Cost-Plus vs. Fixed Price Construction Contracts:
Pros and Cons
Cost-Plus vs. Fixed Price Construction Contracts: Pros and Cons
Cost-plus and fixed price comprises the two most popular ways to contract a construction project. Fixed price construction contracts are built with a specific price in mind that won’t change throughout the course of the job, whereas cost-plus construction contracts use a variety of incentives to keep costs low while preventing ambiguity.
Each type of contract is advantageous under certain circumstances, and when purchasing or providing contracting services, understanding the differences between different contract types and their variables can be essential.
Client-Side Contracts: The Advantages And Disadvantages Of Cost-Plus
To evaluate the advantages of different construction contract types, it’s best to consider each contract from different perspectives. From the client side, the ostensible advantage of cost-plus contracts is improved work efficiency and lower costs.
Cost-plus contracts encourage contractors to buy quality materials, but as contractors are often sharing part of the costs of the job, there’s also an incentive to avoid overspending. Under the terms of most cost-plus contracts, the client will also receive receipts and detailed information about the various costs associated with a project. This information can be useful when evaluating the effectiveness of a provider or when planning for future projects, although this assumes that the client contracts construction work on a regular basis.
Even so, cross-charging fraud is still common when construction companies have both fixed price and cost-plus contracts with a single client, as the contractor’s employees will often report hours under the cost-plus contract. Other types of fraud associated with cost-plus contracts include product and material substitution.
The possibility and potential costs of fraud can be limited or even eliminated with sufficient project oversight and appropriate contract terms. Even so, fraud creates real costs that must be considered when trying to understand the advantages of different types of construction contracts.
Advantages And Disadvantages For Contractors
From the contractor’s side, there are several disadvantages to cost-plus contracts. They can be costly when certain overhead costs are not billable or when direct costs are disallowed under the terms of the contract. As such, construction companies must carefully analyze their potential costs over time before accepting or bidding on cost-plus contracts. This includes office rental fees, regular salaries and other costs that are not related to the job. Billable expenses vary under different types of contracts, so construction contractors must also carefully evaluate the terms of the agreement before making any purchases.
In many cases, the type of cost-plus contract will determine whether or not the construction contractor will see many advantages from its implementation. Cost-plus fixed fee (CPFF) contracts are the most common type of private cost-plus contracts, although, in the public sector, CPFF has been overtaken by other options over the past several decades.
CPFF construction contracts provide construction contractors with reimbursement for part of the costs of a job along with a fixed fee, which provides contractors with an assured payment upon the completion of the job. However, construction contractors need to remember that budget overruns will decrease their total profit. The advantage of CPFF is that it provides contractors with a clear payment schedule that can be used to effectively determine the potential profits associated with a job.
In cost-plus award fee (CPAF) and cost-plus incentive fee (CPIF) contracts, the contractor may receive a higher payment for meeting certain metrics. These are common contracts for large business, military and public construction projects, as they provide the cost-inhibiting characteristics of a traditional CPFF contract with graduated incentives for completing a job quickly.
For many contractors, the incentives of these types of award-driven contracts help to overcome the potential disadvantages inherent in a cost-plus contract and may actually be preferable to the relative stability offered by fixed price construction contracts and CPFF contracts. An award-based cost-plus contract may not be preferable if the terms of the award are unrealistic or if the job is fairly small.
Fixed Cost Advantages For Private Contracts
When considering cost-plus and fixed price contracts, it’s almost impossible to avoid mentioning the major advantages that cost-plus contracts can provide for government projects, some of which have already been mentioned.
Cost-plus contracts have been widely accepted as a viable solution to near-legendary construction inefficiencies in government work for decades. Secretary of State Robert McNamara first argued for cost-plus fixed fee contracts in the 1960s, suggesting that they would be 10% less expensive than fixed price construction contracts on average. Pure fixed price contracts with cost coverage don’t provide sufficient incentives to keep costs down or to ensure that projects completed on time, at least for military contracts, and at the time, construction companies were taking advantage of the terms of these contracts.
However, this is not to say that fixed price construction contracts are inherently disadvantaged. They’re an inferior option under specific circumstances, but defence procurement has a different set of challenges than other forms of construction contracting. In public and especially the private sector, fixed price contracts are occasionally preferred for several reasons.
Most notably, a fixed price contract provides a guaranteed price for both parties. Buyers who are working on a budget often appreciate this type of foreknowledge, particularly if they’re not used to or aware of typical construction costs. Likewise, a construction company might be unwilling to accept a variable payment policy for a small job, as it would not be cost effective to handle the administrative costs associated with a cost-plus contract for an additional percentage of the relatively minor costs associated with a smaller job.
Fixed price contracts are therefore preferable for almost any type of small one-time project, including many residential and private business construction jobs. Private home and business construction clients will often prefer to work for a fixed price, as costs need to be carefully controlled in order to avoid potentially massive and debilitating budget overruns.
There’s still an argument to be made against the inherent inefficiencies of fixed price construction contracts, but these arguments are weaker when considering smaller jobs in competition-driven markets. As private construction contractors must compete with one another to win new business, there’s still a strong incentive for quality control in private fixed price contracting. Time and quality metrics can also be built into a fixed price contract, providing an additional guarantee against low-quality materials and workmanship.
Finally, code requirements can provide severe penalties for construction companies who don’t provide quality services, although code requirements vary from one area to the next. Local laws may even provide guidelines for construction contracts and may technically ban cost-plus contracts in certain parts of the United States.
In any case, the legal and competitive incentives are strong enough to make fixed price contracts an appropriate choice in many circumstances. While the only real advantage of fixed price is a firm total cost, this is a significant advantage under the right circumstances and certainly worthy of consideration.
Acceptable Costs And Other Variables: Controlling Construction Contracts
Buyers have control over many variables when setting up construction contracts, and as such, there’s no overarching answer to the cost-plus versus fixed price question. Variables must always be considered and costs must be managed in a way that provides an acceptable profit for the contractor and high-quality results for the client.
While cost-plus contracts are generally favourable for their incentive-based structure, they’re especially useful for private construction when the contract language specifically limits costs while providing an incentive to save. A not-to-exceed total cost will provide private individuals and groups with the information that they need to form a budget and peace of mind while still utilizing the general cost efficiency of cost-plus contracting. Likewise, the list of acceptable costs associated with a project can also be carefully defined, preventing construction companies from taking advantage of a project or running up unrealistically high bills for the client.
There are certainly other considerations. Oversight is essential for many larger cost-plus construction contracts, especially when a given contractor is providing services under a related contract. Again, oversight can be built into a contract, although this can prove problematic for construction companies and can lead to inefficiencies that drive up overall costs. In general, it’s safe to say that cost-plus provides a wider set of incentives for the contractor, which can be leveraged effectively by the client for a better result, especially on larger contracts. Fixed price construction contracts should only be used for small jobs in which guaranteed costs are extremely important for budgetary reasons.
The simplicity of fixed price construction contracts makes them a highly agreeable choice for private clients, but when efficiency and quality are critical, cost-plus contracts offer a wider set of tools for ensuring that construction projects are completed appropriately.
Credit to: Design Green Construction, a division of Lorman Business Center.
