There are generally two types of construction contracts — time and material and fixed price. In a time and material contract the owner pays the actual costs of the project plus a predetermined percentage or amount for overhead and profit. In a fixed price contract, the owner pays a preset amount for the project, regardless of the actual costs. The contractor bears the risk of underbidding the project and reaps the rewards of cost efficiency.
Often, when you, the contractor, are bidding a fixed price project, the homeowner wants to know how you arrived at your price, or they want to see a “breakdown” of the price to see where they might cut costs. In an effort to accommodate the homeowner, you provide a spreadsheet which allocates a dollar amount to line items of work and materials. The amount at the bottom of the spreadsheet reads as follows:
- Total Costs: $100,000
- Overhead: 10% $10,000
- Profit: 10% $10,000
- Total Fixed Price: $120,000
In all likelihood the various line items broken down to make up the $100,000 include markup amounts. In other words, you do not want to disclose that your true markup is 40 percent because you do not believe you will get the project if the owner knows your markup is that high (although reasonable). Therefore, you hide the markup in the line items and disclose a 20 percent markup at the bottom.
So what is the problem with this scenario? At the end of the project the homeowner may have the right to see all the invoices from the project in order to verify your cost breakdown and actually demand a return of any excess profit. But you are saying: “This was a fixed price contract. They don't have a right to see my books!” The truth of the matter is, however, that they probably do.
When you bid the project you represented to the home-owner that you would only mark up the costs 20 percent for your profit and overhead. In addition, you represented to the homeowner that the “cost” of the project would be $100,000 based on your knowledge and experience. If the homeowner believes that a 20 percent markup is fair and that you truly will have costs of $100,000, they may refrain from seeking out other contractors to bid the project. In fact, they would be looking for a contractor that would be willing to do the project for less than a 40 percent markup, and they could probably find such a contractor. But they don't look for one BECAUSE OF YOUR DISCLOSURE! You have misrepresented information to them and they have relied on it. As a result, you can rest assured that they will be looking for those receipts if something goes wrong with the project or they become aware that the actual costs are less than what you represented.
So how do you avoid the problem and still give the home- owner a breakdown of costs? Try the following:
- Never disclose the percentage markup. Bury the markup in the line items.
- Include a statement that the line items are your price for those items, that each line item contains a markup for overhead and profit and that actual costs of the project may vary.
- Include a statement in your contract that the project is being performed on a fixed price basis and the homeowner is not entitled to review the actual costs of the project.
Keep in mind, if you use allowances or if you have time and material change orders, the homeowner will still be entitled to see receipts associated with those items.
The moral of the story: If you make a disclosure to the homeowner, make sure it is truthful.
Nancy A. Chillag , an attorney specializing in remodeling issues, returns after writing a book for homeowners on how to manage the remodeling process.