Deciding Between Fixed-Price and Cost-Plus Contracts

There are two basic methods of handling remodeling contracts: the fixed-price contract, commonly utilized with smaller, straightforward projects, and the cost-plus contract, utilized with larger projects with frequent changes being a common aspect.

Fixed-Price Contracts

Many of us entered the remodeling business as cabinet dealers, and so it was logical that contracts for a sale that was primarily product oriented would be a fixed amount based on the cabinet layout and cost of the cabinets. As long as a majority of the cost of a project was made up of product, it was fairly easy to project what the cost would be and, therefore, a fixed-price contract was a relatively safe proposition.

As the nature of the projects undertaken becomes more complex, the portion of the cost that consists of labor and/or subcontracts becomes increasingly more difficult to predict. Unlike new construction, remodeling projects usually include a "discovery" process during the demolition phase, where the existing structure and construction quality are revealed. As this complexity grows, the fixed-price contract creates tension in the relationship between contractor and client.

The key to successful fixed-price contracting lies in the planning and specification phase. In order to accurately predict costs of such projects, it is necessary to thoroughly prepare the plans and specifications and have as many of the client's decisions finalized prior to the signing of a contract as possible. Once this has been accomplished, each element of the construction process must then be priced. Once again, product pricing is relatively straightforward, while labor and subcontractors provide the challenge.

If you utilize subcontractors, it's possible to have each of your subs bid their part of the work from the plans and specs. The drawback here is that, if you do many small- to medium-sized projects, your subcontractors will be spending almost as much time bidding your work as they are actually doing it. Additionally, you will still have to have a means of pricing your own employee labor into the jobs. For jobs of this scale, you will need to develop an estimator within your organization who can consistently predict what these costs will be.

As mentioned previously, the plans and specifications become critical to determining what work you will be paid for and what you won't be able to collect. If the specifications are not complete and clear, the client will tend to want the benefit of the doubt as to whether something is or is not included in the contract price. Even when your specifications are very clear, you will often have clients tell you that they "told their salesperson they wanted something and it should have been included."

There are also issues of "scope creep," where the client wants a few more electrical outlets and a little larger tile area, and perhaps the carpenter could put up a shelf in the garage. None of these may be significant and we are all probably a little reluctant to "nickel and dime" our clients with change orders, but they do add up. If adequate contingency money is not in your price, you cannot maintain your profit margin.

The fixed-price contract becomes even more difficult to manage when the client wants to get started with the project while the plans and specs are still being revised. It then becomes worthwhile to consider a different approach to major projects.

Cost-Plus Contracts

When you encounter a project that just doesn't fit the fixed-price model, then the cost-plus approach should be considered. Keep in mind that, whether you work on a fixed-price basis or a cost-plus basis, you still need to maintain the same gross profit margin.

While a reliable job-cost system is necessary for all projects, it is more important than ever when it comes to cost-plus jobs. Your system needs to be able to capture all costs related to each job and provide the necessary documentation to your clients for them to feel confident in their billing.

There are many variations of the cost-plus fixed fee arrangement. Normally, it will have three components that account for your profit margin. These are your charges for design and designer assistance, a fixed fee and a minimal overhead charge. This can be structured and presented in several ways, but must end up producing the required gross profit margin.

The advantage to this approach is that you are not faced with the tension over whether or not items are or are not included within the fixed-price contract.

There are, however, some pitfalls to this approach, as well. For instance, it's important that the contract provide for changes in the fixed fee if there are significant changes in the scope of the project, in order to protect your profits.

You should also take a look at how you classify costs between direct cost and overhead items. There may be some items that you have classified as overhead that will need to be fed into job cost for this type of contract accounting. Examples of these might include delivery driver time, protection materials, etc.

Another area to make sure you cover is what your responsibility will be for materials and work that are not part of the contract. Your client may expect that you will coordinate and supervise this work, even though you may not have felt you were covering this with your fixed fee.

If you use a large percentage charge for your overhead, you will be covered for the "scope creep," but this will provide an incentive for the client to want to move work outside of your contract. Make sure you cover how this sort of situation is to be handled. It's best to have your contract worded so that all work up to the point of occupancy is included, since you will probably wind up supervising it anyway.

The cost-plus contract will allow you to discuss your actual costs for materials and subcontractors to your client, without the discussion of whether or not you are applying a fair markup to the costs going into the project. In this day of online shopping and big-box stores, there seems to be a trend toward more questioning of the prices we are charging for products going into our projects.

Regardless of which contract format you choose to use, make sure you are clear on what your actual costs are. You must then build into your pricing of these the amount of gross profit you need to cover your overhead costs and produce a profit for your business.