Cost Plus Contracts, Part 1
Cost Plus with No Gross Max Price (GMP) is commonly referred to as simply “Cost Plus.” This contact method has no fixed price. Essentially, the Builder is saying: “I’ll build your house, give you every option you want, and you (the Owner) agree to pay for the material and labor cost PLUS a fee. The fee embodies the Contractor’s profit and overhead. The contract should specify what project costs are to be charged, and what is not. For instance, if your house is wood-framed, you would expect to pay for the labor and framing material to build the walls. These are direct costs and easy to understand. But you may not be expecting to see and pay for indirect costs such as the builder’s supervision to manage the framer and coordinate with other trades.
Direct costs are those items that go directly into the house. Then there are indirect costs that are still essential to complete the project but are not directly related to the building. Some examples may be the builder’s superintendent, (as mentioned above), to manage the day-to-day activity, or the cell phone the superintendent uses, and even the pickup and fuel used by the superintendent. You may also see are items such as insurance, trash haul-off, portable bathrooms, and temporary utilities to name just a few common examples. All of these are typical indirect costs you may see as well as other project and location-dependent items.
Cost Plus with a GMP
This contract method is essentially the same as Cost Plus with no GMP, but it includes an upper limit of costs, called “Gross Max Price.” If the total project costs exceeds the GMP, then typically the General Contractor will have to absorb those costs beyond the GMP and not included in a Change Order. This adds a bit of protection to the Owner. The compromise is that if there is a GMP, typically the fee is higher as the risk to the Contractor is higher.
(Throughout, I’ll refer simply to Cost Plus to include both with and without a GMP).
Cost Plus is the contract method to use if you want to know actual costs for all things in your project, and if you are comfortable with adding complexity to save money. The Owner must be willing to be actively involved in the contract, the budget, and in reviewing construction documents on a monthly basis for a Cost Plus contract to work well. A well-coordinated Cost-Plus contract can save the Owner a lot of money. For instance, on a Fixed Price contract, if the Contractor is able to save money by finding a better material price, or using labor-saving strategies, those savings revert to the Contractor. With a Cost Plus contract, those saved costs are the Owner’s savings. However, the same is with cost overruns…on a Fixed Price contract, the cost overruns are paid by the Contractor, (unless there is a signed change order), while on a Cost Plus, those overruns are paid by the Owner. However, the Owner does have protection from arbitrary cost overruns with Cost Plus.
A common misconception is that Owners can be charged for whatever the Builder wants, including rework. This is not the case if you have a proper contract. The Builder is held to perform to the plans and specifications. If it’s not built per the plans & specs the Owner shouldn’t have to pay for that work unless there is a signed change order. Additionally, an Owner shouldn’t pay for any re-work that is related to fixing mistakes or poor quality. Make sure a clause is in your contract that addresses rework. Mistakes happen, and the Builder should fix them with no additional cost to the Owner.
Elements of a Cost Plus Contract
The Cost Plus contract transfers some of the risks of the project from the Contractor, back to the Owner. This risk is in the form of cost and therefore, the Owner should be charged a lower fee as the Contractor has less risk. In order to manage expectations on both sides of a Cost Plus project, it is essential that the contract contain a listing of all direct and indirect costs as well as a detailed budget.
Indirect costs are essential to the project and should be paid by the Owner. The project cannot be completed without dumpsters, and portable toilets, and such. But Owner’s typically balk when they start seeing contractor supervision and cell phones, and vehicle costs in the budget. Understand, that all indirect costs are also included in a Fixed Price contract, you just don’t see them, and you don’t get any costs that may be saved. With Cost Plus, not only does the Owner see (and approve the costs on a monthly basis) they are able to help manage the costs as well. To manage expectations on both sides, the contract should list all expected indirect costs. The project may have a full-time superintendent assigned while a project manager is assigned only half-time. These two positions have different costs and the billing rate should be established for each. Bear in mind that the labor billing rate is not the same that the individual is actually being paid. The billing rate includes things like Worker’s Comp, insurance, payroll taxes, and the like. These numbers are private and an Owner should not expect the Contractor to share them. As we’ve mentioned before, you may also see cell phone costs, vehicle and fuel costs; you may even see other types of costs such as computer/technology, printing, office supplies, etc. Don’t be alarmed, but do have the up-front discussion with your Contractor to ensure you understand all costs.
The contract should have a fully developed budget as well. A good Contractor will have every cost entered in the budget and labeled as either known, estimated, or an allowance. This budget is the starting point for the project. Sometimes, Owners and Contractors alike think that because it is a Cost Plus, Change Orders are not needed. This is incorrect and will lead you to many troubles. The contract should have a detailed scope of work and reference all current project plans and specifications. Also, the contract should contain a detailed budget as an exhibit. If any scope of work is changed or added, you must execute a change order…even if it’s a no-cost change. If it’s not in writing, odds are it won’t turn out the way you want. Also, Change Orders should be used to document budget line-item transfers. If there are savings in one line item, and an over-run in another, it is normal to transfer funds between line items. Just ensure you do so in writing. The budget should never change unless there is a Change Order or other written and signed instrument that acknowledges and authorizes the change.
And then there is the Fee. The fee includes not only the Builder’s profit but also their corporate overhead. Corporate overhead is different than indirect project costs. Corporate overhead on a Cost Plus project includes items such as corporate office rent, office support staff, office supplies, and so forth. These items are part of the fee. Importantly, the fee also includes the Builder’s gross margin for the job. The fee is different than the overhead & profit (OH&P) numbers that you’ll see on a Fixed Price contract, and they should be lower. (This is because the Fixed Price OH&P includes many of the project indirect costs that you are being billed for separately). The fee is charged on all line items, both direct and indirect costs. But, the fee is not charged on itself or taxes.
Next, we’ll go into shared savings and billing in Part 2 of the Cost Plus Contract for a home building project.