Cost-plus, or time-and-materials, contracts are often used on jobs with a lot of unknowns and hidden conditions, such as repair work. While generally used for smaller jobs, these contracts are sometimes used for large jobs as well — even new homes. Whenever the plans and specs are fuzzy for whatever reason (never a good idea), cost-plus may be the only way to proceed.
On jobs with many unknowns, the client can benefit from cost-plus pricing, in theory, because the contractor does not have to add big “fudge factors” into his fixed bid to cover the unknowns. The homeowner pays only for the actual work completed. Without adequate protections built into the bid, however, the owner is taking on an enormous risk that job costs will spiral out of control. There is little incentive for the contractor to get the job done quickly and cheaply.
In general, cost-plus work is an open book process where bills from the contractor should include documentation of all hard costs. This would include invoices for materials and subcontractors, as well as work hours and billing rates for direct labor supplied by the contractor. This is a trust-but-verify process to ensure that the contractor is keeping good records and billing responsibly. In practice, invoices are often not provided unless requested by the client.
The two main variations of this approach to bidding are cost-plus-a-percentage and cost-plus-a-fixed-fee.
Cost-plus-a-percentage. In this scenario, the contractor bills the client for his direct costs for labor, materials, and subs, plus a percentage to cover his overhead and profit. The problem with this approach is that the contractor has no real incentive to complete the job quickly or cheaply – the longer he takes and more he spends, the larger his profit — not necessarily a good deal for the owner.
Cost-plus-a-fixed-fee. In this scenario, the contractor bills the client for direct costs, plus a fixed fee for overhead and profit. In this case, the contractor is motivated to complete the job quickly and cheaply, or his overhead and profit percentage keeps dropping. If the customer increases the scope of work through change orders or a changed scope of work, then the customer and contractor would need to renegotiate the fixed fee or follow a prescribed formula.
Estimates. Nearly all cost-plus work comes with an estimate of costs. As with a fixed-price bid, the estimate should contain detailed plans and scope of work, and material specifications, along with an itemized breakdown of costs. An exception would be an emergency repair, where there is no time for a detailed estimate, so a ballpark estimate will have to do. However, it should be made clear that all cost-plus “estimates,” are a best guess, not a fixed bid. The greater the unknowns, the less precise the estimate will be.
Guaranteed maximum. When clients are concerned that job costs will spiral out of control, some contractors will provide a guaranteed maximum price. In one version, the contractor will split the savings with the customer if the job comes in below the maximum. In this case the contractor has an added incentive to beat the maximum price (or the set the maximum price high enough that he can easily beat it).
A similar approach is to negotiate a flat fee with an incentive bonus if the job comes in on time and on budget. I’ve also seen cost-plus contracts where the owner has the right to terminate the contractor if the owner is over budget by a certain percentage at any draw by the contractor. The goal is to build in some protections and incentives to help protect the owner from a runaway budget.
Defining job costs. For this approach to work, it’s essential that the contractor make it clear to the owner which costs will be considered direct job costs – and therefore reimbursable. The obvious costs are subcontractors, materials and supplies used on the job, such as lumber and nails, along with consumables such as plastic sheeting, bits, and blades used up on the job. For labor, the reimbursable rate typically includes “labor burden” of employee taxes, benefits, and insurance.
Incidental costs like dumpster fees, permit fees, and equipment rental are typically included. Other costs are subject to negotiation: rental/usage fees for equipment owned by the contractor, vehicle expenses, insurance costs. As an owner, I would expect these to be covered by the contractor’s overhead, but either way, it should be clear what you will be billed for as a job cost.
A related issue is the contractor’s time spent on job supervision. Generally, this is reimbursable if he is on the job site overseeing subs or his own crew (or swinging a hammer himself). Management time off-site is generally not reimbursable unless specific tasks are listed as billable, such as making owner-requested plan revisions.
Pros of cost-plus-a-percentage
- For jobs with a lot unknowns, contractor does not have to pad the price for uncertainty.
- Can get started quickly on jobs with many unknowns and incomplete plans.
- You pay only for work completed, with open books, at a known rate.
Cons of cost-plus-a-percentage
- Contractor has little incentive to keep costs down.
- Owner assumes all the risk of cost overruns
- Requires high level of trust in contractor
Pros of Cost-plus-a-fixed-fee
- Same advantages as Cost-plus-a-percentage”
- Contractor has a greater incentive to complete job on time and on budget.
Cons of cost-plus-a-fixed-fee
- Owner assumes most of the risk of cost overruns
Some people love cost-plus work; some hate it. In theory, it can save the owner money on jobs with a lot of unknowns, since the contractor does not have to pad his estimate to cover the unknown potential costs. In some cases, it probably does save money, but you will never know ahead of time – and you absorb most of the risk of cost overruns.
In some cases cost-plus is an easy fall-back for a contractor with limited experience in estimating, or who does not want to invest the time in producing a detailed estimate. This is dangerous as neither you nor the contractor has much idea of what the project will end up costing.
Also the contractor has little incentive to hold down costs — an ongoing battle on any job site. More often than not, cost-plus jobs end up costing the client more money, sometimes a lot more. Also, the client has little leverage at the end of the job when there may be disagreements over quality issues or the scope of work. What, exactly, was included in the original estimate? You can’t hold back the final check to get the work completed properly, since it’s never clear which check is final. You just keep paying and paying.
For these reason I recommend avoiding cost-plus contracts in most cases. They simply carry to many risks for the owner and few benefits. They often lead to cost overruns and disputes over money.
It’s better to nail down as many costs as possible before starting the job and get a fixed bid. If the plans are incomplete, slow down and get them completed. If there are hidden conditions, cut a hole in the wall to investigate further. For the few unknowns that remain, use reasonable allowances.
Where you must use cost-plus because you cannot get a fixed bid, or there are just to many unknowns, you can reduce your risk with these safeguards. It is best suited for small jobs where large cost overruns are unlikely. To protect yourself, I recommend the following:
- Start with a detailed scope of work, with detailed plans and specs, so both parties have a clear understanding of the work to be down.
- Get a detailed estimate — cost-plus is not an excuse to avoid estimating (although it is non-binding).
- Use a cost-plus-a-fixed-fee contract, not a percentage.
- Try to get a guaranteed maximum for peace of mind.
- Get a clear list of reimbursable costs, to avoid misunderstandings.
- Have the contractor provide detailed records of all reimbursable costs when billing. This should be an open-book approach.
- Only use a contractor with a sterling reputation and good references for similar jobs.