When you’re ready to build your next construction project, one of the first decisions you must factor is what type of contract to use. Understanding the project cost is crucial as it encompasses all expenses related to labour, materials, and other direct costs. The contract is the framework that will govern the entire project, from timelines to payment terms to change orders.
The two most common types of contracts are cost-plus and fixed price contracts, also known as lump sum contracts. Each has its pros and cons that impact costs, risks, and incentives for the owner and the contractor.
Cost-Plus Contract Details
Under a cost-plus contract, also known as a cost-reimbursable contract, the contractor tracks all their direct costs, which are the actual costs incurred during the project, for:
- Labour
- Materials
- Equipment rentals
- Subcontractors
The contractor bills the client for the costs incurred plus an additional pre-negotiated amount for profit.
The owner also pays a predetermined amount to cover the contractor’s overhead and profit, usually calculated as a percentage of the total costs.
For example, let’s say a hospital is expanding and signs a cost-plus contract with a construction company. The contract says the hospital will pay for all direct project costs plus a 10% fee to the contractor. If the expansion incurs $5 million in reimbursable expenses, the contractor would get $5.5 million total – the $5 million in costs plus a $500,000 (10%) fee.
Contractors are required to provide the project owner with an estimate for the total cost of a project, including a schedule of values indicating the estimated cost of each aspect of the project.
The key to a cost-plus contract is that the final price isn’t set upfront. You take on the risk of costs going over budget, while the contractor is guaranteed a profit, even if costs are renegotiated.
Advantages of a Cost-Plus Contract
This type of contract can be beneficial in certain situations:
- Flexibility to change plans: Owners have wiggle room to change the project scope or design along the way without having to renegotiate the entire contract.
- Less incentive to cut corners: When profit is guaranteed, contractors are less likely to use cheap materials or take shortcuts, and owners get better quality work.
- Transparency: Owners can request real-time expense reports to see where money is being spent. This transparency helps both parties understand the overall project cost and ensures that all expenses are justified.
Disadvantages of Cost-Plus Contracts
On the other hand, cost-plus contracts have some built-in downsides, such as:
- Expenses can escalate beyond budgetary constraints: Without a cap on spending, the final cost can far exceed the original estimate if the scope changes or change orders pile up. The owner bears most of the risk. You must closely monitor the actual cost to prevent expenses from exceeding the budget.
- More owner involvement: As the owner, you must spend time reviewing contractor invoices and expense reports to stay on top of the budget, which is a more hands-on approach.
- Less incentive for efficiency: Since profit is a percentage, contractors have less motivation to finish work fast or find cost savings. They may let expenses grow unchecked.
What Does Fixed Price Mean?
In contrast, a fixed-price contract (sometimes called a lump sum contract) requires the contractor to complete a defined scope of work for a set price established initially; unlike a cost-plus contract, where the project cost can fluctuate, a fixed-price contract locks in the total cost from the start. That price is firm regardless of the contractor’s actual costs.
To illustrate, imagine a developer hiring a construction company to build a $10 million office complex. With a fixed-price contract, that $10 million is locked in. Even if the contractor’s expenses reach $11 million, they’re only entitled to the originally agreed $10 million. The contractor bears the risk of cost overruns while the owner has cost certainty.
Advantages of a Fixed Price Contract Construction
The benefits of a fixed-price contract are:
- Cost certainty for the owner: With the price set in stone, owners can budget without fear of surprises. This allows them to understand the project cost and avoid unexpected expenses.
- Incentive to work efficiently: Contractors are focused on being productive and negotiating the best rates on labour costs and materials.
- Less administrative work: Owners can take a step back and be hands-off, with less need to review change orders and invoices. The contractor handles the day-to-day financials.
Disadvantages of Fixed Price Contracts
Fixed-price contracts have some drawbacks too:
- Less flexibility: Changing the project scope mid-stream is harder and may require a new agreement. Owners give up some flexibility.
- Quality issues: If contractors feel pinched by the budget, they may use cheaper materials or rush the work, which may also affect the end product. Contractors may struggle to manage the actual cost within the fixed budget, leading to potential quality compromises.
- Scope change friction: Disagreements can arise if the owner requests changes the contractor sees outside the original scope. The inflexibility can put pressure on the relationship.
Which One is Right for You?
So which one is best? It depends on the project and the contract price. Here are the key factors to consider when choosing between cost-plus and fixed-price:
| Cost-Plus Contract | Fixed Price Contract |
| Clearly defines the project scope and specs in writing | Sets a realistic budget and schedule from the start |
| Establishes a fair change process upfront | Maintains an open, collaborative relationship with your contractor |
| Includes a reasonable contingency budget in case of unexpected costs | Requires regular cost reports and audits |
To conclude, it’s about choosing a contract structure that will set both parties up for success. By understanding the tradeoffs and matching the contract type to the project, owners and contractors can start off on the right foot. When in doubt, get a consultation with our construction cost estimators in Duo QS for guidance.
You can also try out our construction cost calculator to get an idea of the cost of your building project.
Key Takeaways
Construction contracts are big and important. Choosing the right one is the first step in any project. To sum it up:
- Cost-plus contracts are flexible but leave owners exposed to cost overruns. Fixed-price contracts offer cost certainty but less scope to change. Understanding the project cost helps owners budget effectively and avoid surprises.
- Contractors take more risk with fixed-price contracts; cost-plus contracts entrust the owner with keeping costs under control. Monitoring the actual cost is crucial to keeping expenses under control in cost-plus contracts.
- It’s all about the scope, the owner’s risk tolerance, and the relationship with the contractor.
FAQs
What’s the main difference between cost-plus and fixed-price contracts?
The final price isn’t set in stone with a cost-plus contract and will depend on the actual costs incurred. A fixed-price contract locks in the price from the start.
Can the contract price ever change under a fixed-price contract?
Generally, no, but most fixed-price contracts include a “change order” process for altering the scope or price if needed. There may also be provisions for material price escalations.
Do cost-plus contracts always end up being more expensive?
Not necessarily. Cost-plus contracts put more of the cost risk on the owner, giving the owner more transparency and control over expenditures. It depends on how the project is managed.
How do I know what kind of contract is best for my project?
Consider your project’s size, complexity, budget, timeline, and risk factors. When in doubt, consult with an experienced construction professional for guidance.