has agreed to pay for the changes.

Efficiency

Often times Cost Plus Contacts can come to fruition far more quickly than a fixed price one. For instance that very same faucet needs to be specified and decide on in a fixed price contract before the builder will commit to providing it to you. Often times drilling down to picking faucets is a tough exercise for most clients who are being overwhelmed with an avalanche of choices for their building project. Sometimes builders will use allowances for this situation in a fixed price contract, but that usually is their green light to abuse that situation and charge whatever they want for that faucet because by the time you pick it, you are 75% through your project and you can't very well fire the builder because you don't like their faucet price.

In a Cost Plus contract, we often handle this situation by educating our clients on the cost range for faucets and using their feedback to provide an allowance to be determined later. For instance most mid range kitchen sink faucets can be had for somewhere between $250-500. We might advise our clients to use a $400 allowance for that and then spend the next couple months picking one out, knowing that if the faucet is more or less than $400 that is what they will pay for it. And with the transparency of a Cost Plus contract, they can be assured that the price was not inflated. This process and transparency allows for a project to move quickly and efficiently through the multitude of decisions the client must make to execute their project.

A cost plus scenario ends up being a collaborative experience where a fixed price contract is more of a transaction. There are appropriate scenarios for each and at Allied we are comfortable with both. Now armed with the inside scoop, you can make your choice based on your preference.