A construction project is about to begin. How much will it cost? Whether the exact amount is known at the project’s outset will depend on the type of contract the contractor and project owner agreed was best. Two common types of contracts are fixed-price, for which the project’s total cost is predetermined, and cost-plus, for which expenses are estimated but the final price is determined at the project’s end. Profit is also handled differently, with varying levels of risk.
Before entering into either type of contract, contractors and project owners alike should understand their pros and cons and why one may be better-suited than the other for a particular project.
What Is a Cost-Plus Contract?
A cost-plus contract may be a good option for a large, long-term project where it’s difficult to determine the full scope of work and, therefore, the final cost. Under a cost-plus contract, the client agrees to pay the contractor’s direct and indirect expenses for a construction project plus an additional, separate fee representing the contractor’s profit. The contractor provides a thorough estimate of expenses upfront and then carefully documents and provides its records to the client.
A construction project’s direct expenses include raw materials, labor (including specialized subcontractors) and equipment bought or rented for the work to be done. In other industries, these are known as cost of goods sold (COGS). Indirect costs include overhead expenses related to business operations, ranging from office rent, fees for maintaining insurance, utilities, transportation and communication systems, to name a few.
The profit part of a cost-plus contract — the “plus” — can be calculated a few different ways. In a cost-plus fixed-fee contract, the contractor is paid a set, negotiated fee regardless of the final cost of the project. Meanwhile, contracts that base a contractor’s profit on a set percentage of the project’s total cost are called cost-plus fixed-percentage contracts.
To guard against expenses getting out of hand, a project owner may require the cost-plus contract to include a cap on the final price. If, for example, a contractor estimates a project will cost approximately $100,000, the project owner may allot a maximum of another $10,000. If the contract also stipulates a fixed $20,000 profit, the most money that can change hands is $130,000.
A cost-plus contract has advantages for both the contractor and project owner. Flexibility is one, allowing work to begin before the project’s full scope can be determined. Another important advantage: Because project expenses are reimbursed, the contractor can better focus on quality of work, using the best materials, rather than worrying about the cost of materials. This also eliminates the contractor’s responsibility for cost overruns (providing they don’t exceed a cap set forth in the contract). And with profit being its own line item, so to speak, how much the contractor makes on the job is protected against unexpected expenses along the way.
Of course, a cost-plus contract has some drawbacks to consider as well. Significant among them, a contractor must be meticulous about managing and tracking all expenses it lays out in order to be reimbursed. This can create potential cash-flow issues if not handled well, which is why many turn to software for the heavy lifting.
Not knowing how much the project will cost in the end may make some project owners feel uneasy. If profit is to be paid as a percentage of costs, a contractor has little reason to keep costs down, right? A cost-plus contract that includes a cap on expenses can go far in avoiding disputes down the line.
Finally, some project owners may push back on having to pay a contractor’s indirect costs. A contractor will want to think ahead about how to handle the situation should it arise.
What Is a Fixed-Price Contract?
A fixed-price contract is typically used for simple projects with predictable costs. Under this agreement, the contractor and project owner agree to the scope of work required and set a price to complete a project. The contractor’s profit is built into the fee. Any changes along the way — for example, if additional material is needed — would require an approved change order.
Take, for example, a contractor who specializes in building and repairing driveways and sidewalks. The contractor knows exactly how much cement it takes to replace a square foot of a sidewalk, as well as how long the job will likely take. With measurements in hand, the contractor can easily determine how much the project will cost and submit a fixed-price bid for the work.
Fixed-price contracts come in a few variations. The one described above is a firm fixed-price contract. Another type is a fixed-price incentive contract, which includes financial incentives if, for example, the contractor completes the project ahead of schedule. Yet a third type, a fixed-price contract with economic price adjustments (FP-EPA), allows for the fixed price to be adjusted based on inflation or a significant change in cost for materials or labor. This contract usually works better for longer-term projects that span several years.
With a fixed-price contract, the cost is clear right from the project’s outset. Perhaps that advantage is the most obvious. Prices for time and materials are understood in advance. The contractor and project owner know what is to be done and exactly how much money will change hands in the process. The contractor knows how much profit they will make, too.
Administrative needs tend to be minimal with a fixed-price contract compared to a cost-plus contract, but some monitoring is necessary. However, this can be to the contractor’s advantage in terms of managing costs and possibly coming in under budget, which would lead to a higher profit.
Disadvantages:On the flip side, a fixed-price contract may increase risk for any contractor who underestimates the project’s total price. In that case, the contractor is responsible for paying for the added expenses, which eat into the profit margin.
Along those lines, another disadvantage lies in the difficulty in making changes to a fixed-price contract once it has been signed. It’s not out of the realm of possibility that something may change during the course of a project — perhaps a change in direction or scope. A good contract will stipulate a process for making changes, but it’s important to realize such a process can slow down the project’s progress.
Finally, added attention to maintaining costs under a fixed-price contract may sometimes come at the cost of work quality and creativity.
Fixed-Price vs. Cost-Plus Contracts: Key Differences
Differentiating between fixed-price and cost-plus contracts mainly comes down to three factors: budget, profit and risk.
- Budget: A fixed-price contract is just that: fixed. The agreed-on price at the beginning of the project is the price at the end. Conversely, a cost-plus contract estimates a project’s costs but doesn’t set the final price until the project is completed.
- Profit: In a fixed-price contact, profits are not guaranteed. Prices are established at the beginning of the job — with profit built in — but if costs exceed estimates, the contractor has to absorb them. A cost-plus job, meanwhile, separates profit from expenses. Profit can be a fixed fee or a percentage of the project’s total price.
- Risk: With a fixed-price contract, the bulk of the risk rests on the contractor, who must work to keep costs as budgeted so as to not cut into the profit margin. Miscalculations at the onset can also prove costly to the bottom line at the end. With a cost-plus contract, the project owner assumes more risk should a project’s costs exceed expectations.
Choosing the Right Contract
The “right” contract depends on what a contractor and project owner negotiate. Whether fixed-price or cost-plus, all terms must be agreed to at the outset, and each party should feel comfortable with the other. The more significant in scope the project, the more it makes sense to have a legal specialist review the terms. This could save both parties stress and money down the road.
A fixed-price contract is often appropriate for projects with a predictable scope. These tend to be smaller projects that a contractor has performed numerous times, like replacing a roof. But for bigger projects where the scope of work is hard to fully know ahead of time, such as the construction of a new apartment complex, a cost-plus contract is often the better choice.
Either way, it’s critical that contractors track all expenses and keep accurate records not only for reimbursement purposes, but also to maximize their profitability. Project accounting and financial management software automates many of these tasks so that contractors can focus on doing their best work and win new business.
Construction projects carry with them a degree of uncertainty. Just how much underpins whether a contractor and project owner decide to use a cost-plus or a fixed-fee contract. In short, smaller, straightforward projects lend themselves well to a fixed-price contract, which establishes the full price from the outset. Larger, longer-term projects for which the scope is difficult to determine at the outset are more the domain of a cost-plus contract, which estimates costs for a project’s various needs but leaves open a final price until the end. But whichever contract type is selected, all parties should understand their pros and cons and be prepared to carefully monitor and track expenses.
Cost-Plus vs. Fixed-Price Contracts FAQ
Which is better, cost-plus contract or fixed-price contract?
The “better” contract depends on a variety of factors. A fixed-price contract is often appropriate for projects with a predictable scope. These tend to be smaller projects that a contractor has performed numerous times. But for bigger projects where the scope of work is hard to fully know ahead of time, a cost-plus contract is often the better choice.
What is a disadvantage of a cost-plus fixed-fee contract?
A cost-plus fixed-fee contract predetermines a contractor’s exact profit for a project, regardless of the project’s total cost. That means if a project’s scope increases, the contractor still makes the same profit, decreasing the profit margin.
What are the advantages of a cost-plus contract?
A cost-plus contract has several advantages. Flexibility is one, since work can begin before the project’s full scope is determined. Another is that project expenses are reimbursed, which means contractors can choose the best materials, rather than worrying about the cost of materials or the risk of cost overruns. And since profit is separated from costs, the contractor makes money regardless of unexpected expenses along the way.
How much do contractors charge for cost-plus?
The profit in a cost-plus contract is typically set as a fixed amount or a fixed percentage of the project’s total costs. The percentage typically ranges from 10% to 20% of the total cost of the project.