Contract Structures: Fixed Price or Cost Plus?
Part of a Five-Part Series: Getting Estimates and Choosing a Contractor
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Introduction
If you’re just joining us, we’re in the middle of a 5-part series covering how to get good estimates for your construction project. Everyone knows it’s important, but most people have no idea where to start, or how to determine whether the answers they’re getting are good, bad, or ugly.
Please see previous parts for more of an introduction – and as always, proceed with caution - things can vary widely depending on what jurisdiction you’re in. This is meant to be an *overview,* not a comprehensive analysis. Believe it or not, there is *a lot* more to all these topics than I’m able to cover even in five newsletters. But this is a great start!
First, some resources
- Downloadable PDFs - including a compiled version of this 5-part series – worksheets, templates and more – in my store!
- My new podcast is in the top 25% of podcasts nationwide!! Check it out, wherever you get podcasts. It’s full of practical advice, some wild stories, and lots of hard-won wisdom from owners who’ve gone through it and lived to tell the tale: “Home: The Second Story,” [Apple, Spotify, YouTube, etc.]
Ok, let’s dive in to the final installment, Part 5!
Contract Structures: Fixed Price or Cost Plus?
In construction, there are two main contract structures, Fixed Price, and Cost Plus. Just about every possible contract structure is some variation on one of these two, so understanding the fundamental underpinnings of each of them is extremely helpful.
Note: I am not an attorney, and none of this is legal advice. The laws around construction contracts vary state to state, as do the regional norms and expectations. Before signing any contract, you should consult an attorney *with relevant experience* - in construction, and in the *type* of project you’re working on.
A fixed price contract, also known as lump sum, establishes – you guessed it – a mutually agreed upon price for the project. If the project exceeds that amount, the contractor is on the hook for the overage. The contract is based on a detailed estimate that is built on a detailed set of construction documents and specifications. The contract scope and/or amount can be altered via “change order,” which must be approved by the owner.
A cost plus contract, also known as time and materials, bills the cost of the work to the owner plus an agreed upon markup percentage. There is a control estimate, but if the work exceeds that amount, the owner pays the overage. The contract should be based on a set of drawings and specifications, but can also be looser – the contractor can work “as directed” rather than to a strict scope that’s already been planned out. There are no change orders, because the work is paid for and proceeds as it happens, not according to a pre-approved amount.
The fundamental difference between these two contract structures is RISK and who is taking it. In a fixed price scenario, the contractor is taking the risk. If the project costs more, they will have to pay…but if it costs less, they can pocket the difference. This means that the contractor will have the tendency to pad their numbers in a fixed price estimate, knowing that they may have to cover themselves. The owner understands they’re paying a bit more for the security of having a fixed number.
In a cost plus scenario, the owner is taking the risk – if it’s more expensive, they have to cover it, if it’s less expensive, they keep that money in their pocket. Most owners aren’t comfortable giving a “blank check” to a contractor, and as a result, most cost plus contracts have various measures in place to cap costs. That could be a GMP [guaranteed maximum price], or various contract provisions that require the contractor to check in with the owner for certain overages, issues, scope changes, etc.
There are advantages and disadvantages to working under each structure – some of that has to do with the project itself, and some of it has to do with you and your personality. If you’d rather have the surety of a fixed price, you should go that direction, for example – but you have to understand that the contractor will be padding their numbers.
For some projects, there is no real way to fix the price – for renovations, for example. Even with the most complete and detailed set of drawings, there are still too many opportunities for surprises. As soon as you open up walls, you may find all kinds of issues that require additional work. That’s not the contractor’s fault, and they would have no way of knowing about those surprises. So, often, renovations are handled with a cost plus contract.
Cost plus contracts are also useful when you *don’t* have very detailed drawings, or you need to get started in a hurry. A contractor won’t be willing to fix a price on a napkin sketch [or, they might, but it will be a ridiculously high price because they simply don’t know what the project contains], but they can certainly get going on the project with a cost plus. The contract establishes the methods and logistics of working together, the percentage markup, etc, but does not come with a fully fleshed out scope.
In reality, most construction contracts are a bit of a hybrid between these two approaches. For example, in a fixed price contract, you may have portions of the scope that are undefined yet – you don’t want to hold up signing the whole contract, so you assign those undefined categories an “allowance.” An allowance is a placeholder amount that will be honed once the scope for that category is honed; it also places the risk back on the owner.
For example, you may have everything figured out for the project except for the appliance and tile selections. No need to hold up the whole contract and the whole project, just assign an allowance – let’s say $20k for appliances and $15k for tile. If you, as owner, end up spending more than $20k on the appliances, it’s on you, and if you spend less, you get that money back. Same with the $15k for tile.
When dealing with allowances, it’s important to remember *what* is included – is it just material? Labor? Markup? That $15k for tile changes real quick if it’s also inclusive of the contractor’s 20% markup, the backerboard and Schluter, and the labor to install. Typically, allowances are material only, unless it’s something highly specialized.
It’s worth checking consumer protection laws in your state – many have rules around what contractors are obligated to provide in their contracts, control estimates, etc – especially for projects with homeowners.
While it’s beyond the scope of this topic, there are other contract provisions you should make sure are considered and included, whether the contract is cost plus or fixed price:
Duration, and what happens if the contractor takes longer than the stated duration
Invoicing schedule – whether you’re paying in cash or working with bank draws on a construction loan, you want to be sure you’re not letting the contractor get ahead of you
Final payment – there has been a lot of ink spilled trying to define what constitutes a “finished project” – is it final inspections, move-in, end of punch-list? Be sure you know and have that covered, so you’re not left hanging.
Retainage – many residential contractors will not agree to retainage, but it’s worth investigating. This is also highly regional – it’s more normal for some areas of the country than others
How to get out of the contract – extricating yourself from a construction contract can be complicated – most contractors won’t be eager to take over a project that another contractor was fired from, so you want to be sure you’re getting this part right [and the whole thing, for that matter, so you don’t have to worry about getting to this point!]
Many, many more!
Another word of caution - many contractors have an “in-house” contract they’ve developed – they obviously prefer that owners go with that one, since it’s usually highly in their favor. The American Institute of Architects [AIA] suite of contracts – especially for small projects – is usually a safer bet, in terms of having stronger protections in place for the owner. You can learn more about AIA contracts, which have been around for more than 100 years, here. There’s nothing automatically wrong with using a contractor-generated contract, just be sure to double check it with your attorney!
The bottom line when trying to decide between cost plus and fixed price contract structures is that there’s no one-size-fits-all solution for every project and every owner. Working with seasoned professionals who are acting in your interest – attorney and architect – as well as reputable contractors with a good track record – are all your surest bets to avoiding conflict and being dealt fairly with.
Good contractors who’ve been in business for a long time, and who have a strong stable of quality references, didn’t get there by constantly having contract disputes or dealing unfairly with their clients…so in many ways, finding the right contractor first will make the contract negotiation a lot easier!
Conclusion
Thank you for joining me for this 5-part series! If you’re interested in downloading the whole thing in an E-book format, you can do that here. And of course, all 5 installments will be freely available on Substack, in newsletter format.
After writing nearly 8000 words on this topic [!] I feel like there’s still so much more ground to cover…please let me know if you have specific questions or have other topics/deep dives you’d like me to cover! And as always, thank you for being a subscriber – please do share with someone who might find this useful!