Fixed Price vs. Cost Plus Construction Contracts

Building a new home can be both exciting and intimidating. There are a lot of things to learn about the process and a lot of important decisions to make. One of those decisions might be regarding the form of construction agreement you sign with your contractor. The type of contract that is best for you will depend on a combination of factors including your preferred alignment of incentives, budget flexibility, tolerance for risk, need for detailed disclosure, time and willingness to monitor the process and ability to effectively assess the costs.

There are two main types of construction contract: fixed price; and cost plus.
Essentially, a fixed-price contract establishes a total price for a pre-specified scope of work and includes all building materials, labour costs and profit to the contractor. The contractor takes on the risk that her costs will exceed the contract price in exchange for the potential reward that costs will be much less than the contract price. Since the contractor is taking the risk of a loss if costs rise too fast or high, most contractors will be less inclined to offer fixed price agreement unless they are operating in a relatively stable market or they are large enough to control the risk. On the other hand, a cost-plus contract is an agreement under which payment is made based on the actual cost of the work plus an additional fee. Cost of work typically includes the building materials and labour costs as well as any extra materials that need to be purchased for the construction. The additional fee is the profit (before her normal overhead and similar expenses) to the contractor and is usually a predetermined percentage of the total costs.

Advantages of Fixed Price (for you the owner or buyer):

The most obvious benefit of a fixed-price contract is that it provides certainty of cost. The total cost to you should be known well in advance and the risk of cost overrun is borne by the contactor. It requires the contractor (usually) to deliver a detailed plan and estimate at the very start. Also, your involvement in the project is reasonably limited a small range of selections and your assessment of whether the product being built or delivered is of the same or substantially similar quality characteristics promised.

Disadvantages of Fixed-Price (for you the owner or buyer):

Price certainty often needs to be purchased for a premium. The same principal applies to mortgage rates generally, if you want certainty in the form of a fixed mortgage rate, you will likely be required commit to a higher rate than the currently offered variable or floating rate. Fixed-price contacts can also be less flexible for managing changes. Change requests may lead to complications in the ultimate pricing model and impact the project’s schedule. Another challenge the you may face under the fixed price model is pressure to make most of the major decisions early in the process so that certainty of cost can be built into the process.

Advantages of Cost-Plus (for you the owner or buyer):

Cost-plus contracts can be appealing because they are easy to calculate (requiring less front-end work) and can be applied in a variety of situations. The most obvious advantage to you is the contractor’s requirement for transparency. Under this contract model, the contractor is required to share the details that make up its costs. Also, very little information is needed to start the project. The difficult work of establishing the total cost happens over time as the actual number become known.

Disadvantages of Cost-Plus (for you the owner or buyer):

The most obvious disadvantage of cost-plus is your potential uncertainty regarding the total cost. This uncertainty can be mitigated by an experienced contractor and a carefully managed project and where you are willing to accept and manage potential changes to product required to achieve a certain budget.

Consider the most compelling incentive:

Under fixed-price, one of the primary incentives for the contractor is to complete the work in the shortest amount of time for the lowest cost. In theory, this incentive may not be in perfect alignment with your objective, which is to obtain the highest quality product and has the potential to cause the contractor to focus less on quality and more on speed and cost. This may be a problem particularly if you are not well positioned evaluate the quality of the product. On the other hand, the motivation to establish and maintain a good reputation and to gain referral business from you may effectively counter the incentive to pursue short term profit at the expense of quality.
Under a cost-plus arrangement, the contactor may be less motivated to control costs because as prices rise, his profits may increase. You are at risk of paying an inflated price if you are not well suited to determine whether the “cost” is reasonable and to monitor the project closely. However, the temptation to inflate costs can be countered by the contractor’s incentive to maintain or establish his professional reputation for as an “on time, on budget” work.
Considering what you know about your contractor and your unique circumstances, with which combination of incentives you are most comfortable?

Legal Advice:

No matter which contracts you choose, it is important that it is drafted properly to help you avoid costly disputes. The cost of a contract review or drafting retainer is modest compared with the potential costs of a dispute or misunderstanding your potential liabilities.

Scott Bollinger

Lawyer and Founder of Bollinger & Associates Law