What Exactly is a Cost Plus Construction Contract?
Definition of a Cost Plus Construction Contract
To start, a cost-plus contract is where the contractor is reimbursed for the actual building costs plus an agreed-upon fee. This fee is usually a percentage of the actual project production costs. Example: A contractor uses a 5% mark-up on the actual production costs of the project.
What a Cost Plus Construction Contract Entails
In the construction industry, the "cost" parts of a cost-plus contract are made up of all the raw materials and direct labor used for the project, along with the indirect costs. These indirect cost expenses are things such as the daily operations costs for running the construction company during production, or the indirect costs of the project such as the cost of renting the equipment or transporting workers to the job site.
For example: The direct labor costs for framing the walls for a new commercial office project may be $500,000. The cost of materials for the walls (studs, screws, shims, drywall, drywall screws, etc.) is another $100 , 000. The cost of operating the construction company for the three months during the project (rent, utilities, wages, insurance, overhead) is another $250,000. The cost of renting the boom lifts for the six months they were on site is $50,000. The cost of transporting workers to and from the job site during the project is $10,000. This netted a total of $910,000 paid to the contractor.
Under a cost-plus contract, the contractor would receive their 5% fee added to the cost of $910,000, or $45,500. This would mean the total owner cost for this cost-plus contract would be $955,500.
Why Use Cost Plus Contracts in the Construction Industry
There are several advantages to using cost-plus contracts in the construction industry. Some of these include:
There are also several disadvantages to using cost-plus contracts. Some of these include:
Cost-plus contracts in the construction industry can be beneficial to both the owner and the general contractor when implemented correctly. A construction attorney may be needed for reading the contract for potential red flags or to understand all of the consequences.
The Vital Elements of a Cost Plus Contract
Cost plus construction contracts can vary widely based on the complexity of the project and the scope of work to be performed. However, there are three key components typically found in any cost plus construction contract. They are likely to include clause provisions to compensate the contractor for the following three components:
Materials: This clause covers hard costs including all building materials and supplies necessary to complete the job. All materials purchased for the purpose of completing a cost plus construction contract are the property of the owner once paid for by the contractor. Any unused materials must be returned to the owner at the completion of the project. All materials used must also be free of liens. It is the contractor’s responsibility to make sure that the obligation to pay suppliers and subcontractors is met and to provide any documentation requested by the owner to support this.
Labor: Labor refers to the cost of both direct and indirect labor required to carry out the scope of work. Direct labor includes the wages paid to workers whose principal task is within the scope of work outlined in the contract. Indirect labor includes subcontractor management, quality control inspections and other supervisory or administrative tasks assigned to direct labor employees. Equipment and overhead costs are not covered in the cost of labor. Again, proof of payment should be expected from the owner upon request so that lien rights can be properly protected.
Overhead: Overhead is a pre-negotiated cost paid to the contractor to cover their indirect costs for the project. It includes office facilities, equipment, vehicles, executive salaries and other general business expenses that are not easily allocable to the project. It is common for contractors to charge a lower overhead for cost plus work than that of a lump sum contract.
Types of Cost Plus Contracts
Cost Plus with Guaranteed Maximum Price (GMP)
A GMP contract provides for the actual cost of construction, however, caps the contractor’s fee at a certain point. It is common to see GMP contracts written as follows: contractor agrees to build a structure for $1,000,000 for a 1% contractor fee or a cost plus 10%, whichever is less. Essentially the fee structure will cap out at $10,000. In this example, if the construction cost comes in at $1,200,000, the contractor still only gets paid $1,010,000. However, if the final bill comes in at $950,000; the contractor receives the same fee of $10,000 despite the reduced costs. For building owners, GMP contracts see the benefit of spending less than anticipated, without paying extra to contractors. For the contractors, they know up front exactly how much money they will make, barring unforeseeable circumstances.
Cost Plus with a Fixed Fee
This is very similar to a GMP contract, the contractor is still reimbursed for costs plus a fee, but the fee is agreed upon before the project begins. The fee is considered fixed, regardless of labor costs and overhead. Unlike the GMP contract, a Cost Plus with a Fixed Fee doesn’t protect the building owner. If the cost to construct and operate the building goes over estimate, the contractor still receives the fixed fee.
The four main variations of Cost Plus Contracts allow for a spectrum of flexibility when deciding how the contract should operate. One of the main benefits to each type of Cost Plus Contract is that the contractor is incentivized to do good work, because the more valuable the building becomes the more the contractor will be compensated. The biggest downside to each type of Cost Plus Contract is that they usually require more oversight by the building owner.
Sample Cost Plus Construction Contract
A basic cost plus construction contract will specify the developer will establish a list outlining various subcontractor fee structures including labor and materials. For example:
• Electrician: $90/hr
• Drywall: $65/hr
• Painter: $50/hr
• Mechanic: $75/hr
• Plumber: $70/hr
• Labor: $50/hr
• Equipment rentals: $ per hour, etc.
The actual cost of parts and materials is added to the cost of labor when invoiced to the developer or owner.
The basic terms of the agreement will provide that the developer is responsible for all payments and costs. At the same time, there are usually caps or ceiling on the amounts paid to specific trades.
In the above example, Drywall would be compensated at the rate of $65/hour until the system is completed. If the work took 10 hours, the developer would pay $650. If the work took 15 hours the developer would pay $975, etc. There would be no time or cost cap with regard to this subcontractor.
To the extent there is less work to complete that anticipated, the developer will pay accordingly. In other words, if the drywall work only took 5 hours to finish, the developer would only pay $325, not requesting back any amount for the already invoiced 10 hours.
Both parties are required to keep accurate and timely records of the materials and labor going into the project.
When is a Cost Plus Contract Beneficial
A big advantage of the cost plus construction contract is its flexibility. By nature, cost plus contracts are open-ended agreements that permit the client to make many changes to the construction project after construction has begun. For example, once construction has started, the client may decide that they want to change one of the installed cabinets for a more expensive one. Or perhaps the client wants to add a tile back splash to their kitchen. This is not a problem under a cost plus contract as it would be under a lump sum contract. How much does it cost? Whatever the material cost is plus the decided upon labor rate between the contractors and the client.
The second advantage is cost transparency. While the contractor is free to make whatever profit he wants on materials sold to the client (this is how a cost plus contract works), the client gets to see all materials costs and billing. Essentially , the contractor is required by the agreement to provide the client with receipts for all purchases made on behalf of the project and to submit detailed bills or invoices for all labor performed on the project. The contractor performs work and submits an invoice to the client. The client reviews the invoice and pays the contractor.
Further, costing and invoicing under a cost plus contract provides the client with detailed itemization of all expenses. From receipts to invoices, the cost breakdown of every item, material and service purchased for the project are presented in a simple and easy to read manner, reducing errors and misunderstandings.
Finally, the client (and the contractor) have peace of mind knowing that the cost of each agreed upon task, service or project is billable. If the contractor did not do the flooring or ran off with an unapproved $5,000 appliance purchase, the client will not be left holding the bag. The contractor is entitled to be paid for work performed but no more than the agreed upon rate and only if expenses are actually incurred.
Common Cost Plus Construction Issues and Solutions
Cost Plus Construction Contracts: An In-Depth Example
Overbudget or Death by 1,000 Cuts – Cost overruns are the biggest problem in cost plus contracting. The contractor is a fiduciary of the owner’s money, and thus has an ethical obligation to avoid overcharging; but a loss incentive to do so. The more cost a contractor incurs, the more money he or she can charge. Plus, there is an inherent bias present in every contractor’s estimate to bid low and then increase allowances later to cover unforeseen costs or to recoup for amounts that should have been taken into account up front. Any way you cut it, however, the owner loses if the contractor decides to package together known costs with unknown costs, or simply does not attempt to reduce known costs. Unlike a fixed sum contract, where the contractor is obliged to eat all of the cost overruns, in a cost contract, he is at least entitled to some recovery, right? The contract must require the contractor to use good business judgment to the greatest extent possible. This can be done either by requiring the contractor to obtain more than one bid on any sub-contract work (and, in reality, this will involve at least three bids, thus giving the contractor the option to take the lowest bidders for each sub-trade or combination of sub-trades), or by limiting markup on change orders or allowances (assuming that the parties to the contract have not already eaten the profit margin through a guaranteed maximum price provision). With regard to allowances and change orders, although the contractor is entitled to a markup, owners are discouraged from modifying a contract until the incentive to exercise the change order clause has been removed by discounting the contractor’s markup from zero to five percent.
Should You Use a Cost Plus Construction Contract on Your Project?
Cost Plus construction contracts are great tools for certain types of construction projects. However, there are several factors that you should consider to help ensure that a Cost Plus construction contract is right for your project.
Does the project involve complicated design elements? If the project will include complex design elements and a lot of changes during construction, then a Cost Plus construction contract will likely be a good option. Under a Cost Plus contract, the contractor will be incentivized to work with the client and designer to create the desired design elements. A lump sum contractor may be less interested in changes, as it could impact its bottom line.
Does the client want flexibility to make changes during construction? A lump sum contract will most likely place significant design limitations on the client. If the client wants the ability to select from different design options or add changes during construction, then a Cost Plus contract will likely be the best fit. A lump sum contract does not usually encourage communication between the client and contractor regarding the design during construction. A Cost Plus contract , on the other hand, encourages ongoing communication between the client and contractor.
Is the project the result of a disaster? If your home suffered a fire and is being rebuilt, or other disaster occurred, then a Cost Plus contract may be your best option. In disasters, the full impact is often unknown at the time of project commencement. A Cost Plus contract allows the contractor to assess the situation and make the changes necessary to effect proper repairs.
Will the project include changes that offset each other? Most Cost Plus contracts allow the owner to make changes to the project. So, if there are changes that reduce the cost of construction, the owner receives those savings. However, when there are changes that increase the cost, there may be a surprise bill when the cost estimate is given to the owner. To avoid this, owners should understand that changes will likely be more expensive and should communicate this to their contractor.