Why Cost-Plus Contracts are the Better Choice in Custom Residential Construction
When embarking on a single-family residential construction project, one of the most crucial decisions you'll make is the type of contract you'll use. This choice can significantly impact your project's budget, timeline, and overall experience. Two common contract types are fixed price contracts and cost-plus contracts. While both have their merits, we believe that cost-plus contracts are the superior choice due to their transparency and potential for cost savings. Let's dive into the details.
What is a Fixed Price Contract?
A fixed price contract, also known as a lump sum contract, sets a predetermined total cost for the project. This means that the contractor agrees to complete the construction for a fixed amount, regardless of the actual costs incurred.
Characteristics:
Predetermined total cost: The total price is set before construction begins.
Contractor bears the risk: If costs exceed the agreed amount, the contractor is responsible for covering the overrun.
Fixed timeline: The project timeline is generally set in advance.
Advantages:
Predictable budget: Homeowners know the total cost upfront.
Easier financing: Lenders may prefer the predictability of fixed costs.
Simple project management: Less need for detailed cost tracking by the homeowner.
Disadvantages:
Higher initial bids: Contractors often include a risk premium in their bids to cover potential overruns.
Quality compromises: To stay within budget, contractors might cut corners.
Lack of transparency: Homeowners may not see a detailed breakdown of costs.
Scope Changes and Change Orders: Although the price is fixed, it is for a given scope of work. When changes occur during construction (and they always do), the contractor will issue change orders. Since the markup is hidden from the customer, the contractor may use these change orders to make up for losses elsewhere on the project.
What is a Cost-Plus Contract?
A cost-plus contract, on the other hand, involves the homeowner paying for the actual costs of construction plus a fixed fee or percentage for the contractor's overhead and profit.
Characteristics:
Payment for actual costs: Homeowners pay the actual expenses incurred during construction, plus an agreed-upon fee.
Flexible budget: The budget can adjust as project needs evolve.
Homeowner bears the risk: The homeowner is responsible for any cost overruns, as they are paying the actual costs.
Types of Cost-Plus Contracts:
Cost-plus-fixed-fee: The contractor is paid a fixed fee regardless of project cost.
Cost-plus-percentage-of-cost: The contractor's fee is a percentage of the total project cost.
Advantages:
Full transparency: Detailed visibility into actual costs.
Flexibility: Easier to accommodate design changes and unexpected issues.
Potential for lower costs: No risk premium included, potentially lowering overall costs.
Disadvantages:
Less predictable budget: Final costs can vary from initial estimates.
Complex project management: Requires more diligent cost tracking and management.
Potential for disputes: Disagreements over what constitutes allowable costs can arise.
Key Differences Between Fixed Price and Cost-Plus Contracts
Risk Allocation:
Fixed Price: Contractor bears the financial risk of cost overruns, leading to higher initial bids.
Cost-Plus: Homeowner bears the risk of cost overruns, as they pay for the actual costs incurred.
Budgeting and Cost Control:
Fixed Price: Budget is fixed, but often includes a high markup to cover potential risks.
Cost-Plus: Budget is flexible, with transparent tracking of actual costs, reducing the likelihood of inflated prices.
Project Scope and Changes:
Fixed Price: Limited flexibility for changes once the contract is signed.
Cost-Plus: Easier to make adjustments and handle unexpected issues without renegotiating the contract.
Contractor Incentives:
Fixed Price: Contractor is motivated to cut costs, which can affect quality.
Cost-Plus: Contractor is motivated to work efficiently and transparently, fostering trust and collaboration.
The Transparency Advantage of Cost-Plus Contracts
Transparent Cost Breakdown:
With a cost-plus contract, homeowners gain detailed visibility into every aspect of the project's costs. This transparency helps avoid hidden fees and inflated prices, ensuring that every dollar spent contributes directly to the project's success.
Avoiding High Markups:
In fixed price contracts, contractors often mitigate their risk by including high markups. These markups protect them from potential cost overruns but can significantly inflate the project's overall cost. In contrast, cost-plus contracts eliminate the need for such markups, as actual costs are reimbursed, and the contractor's profit is clearly defined.
Better Owner-Contractor Relationship:
The transparency of cost-plus contracts fosters a collaborative relationship between homeowners and contractors. With a clear understanding of costs, both parties can work together more effectively, reducing disputes and misunderstandings. This collaboration often leads to higher-quality work and a more satisfying construction experience.
Choosing the Right Contract for Your Project
Factors to Consider:
Project size and complexity: Larger, more complex projects may benefit more from the flexibility of cost-plus contracts.
Budget constraints: Fixed price contracts provide budget certainty but may come at a higher cost.
Owner’s involvement and preferences: Cost-plus contracts are ideal for homeowners who want to be actively involved in the project's financial aspects.
Market conditions and contractor availability: The choice of contract may also depend on current market conditions and the availability of contractors.
Case Studies:
Fixed Price Contracts: Examples include smaller, straightforward projects where budget certainty is paramount.
Cost-Plus Contracts: Examples include custom homes and renovations where flexibility and transparency are critical.
Conclusion
In conclusion, while fixed price contracts offer the advantage of budget predictability, they often come with higher initial bids due to risk markups and lack the transparency that homeowners desire. Additionally, fixed price contracts may lead to unexpected change orders, with hidden markups, making it difficult for homeowners to understand the true cost of their project. Cost-plus contracts, with their transparent cost breakdowns and flexible budgeting, provide a superior choice for single-family residential construction. By fostering a collaborative relationship between homeowners and contractors and avoiding the inflated costs associated with risk premiums, cost-plus contracts ensure that every dollar is spent wisely, resulting in a higher-quality and more satisfying construction experience.
Final Thoughts:
Selecting the right contract type is crucial for the success of your construction project. By choosing a cost-plus contract, you can benefit from transparency, flexibility, and potential cost savings, making it the better choice for most single-family residential construction projects.
Call to Action:
If you're planning a construction project, consult with a construction professional to determine the best contract type for your specific needs. Transparency and collaboration can make all the difference in achieving your dream home.
Meet the Author
Dave Cook is co-owner of Lighthaus Built and has spent 17 years working in single-family construction in Toronto. Through the years, he has worked as a carpenter, site supervisor, and project manager for more than 60+ major, high-end renovations and custom homes.
As an HCRA-licensed builder, he and his company (Lighthaus Built) are well-versed in constructing high-quality homes and take pride in what they do.
On a personal level, Dave is very active in several sports - most notably, distance running, road cycling, and tennis. He bakes bread (for personal consumption) and no, this was not a Covid thing. He grew up eating homemade bread and has made my own for the past 20 years. He has been married for 20 years and has two teenage children and a dog.