Introduction to Contract Types
Cost-plus contracts and fixed price contracts are two of the most common ways to structure a construction contract. Understanding how each type operates is essential in order to determine which option is appropriate for your construction project.
What is a Fixed Price Contract? Fixed price contracts are, as the name suggests, a predetermined price for a specific scope of work under a construction project. If the actual costs are less than the quoted price, the contractor keeps the difference. If the actual cost exceeds the quoted price, the contractor has no ability to recover any additional funds from the owner.
With a fixed price contract, it is up to the contractor to complete the work within the quoted price for the scope of work. A lot of risk is placed on the contractor in this type of contract because the contractor may not be compensated for any increase in the cost of materials or labor. However, if the price quoted by the contractor is accurate, the contractor can realize a significant profit.
A fixed price contract is most likely going to be beneficial when there are no foreseeable issues or problems that will result in a higher cost to the project. For example, if a home is being built in an area with a stable real estate market, and there are not many variables for the builder to consider, a fixed price contract would be a good option. However, if there are many unknowns associated with the job, a fixed price contract could turn out to be disastrous for the contractor. The contractor needs to be well aware of the scope of the work required and confident that there will be no need for change orders or other increases in cost.
What is a Cost Plus Contract? In contrast to the fixed price contract, a cost plus contract sets a guaranteed maximum price for the project, but the contractor has the ability to bill the owner for any overages . The project owner is responsible for all costs, including materials, labor, and overhead, but the contractor would be guaranteed a specific profit. For example, the contract may stipulate that the contractor is entitled to 10% of the cost of the job as profit. This means that if the cost of the project is $10,000, the guaranteed maximum is $11,000. However, if the cost of the job goes up to $15,000, the contractor receives the full $15,000, plus a $1,000 profit. The contract may also set a maximum price on each individual piece of the job, rather than the project as a whole. For example, the contract may set a maximum price of $5,000 for the entire roofing package. Therefore, as long as the roofing does not exceed the $5,000 limit, the contractor is entitled to full reimbursement.
How Do I Know Which Type of Contract I Need? Determining whether to use a fixed price contract or a cost-plus contract depends on the nature of your project and the range of issues associated with the job. A fixed price contract would be beneficial if the scope of work is well-defined and there are not going to be any difficulties that result in unforeseen costs. Although the contractor would be taking a risk if the job exceeds the proposed cost, the contractor also has the opportunity to make a significant profit if the project proceeds under-budget. A cost plus contract is likely to be a better option when there are a lot of unknowns associated with the project. A cost plus contract would allow you to have full knowledge of the price without being required to pay for any overages. It is probable that the contractor does not want the risks associated with a fixed price contract and would prefer the cost plus contract.
The Difference Between Cost Plus and Fixed Price
The most fundamental difference between the cost plus contract and the fixed price contract is that a cost plus contract allows for flexibility in all of the components of the cost so that any changes in the components can be factored into the overall price. In contrast, the fixed price contract holds the fact and the estimate of the costs firm such that if the actual cost was greater than the estimated cost, the contractor must absorb the additional expense out of profit and vice-versa. A cost plus contract will provide the contractor with more control over the costs being incurred than the fixed price contract. In a fixed price contract, the contractor has an incentive to reduce government costs in order to make a profit, whereas, in a cost-plus contract, the contractor is incentivized to be as efficient as possible but is guaranteed a profit whatever the actual cost. The distribution of the risks associated with the contract varies under the two types of contracts. A fixed price contract places essentially all of the risk on the contractor because any increase in costs must be absorbed by the contractor. In contrast, under a cost-plus contract, the owner and the contractor will share the risk of the costs. If the actual cost is less than the estimated cost, the contractor will maintain a portion of the savings and the remaining balance will accrue to the owner. Conversely, if the costs are increased, the contractor will be entitled to be paid for the actual cost of performance and not merely the fixed cost of performance.
Benefits of Cost Plus Contracts
Consider these advantages of a cost plus contract before you make your decision:
Flexibility in Scope of Work. Unlike a fixed price contract, a cost plus contract provides the flexibility to modify the scope of work throughout the course of the project without having to renegotiate the contract. These change orders are typically charged at the contractor’s hourly billing rates and are not as burdensome as additional work under a fixed price contract.
Open and Transparent Cost Reporting. Because a cost plus contract is paid on a time and materials basis, the contractor is required to provide an accounting of not only the actual costs and expenses incurred in performing the work, but also the contractor’s labor rates, markups, and other overhead and profit.
Increased Quality. A cost plus contract allows the contractor to concentrate on performing a quality job, without the need to cut corners to reduce costs. Without having to work within an artificially fixed budget, a contractor can suggest high quality or state of the art materials and systems that your design professional may have originally rejected in favor of a lower quality option in order to remain within the budget.
Upsides of Fixed Price Contracts
Because a fixed price contract combines a bid amount with a set schedule, it is one of the least risky types of contract for owners and project managers. It’s imperative that owners and project managers understand their cost to construct a project so be sure you will be correctly compensated for the work you needed done. With a fixed price, your costs are known in advance which means you can invest the funds into other projects that would normally be tied up as a contingency fund. Predictability for your budget is paramount so you can allocate funds where needed, and having a lump sum contract gives you that ability.
A fixed price contract may also make it easier to forecast cost overruns at the end of the project, so you can potentially increase your overall return on investment. These contracts also have a number of advantages in terms of budgeting, planning and forecasting because there are no penalties or change costs associated with the management of funds.
Fixed price contracts reduce the work required for project managers to stay within the budget. There is a much lower overhead for project managers to track the flow of funds because the work is already paid for, and project managers don’t have to check in with owners and answer questions about payment schedules. A fixed price contract allows project managers to manage performance and materials instead of funds. This lets project managers focus on other areas for a better ROI.
When To Use Cost Plus Contracts
In general, cost-plus contracts tend to be advantageous in the following situations. First, they’re great for projects with uncertain scope as the costs can be a lot for the client to manage but the flexibility in this type of contract allows for those changes to happen seamlessly. Second, they make sense for experimental projects where adaptability is the focus rather than timeline or end amount. Construction can be full of unexpected issues that come with no warning. Changes in scenery, design or cost can all be concerns that lead the way for a cost-plus contract. For instance, if a new type of technology is being tested and might be used across multiple projects but you don’t have a clear understanding of how that will affect the total cost, cost-plus makes the most sense. Third, if your company is in the business of testing and building new products for clients, using a cost-plus contract is a big benefit. It can help you build a more collaborative model with clients around your pricing as they invest in the cost of developing that project and have the possibility of it becoming a product that can make both parties money down the line. Fourth, if one party’s the experienced "specialist" on a particular project but you’re not quite sure if your input will pay off—and you don’t want to be responsible for something if it doesn’t work out—then this type of contract can be a benefit as well. That "specialist" can input his or her ideas and take less risk by just charging a piece of the cost of the project.
When To Use Fixed Price Contracts
In certain situations, fixed price construction projects may be preferable. If the free market enables prices to be arrived at for a specific contract, an owner may wish to minimize its risk by entering a fixed price contract with a contractor. For example, if the parameters of the project are clearly defined and the duration and scope are established, the parties may decide that the fixed price is an appropriate method of doing business . Well defined construction documentation will enable the owner to outline the scope of work in a contract so as to reduce the contractor’s need for contingency in a bid or proposal.
Therefore, the fixed price contract may be preferable for well-defined construction projects that have set timelines and tightly controlled budgets.
Drawbacks
Like most things, there are risks and rewards when it comes to each type of contract. Cost plus contracts are typically more risky for you as the owner. That’s because there is no incentive for your contractor or sub to work efficiently when you are paying them for their actual costs. In fact, you may be incentivizing your contractor or sub to work inefficiently. If you pay them for hours worked and cost materials, there is no incentive to complete work in less time. In addition, since your contractor or sub is being paid based on its actual costs, there is no cap on the amount you will have to pay. Consequently, your contractor or sub may inflate their costs with the expectation that you will pay it.
Conversely, with a fixed price contract, your contractor or sub takes on some risk. With a fixed price contract for a specific scope of work, your contractor or sub is incentivized to work efficiently because if they don’t, it will be costing them money. It also incentivizes them to cut corners. When subcontractors or contractors are competing for your business, they may offer to perform the work for an unrealistically low price because they intend to skimp on quality to turn a profit later. In addition, in the event you want to change the work, you will have to pay extra. In some cases, if the work to be changed is material to the original contract, you may even end up with a new project altogether – as opposed to an extra cost under the original contract. At the end of the day, you are probably paying for the same exact work, but under two different contracts.
Selecting The Right Contract Type
Sectioning the project into multiple smaller contracts to improve your cost recovery
Your project requirements should be the deciding factor when determining whether to implement a fixed price contract or a cost plus contract, and that determination is not always so clear cut. The decision to use one type of contract instead of the other depends on many factors, including your project’s requirements and scope of work. Here are some questions to consider when deciding which contract is best for your project: When it comes to cost-reimbursable contracts, both construction and design professionals have had to deal with its vagaries and unexpected consequences. So in considering these contracts here are some additional factors you should consider before deciding whether to use these contracts on your project:
- Understand the potential for losses resulting from a cost plus contract. In a fixed price contract, there’s an expectation of no profit for the designer or contractor until the project is completed. In contrast, a cost plus contract requires your designers or contractors to work in good faith. With a fixed price contract, there is no real incentive for them to provide quality work or diligently oversee sub-contractors because their fees are still being paid whether the project is completed in a timely manner or not. In comparison, since the cost-plus contract provides the designers or contractors with a percentage of the costs as their profit, they have an incentive to control costs and eliminate waste. However, it can be difficult to reach a point where everyone can agree on what things are being done in good faith. Misconceptions can be made that the designer or contractor is not doing their job.
- Determine your area of risk. If this is your first project involving a cost plus contract, and you are self performing the work, there is limited risk to you. But if you are responsible for designing the project, this may not be the best approach. In a large project, the cost plus contract may require a cost plus contract with the designer and a fixed price contract with the construction manager as general contractor. This way the risks and benefits of both contract types can be shared.
- Compensate contractors and designers based on their skill. The cost plus contract was primarily intended to remunerate those designers or contractors that had skill sets that are highly specialized. If you decide to use a cost plus contract, you first need to make sure that the contract is structured appropriately. One way is to include an agreed upon fee based on an hourly rate or a set fee. The costs may be expenses that are either reimbursed at actual cost or at a specific rate associated with the contractor’s or designer’s services.
- Estimate the estimated costs for the project and/or project phases. At the start of the project, there really is no defined scope of work. However, you should have a rough estimate of what the project will cost. Use this as a guide for estimating the budget of the project. You can then break down the project into components and/or phases. By doing so, you will give yourself some room for deviation despite unexpected circumstances. It is crucial that you keep track of the project budget once the project kicks off. You can find out the status of the budget through weekly reports.
- Be mindful of scope change. Any change in the project scope can result in costs that exceed the estimate, and the same holds true for cost plus contracts. Even if cost plus contracts are usually based on fixed rates, the same can be said for them. Therefore, if the project scope changes, appropriate adjustment should be made to the cost reimbursable contracts, too. This is why it is so important that all parties keep a progress of the cost and project status so they can anticipate any problems that may arise.
Conclusion: Make An Informed Choice
As is the case with both Fixed Price and Cost Plus contracts, there are distinct advantages and disadvantages to each type of contract. There is a reason that both types of contracts exist in the market and are so widely used. A detailed understanding of the characteristics and differences between the contracts will give you the information you need to make the best decision for your specific project. An informed decision will help ensure that you get the work you want to be done for a price that works for you.
This discussion has focused on the construction industry. However, this is by no means a discussion for the construction industry only . This discussion has application in many different contracts. If you are entering a service contract or a product purchase contract, the same considerations apply. The goal in these agreements is to obtain the desired work/product for the desired price, which often times leads to a Cost Plus arrangement.
If you plan on fixed pricing, you should be comfortable making your own decisions as to how work is done. A good plan is to hire a construction management company who can organize the project and set the schedule. A good advocate for efficiency will help ensure everything stays on its projected path.