Construction Success Story: Cost-Plus vs. Fixed-Price Contracts

After 10 years in the field, a remodeling contractor had worked on quite a few jobs. Some had been set up as fixed-price contracts and others had been performed on a cost-plus basis. Looking to improve his company’s financial performance, he asked his CPA to review the pros and cons of both formats and to recommend the best approach.

“Both types of contracts can work if you have a reasonable client with clear and realistic expectations,” she began. They both agreed, however, that this ideal situation wasn’t always the case.

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Under a fixed-price arrangement, the contractor establishes a set price for the job regardless of the actual time and materials used. This type of contract requires a detailed and accurate estimate. The CPA advised the contractor to:

• Assess his confidence in his own estimates,
• Examine the calculations he was using to forecast job costs, and
• Arrive at an appropriate markup to cover overhead and profit.

In addition, he needed to re-examine his change order process.

When you have sufficient information going in, a fixed-price contract will ensure that you’ll be compensated adequately. It also gives your client the assurance that his or her budgeted amount will get the job done, barring any major changes (which is why it’s important to have a good change order process in place).

On the other hand, the CPA said, it’s risky to submit a fixed-price bid and sign a contract when too many details remain unspecified. Clients repeatedly ask to set a price before specific fixtures and finishes are decided, for example. So the contractor is continually at risk for underestimating and losing money. Again, it comes down to whether the contractor can establish detailed specs at the outset.

Costly disputes

On a cost-plus job, the client agrees to pay job-related expenses plus an additional percentage or lump-sum amount to cover overhead and profit. When only limited information is available at a project’s outset, this approach allows the contractor to bill for actual costs incurred rather than having to estimate ahead of time.

The CPA noted that, in the past, cost-plus arrangements have enabled the contractor to find the best prices on building assets — saving clients money. She also noted that the company has experienced several expensive and time-consuming customer disputes. Thus, the contractor needed to evaluate whether the fallout from these conflicts was worth the greater pricing flexibility.

Better approach

In this case, the contractor and CPA were able to go back several years and, using historical company data, perform a cost-benefit analysis for both approaches. They decided that, because of his advanced estimating methods, fixed-price contracts were likely better. But this may not be the case with every construction company.

For more information on Smith and Howard’s construction advisory services, contact Marvin Willis at 404-874-6244 or simply fill out the form below.