When contracting parties agree to a fixed price or lump sum amount for a defined scope of work, the contractor is generally obligated to build that scope of work for that price regardless of what it costs him to do so or what unmentioned obstacles he may face. His price will typically be set to cover overhead costs and a reasonable profit. And time is money; all other things being equal, the sooner the contractor completes the work, the more profit he will make. Framing a building in a week rather than two, or drywalling a room in a day rather than two, saves money and acts as an incentive to move fast.
Some think that this incentive spawns corner-cutting and less attention to detail, particularly when an owner lacks the resources or (as in most residential construction) the expertise to catch poor workmanship, which is often covered up before any opportunity for observation. A measure of trust is accordingly essential in fixed price contracts.
If quality is an owner’s priority, some think that “cost-plus-a-fee” contracts – reimbursement for labor and materials expenses, plus either a percentage or a fixed amount for overhead and profit – are the way to go. This eliminates incentives to cut corners or rush a project through, as the time spent on “getting it right” will be compensated. But that time may include many man-hours spent reworking areas of the construction that, if the worker were more skilled, should have been built properly the first time. The productivity of the contractor’s workforce is not easy for the inexperienced owner to gauge. A measure of trust is accordingly essential in cost plus contracts.
In the commercial setting, various form contracts are designed to lessen the risks for both fixed price and cost plus contracts by changing “trust” to “trust but verify.” Plans and specifications are more detailed; architects or owner reps observe the work and approve payment; differing site conditions clauses are included; scheduling is monitored; subcontractors are often approved in advance; and in cost-plus contracts a “not to exceed” or “guaranteed maximum” price is often agreed upon, reimbursables are defined with care, and the back-up for reimbursable expenses is scrutinized. Residential contracts rarely include such provisions.
So which type of contract is better? There is no one-size-fits-all answer, but here are some considerations:
1. Is the scope of work uncertain, such that many changes are likely to occur during the project? Cost plus contracts may offer more flexibility and transparency for both parties, and change orders (which is where many fixed price contractors earn their highest return) are less dominant.
2. Are quantities uncertain? “Unit prices” (fixed amounts per linear or cubic yard of work performed or per ton of materials used) can lessen the impact of quantitative uncertainties, and reduce the risk of fixed price contracts for contractors and thus the cost for owners.
3. Is the completion date of paramount importance? A cost plus contract is likely to be lower on a busy contractor’s priority list than his fixed price arrangements, and take longer to complete. And the tracking of expenses by the contractor is project management time devoted to paperwork rather than production.
4. Is saving as much money as possible paramount? In a tight construction market with limited availability of builders, fixed price contracts tend to be padded to deal with uncertainties, contingencies, mistakes, etc.
5. Is the budget set in stone? A fixed price contract gives greater certainty.
6. Are “allowance” items a large part of the price? These make fixed price contracts a hybrid contract, as allowance items are cost-plus elements of an otherwise fixed price arrangement.
Clarity on which type of contract is in place is a must. In the residential setting I occasionally see agreement to what is styled as an “estimate,” followed by disagreement over whether that estimate was really intended as a fixed price when, almost inevitably, the job comes in over budget. The parties should tighten this up at the beginning, at a minimum by limiting the contractor to staying within some agreed percentage of his estimate.
Some think that this incentive spawns corner-cutting and less attention to detail, particularly when an owner lacks the resources or (as in most residential construction) the expertise to catch poor workmanship, which is often covered up before any opportunity for observation. A measure of trust is accordingly essential in fixed price contracts.
If quality is an owner’s priority, some think that “cost-plus-a-fee” contracts – reimbursement for labor and materials expenses, plus either a percentage or a fixed amount for overhead and profit – are the way to go. This eliminates incentives to cut corners or rush a project through, as the time spent on “getting it right” will be compensated. But that time may include many man-hours spent reworking areas of the construction that, if the worker were more skilled, should have been built properly the first time. The productivity of the contractor’s workforce is not easy for the inexperienced owner to gauge. A measure of trust is accordingly essential in cost plus contracts.
In the commercial setting, various form contracts are designed to lessen the risks for both fixed price and cost plus contracts by changing “trust” to “trust but verify.” Plans and specifications are more detailed; architects or owner reps observe the work and approve payment; differing site conditions clauses are included; scheduling is monitored; subcontractors are often approved in advance; and in cost-plus contracts a “not to exceed” or “guaranteed maximum” price is often agreed upon, reimbursables are defined with care, and the back-up for reimbursable expenses is scrutinized. Residential contracts rarely include such provisions.
So which type of contract is better? There is no one-size-fits-all answer, but here are some considerations:
1. Is the scope of work uncertain, such that many changes are likely to occur during the project? Cost plus contracts may offer more flexibility and transparency for both parties, and change orders (which is where many fixed price contractors earn their highest return) are less dominant.
2. Are quantities uncertain? “Unit prices” (fixed amounts per linear or cubic yard of work performed or per ton of materials used) can lessen the impact of quantitative uncertainties, and reduce the risk of fixed price contracts for contractors and thus the cost for owners.
3. Is the completion date of paramount importance? A cost plus contract is likely to be lower on a busy contractor’s priority list than his fixed price arrangements, and take longer to complete. And the tracking of expenses by the contractor is project management time devoted to paperwork rather than production.
4. Is saving as much money as possible paramount? In a tight construction market with limited availability of builders, fixed price contracts tend to be padded to deal with uncertainties, contingencies, mistakes, etc.
5. Is the budget set in stone? A fixed price contract gives greater certainty.
6. Are “allowance” items a large part of the price? These make fixed price contracts a hybrid contract, as allowance items are cost-plus elements of an otherwise fixed price arrangement.
Clarity on which type of contract is in place is a must. In the residential setting I occasionally see agreement to what is styled as an “estimate,” followed by disagreement over whether that estimate was really intended as a fixed price when, almost inevitably, the job comes in over budget. The parties should tighten this up at the beginning, at a minimum by limiting the contractor to staying within some agreed percentage of his estimate.
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