Fixed-price vs Cost-plus Building Contract

When planning your new build construction work, one of the first and most important things to consider is choosing which contract you’ll use. Construction contracts provide you with the legal framework for your project, making sure everything is above board and you’re not burned by uncertain payment terms, delegated responsibilities, change order processes, and more.

The type of contract you choose will significantly impact both parties in many ways, including costs, incentives, and financial risks. Fixed-price and cost-plus are two of the most common building contracts to utilise here, each coming with its own benefits and drawbacks. Explore both types of contracts, along with which is best for you, below.

What is a fixed-price building contract?

A firm fixed-price contract, otherwise called a lump sum contract, is an agreement where a total cost is given for the entire scope of the project before any work commences. This is a base contract price and can’t be changed later based on actual costs or unforeseen circumstances. Both parties will agree on this number before work begins, and once set, the price has to remain constant no matter what.

What are the key features of a fixed-price building contract?

The main features of a fixed-price contract are:

• A total price is set and agreed upon by both parties before any work commences
• The contractor assumes full responsibility if expenses exceed the initial projections by locking in the fixed-price
• Project owners are protected from any unforeseen costs, even if labour or material prices rise unexpectedly
• Risk is shifted away from the project owner and placed entirely on contractors who estimate all costs, giving them more incentive to contain expenses and operate efficiently to avoid wasting money

What are the benefits of fixed-price contracts?

As you might’ve guessed, there are some clear benefits of fixed-price contracts for developers:

• Cost assurance: As the developer, you’ll be able to depend on the fixed price that you and the contractor agreed upon at the start of work – without any nasty surprises as work progresses.
• Contained costs: Contractors will have a strong incentive to make sure they stick within their budget dictated by the fixed pricing instead of relying on you to pick up the slack.
• Less stress for the project owner: If you’re concerned about a fluctuating price, you’ll have to scrutinise expenses, change orders, and continually follow up with your contractor to speed up the process.
• Potential quicker turnaround: Contractors won’t want to waste time on labour costs due to slow workers, so they’ll be stricter on their teams to make sure they’re working efficiently and getting the job done quickly.

What are the drawbacks of fixed-price contacts?

However, it’s not all sunshine and rainbows when operating a fixed-price contract – there are also a few drawbacks:

• Less flexibility to alter the scope: Fixed-price contracts don’t usually allow for change orders, or they can at least make them more difficult and expensive for the project owner.
• Potential disputes: If you need to change your project’s scope, both you and your contractor may become frustrated by the inflexibility of fixed pricing, resulting in disputes over the extra costs.
• Increased risk of cutting corners: If your contractor is trying to fit the work within a tight budget, they might use cheaper materials or take shortcuts which can leave you with quality issues.

What is a cost-plus building contract?

A cost-plus contract is an agreement where the project owner is billed by the contractor for any and all costs incurred by the work as it’s completed. They’ll also bill for a pre-negotiated amount for profit. While there are a few negotiations discussed before work begins, the final price won’t be determined until after completion as the project owner will need to pay the actual costs instead of a projected sum. This contract directs all costs, including labour, materials, equipment, subcontractors, and other expenses to the owner.

What are the key features of a cost-plus building contract?

• The actual price of work isn’t finalised until after the project has been finalised
• Project owners will assume all responsibility for the actual costs of labour, materials, and more, as well as an agreed-upon profit margin
• The profit margin is usually a percentage of total costs, such as 15% on top of all reimbursed expenses
• Most financial risk is put on the developer, including a higher actual cost that exceeds the budgeted costs
• Contractors are guaranteed a profit regardless of whether the initial budget is met or not

What are the benefits of cost-plus building contracts?

Just like fixed-price contracts, cost-plus contracts come with plenty of benefits, including:

• More flexibility to change project scopes: Cost-plus contracts let project owners modify the scope of their project much more easily, even as the project begins to conclude, as the added flexibility can accommodate your requirements without disputes.
• Project owners can closely monitor spending: You’ll have the right to monitor what your contractors are spending on a weekly and monthly basis, so you can request expense reports and scrutinise them to prevent overspending.
• Prevents contractors from cutting corners: A cost-plus contract guarantees contractors a profit, so they’re less likely to cut corners in order to achieve the biggest profit margin possible. You might see fewer compromises to quality with this type of contract.
• Gives developers more say in decisions: As you’re paying for the final materials, you can have more say in the decisions and make sure your contractor is getting the best deals possible.

What are the drawbacks of cost-plus building contacts?

There are also drawbacks to cost-plus contracts, such as:

• Costs can become higher than your budget: Without the reassurance of a fixed-price contract, you might not notice the total cost exceeding your initial budget. This puts extra financial risk on owners.
• Contractors have less incentive to contain costs: Since their profit margin doesn’t change and they’ll most likely get paid more for the extra costs, contractors don’t have any incentive to minimise expenses or operate as efficiently as if they were under a fixed-price contract.
• Extra burden on the project owner: While scrutinising over expense reports gives you more say over costs, it can quickly become overwhelming when you’re also dealing with other responsibilities as a project owner.

What are the key differences between fixed-price contracts & cost-plus contracts?

The main difference between a fixed-price vs cost-plus contract is who the financial risk falls onto. With a fixed-price contract, the contractor swallows all financial risk due to working for a price pre-negotiated before work commences. With a cost-plus contract, the project owner will be burdened with any financial risk as they’ll pay the total costs plus interest, even if this exceeds their initial budget.

Most contracts, whether they’re fixed-price or cost-plus, will require the bill to be paid after work has finished. Cost control is another key difference though, with fixed-price contracts requiring higher levels of cost control by the contractor to make sure they still make a profit. Cost-plus contracts still require cost control, but this will fall onto the project owner’s shoulders. You’ll need to adopt detailed cost tracking and reporting to make sure you don’t exceed your ideal budget.

How to decide which is best for your situation?

You might think choosing between a fixed-price and cost-plus is easy – but there’s more to consider than just financial risk and the final price. Here are some factors to consider before choosing the type of contract to write up:

Predictability of project scope

The project scope is how long you believe it will take to complete. Fixed-price contracts are much less forgiving for scope changes and will often end in discrepancies between the contractor and project owner, so if your project scope is likely to change during construction, a cost-plus contract gives you more flexibility to accommodate these changes.

However, if your plans, specifications, and expectations are very well-defined and unlikely to change during the project’s timeline, a fixed-price contract might work best. It gives the contractor an accurate estimate of the timeline on which to base their overall cost.

Your financial risk tolerance

Project owners who are willing to accept the possibility of actual costs exceeding budgets can still utilise the benefits of cost-plus contracts, despite the extra financial risk. If you’re not worried about absorbing the extra costs, you can enjoy higher quality and extra control over your project thanks to your contract type.

However, if an owner demands strict cost certainty and is very unwilling to tolerate financial risks, they can push for a fixed-price contract to control their spending and have the contractors absorb this risk instead.

Trust between contractor and project owner

How much trust you and your contractor have in each other will also influence which type of contract you choose. If you have a positive relationship with your contractor, cost-plus contracts are often more tolerable and easier to work through. However, if this is the first time you’re hiring your contractor and are unsure of whether they’re trusted or not, a fixed-price contract might be more desirable to prevent you from having to pay for their procrastination or higher material costs.

Size and complexity of your project

Larger projects that are projected to last multiple years often require the flexibility of cost-plus contracts, but the sheer size of them can also make it more difficult for you to keep on top of your expenses and total budget.

Smaller projects with limited scope can leverage fixed-price contracts, even if some change orders rear their heads. Simple projects are also easier to project expenses for, so contractors are often happier to use this type of contract for quick and easy projects.

Common mistakes of each contract type & how to avoid them

Common mistakes of fixed-price contracts include:

• Using them when you’re uncertain about the scope of your project, as fixed-price contracts don’t offer much flexibility
• Not vetting your contractor beforehand to make sure their work is up to your standards, as fixed-price contracts can lead to cutting corners
• Neglecting to inform contractors of defects and difficulties, as these can land you disputes or claims from the contractor
• Not getting multiple quotes from contractors, as some might inflate prices to earn more of a profit from your project

Similarly, common mistakes in drawing up a cost-plus contract include:

• Not setting out a clear budget with your contractor so they can attempt to stay below it
• Failing to create a contingency budget to use should the total cost exceed your budget
• Not utilising your ability to check over all expense reports to keep an eye on where your money is going
• Not checking contractor reviews and previous customer testimonials to make sure they’re trusted enough to operate under a cost-plus contract

Get free advice from an experienced building broker on the best way to build your new home

Are you about to draw up a contract with your contractor and are still unsure which is the best contract for your business relationship? Our team at Buildi is full of expert building brokers to help give you as much free advice as you need. Give us a call at 1300 947 132 or fill out our Contact Form to talk to one of us and choose the best contract for you once and for all.