In the business of homebuilding, there are two widely used types of construction contracts:
Fixed Cost vs. Cost-Plus.
Although there are some similarities, these two types of contracts fundamentally differ when it comes to answering the question of total construction cost. In this article, we will explain the difference between Fixed-Cost vs. Cost-Plus contracts. Both have clear advantages and disadvantages that can impact which one will ultimately be the best choice for both the client and the builder. Neither one is inherently “better” than the other, but it is important to know the differences and how each one can impact the financial side of the project.
Fixed-Cost Contracts
A Fixed-Cost contract is one in which the builder agrees to complete the project for a set (fixed) total price based on the plans, specifications, and allowances.
How it Works:
- The builder estimates all labor, materials, subcontractors, overhead, and profit
- A single contract price is agreed to before construction starts
- Payments are typically made in draws based on progress
Advantages for the Homeowner:
- Provides a clear total price upfront
- Easier budgeting and financing
- Builder carries most of the cost risk
Disadvantages for the Homeowner:
- Builder may include a larger contingency fee in the price, resulting in higher total cost to the homeowner
- Changes (change orders) can be expensive
- Less transparency into actual costs
Common Use:
- Production homes or semi-custom homes
- Projects with fully defined plans and selections
Note: Under a Fixed-Cost contract, the builder/contractor assumes most of the risk from a financial standpoint. If the builder misses something, or if an item pertaining to the scope is underestimated, the cost to correct it falls on the builder. The overage is not passed onto the client. Conversely, if the builder receives any credits throughout the project, such as unused pump fees or a lesser-than-estimated final insulation invoice, it’s their gain. If there is any surplus money left over after completion, it goes to the contractor. Savings are not passed onto the client. Fixed-cost jobs will almost always have a higher markup because the contractor assumes most of the risk. The higher the risk, the higher the markup. Another thing to note is that fixed-cost contracts, despite their name, do carry some variability. As one might expect, client-driven changes to the scope will result in change orders that add to or subtract from the total cost of construction, but there are other variable costs that aren’t as straightforward. The biggest example of a variable cost within a fixed-cost contract is an allowance. Allowances are estimated budgets for line-items that often carry uncertainty in pricing. It’s common to use allowances for things like lumber or excavation, for which it can be impossible to know the true cost until the lumber is ordered or the excavation is underway.
Cost-Plus Contracts
A Cost-Plus contract means the homeowner pays the actual cost of construction in addition to the builder’s fee. The fee is usually a percentage of cost.
How it Works:
- The builder estimates all labor, material, subcontractors and estimates a total project cost
- The owner pays actual invoices for labor, material, and subcontractors
- The builder adds the agreed-upon fee for management and profit
Advantages for the Homeowner:
- Flexibility for changes
- Transparent pricing. Clients can see all the invoices
- No large contingency fee in the price from the builder, thus a lower end cost to the homeowner
- Any surplus line-items and cost reductions are credited back to the client
Disadvantages for the Homeowner:
- Final price is not guaranteed. It can fluctuate based on real price increases/decreases and change orders
- The owner carries the risk of cost overrun
- Requires trust and oversight
Common Use:
- Custom Homes
- Complex builds or renovations
Note: If the contractor misses something, or if more material is needed for the project, the cost and fee are added to the project total via a change order. If there are any credits or surpluses, like an unused pump fee, the credit goes to the client, and the cost is deducted from the project total. If there is money left on a line-item after all invoices are paid, the balance goes to the client. The fees charges by the contractor are lesser than in a fixed cost contract because the owner assumes some of the risk due to potential overages, and benefits from any credits due to any surplus line-items. This structure can be very beneficial as long as the client works with a reputable builder whom they trust. Under a Cost-Plus contract, the builder is inherently held to a higher standard regarding the project budget. Because of this, a good builder will be heavily incentivized to provide more “open book” accounting and financial reporting throughout the duration of the project.
So which type of contract does Stockell use, and why?
Stockell Custom Homes uses Cost-Plus contracts for new home builds. There are a few reasons for this:
- We build fully custom homes that can be quite complex and also evolve over time.
- We are extremely confident in our ability to provide accurate estimating during pre-construction and a high standard of project management during construction.
- We greatly value transparency and collaboration with our clients.
Every home we build is a one-of-a-kind original. Nearly every aspect of the home is a custom selection, and these design choices & selections often evolve, even during construction. A cost-plus contract enables us to implement these changes on the fly, without the need for a new contract. In other words, a cost-plus contract simplifies change orders, whether they are requested by the client in the form of design changes, or if they are from unforeseen circumstances. We trust in our ability to keep the combined total of all unforeseen (non-client requested) change orders within 5% of the original contract price, and we have never gone over that percentage regarding cost increases. In addition to change orders that carry additional cost, it is important to mention changes that reduce cost as well. These can stem from design changes, vendor discounts and credits, price decreases, and general surpluses from unused line-items. All of these are quite common and can occur just as frequently as change orders that increase cost. Unlike in a Fixed-Cost contract, these negative change orders (credits) are passed on to the client. In other words, the client directly benefits from and receives these savings. Our ability to minimize unexpected costs and our low markup eliminate nearly all of the “uncertainty” that is often associated with cost-plus contracts.
On the topic of eliminating uncertainty, we like to nail down exact pricing on everything we can before construction begins. During the pre-construction phase, we get exact pricing from our vendors and subcontractors regarding every specification, finish, and selection for the project. Unless the cost of an item is always fluctuating, like lumber, we do NOT use allowances. We strictly use bids from our trade partners that give us a very accurate estimate of how much the home will cost before we begin construction. Before the client signs a construction contract with us, they will see the entire cost of the home broken out into categories, such as Exterior Finishes, Interior Finishes, MEP (Mechanical, Electrical, Plumbing), Building & Framing, and several more. Within each of these, costs are broken down even further into line-items, such as Insulation and Drywall. The cost breakdown needs to be specific enough so that exact costs are defined, as opposed to general lump-sum dollar amounts for categories that don’t properly outline detailed costs.
Because fully custom homebuilding is such a collaborative effort, it is absolutely necessary to be transparent about everything with our clients. This is especially true when it comes to the cost of construction. We are 100% confident in our ability to stay on budget, which is why we are an open book when it comes to sharing all of the specific pricing details with our clients. Our spreadsheets and all project-related financial reporting is shared with the client, because we want them to see how efficient we are. Collaboration requires trust, and the only way to build that trust between the builder and client is through honesty and communication. We do not mark things up or add costs without the client knowing. We are a high-end, luxury custom home builder with 40 years of experience, and it shows in how we operate.
Although Fixed-Cost contracts have their uses, they simply don’t fit our fully custom, detail-driven, and transparency-centered style of business when it comes to most of our projects.
