If you are considering building or renovating a home using a cost-plus contract, think again. From a homeowner’s perspective, there few advantages to cost-plus and many disadvantages. The risks of entering a cost-plus contract far outweigh any potential benefits.
I receive a steady stream of questions and complaints from owners who have run into serious problems on cost-plus jobs. In a number of cases, the final costs are more than double the original estimate.
In many cases, there is no written contract, which is always a bad idea and is illegal for home-improvement contractors in some states. Some homeowners are not even aware that they have entered into a cost-plus contract. They do not fully understand the difference between a fixed-bid and a non-binding estimate. The term “estimate” can be used in both ways, adding to the confusion.
Cost-plus contracts are very risky for the homeowner. Even a contractor of the highest integrity is not immune to economic incentives. It’s just human nature. A disproportionate number of these jobs end up in dispute. Consider these risks before entering a cost-plus contract.
RISKS OF A COST-PLUS CONTRACT
- Cost controls lacking: The contractor has no economic incentive to control costs, always a difficult task on construction sites.
- Perverse incentives: The contractor has a perverse incentive to increase costs and job duration – especially on a cost plus-percentage job. The longer it takes, the higher his profit.
- Estimate is non-binding: The “estimate” you receive is just a non-binding “guesstimate”. The contractor has little incentive to put a lot of hours into a precise estimate. Without a guaranteed maximum price, the estimate could be way off. You may have spent 100% of your budget on a job that is 50% complete. It happens!
- Pass-through costs: The contractor has no incentive to negotiate and shop for the best prices from suppliers and subs that pass through to you. Subs may also be working cost-plus, increasing the risk of cost overruns.
- Pay twice for mistakes: If the contractor makes a mistake, or there are problems with materials or their installation, you will pay extra to make things right. You may pay to have the work done twice.
- Permitting and code compliance: If there are problems with permitting, code compliance, zoning, or engineering, you will absorb all the additional costs.
- Double dipping: Some contractors charge hourly for supervision, office expenses, customer meetings, and other administrative costs that should be covered by the markup.
- Cost information lacking: Change orders are rarely used, so you may not learn about “extra” costs or cost overruns until it is too late to make adjustments. You may get large surprise bills at the end of the job.
- Punch list costs: You will have no leverage at the end of the job to get substandard or incomplete work finished correctly or the job site cleaned up. Your punch list comes with a bill.. Either you pay more to have the loose ends tied up, or you will end up doing them yourself.
- Callbacks and warranty claims. If problems crop up after the final check has cleared, will the contractor charge you to come back and make things right? Not always clear on cost-plus jobs.
Get the picture? As unanticipated costs pile up, you pay and pay and pay – sometimes with no end in sight. By the time you realize that job costs are spiraling out of control, you are too far along to change course or back out.In theory, the owner can save money, since the contractor does not have to pad his budget for “contingencies,” that is, things that do not go as planned, items missed on the estimate, or other unknowns that cause cost overruns.
I believe that Murphy of “Murphy’s Law” was a construction contractor. Murphy’s Law states that if anything can go wrong, it will. When things do not “go as planned,” they almost always cost more, not less – another of Murphy’s Laws.
A contractor with a fixed bid must work very hard to keep costs under control. He may need to push back on his subs or suppliers a little, order more carefully, buy or rent a more efficient tool, or find other ways to work efficiently – e.g., have materials delivered to the second floor by a boom truck.
It is true that a contractor working on a fixed bid may be tempted to cut corners that could affect the quality of the work. That places a greater burden on you to have complete plans and specs, find a reputable contractor, and keep a watchful eye on the project. This can be done by an architect, independent construction inspector, or yourself if you have the skill.
Of course, you should take these same steps on a cost-plus job also, although for a slightly different reason. You will still want clear plans and specs for efficiency and predictability. Making it up as you go is slow (expensive) and risky as details designed in the field may be less than optimal.
The fundamental problem is that the owner assumes all the risk for cost overruns, but has little ability to control those costs. Too often the end result is a big bill and a lot of tension toward the end of the job. Once you are over-budget, the relationship with the contractor often sours.
If you end things on a bad note, you can expect little cooperation for callbacks and warranty problems that show up after the work is completed and the final bill paid.
On any construction job, always:
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- Written contract. Have a written contract that, at a minimum, defines the scope of work, price, and payment schedule.
- Plans and specifications. Start with detailed plans and specifications that accurately describe the work to be completed.
- Contractor choice. Find a competent and choosing a contractor. Often this is not the low bidder,
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Read more about Cost-Plus Contracts.
Alan says
Should We Build New Home Cost-Plus With Owner’s Rep?
I need some advice. We are attempting to build a new home on a very strict budget. We are using Superior Walls and SIPS (structural insulated panels) for the exterior walls. Most builders have told me they would not build they we want, Others were price double or triple the budget. So we have found a builder that would act as an Owner’s Rep with a cost-plus-10% contract. We have done all the work for pricing on most of the major items needed and have some of the contractors lined up.
Your notes about working cost plus have now put a fear into the process and I am looking for some feedback and advice.
Looking forward to any assistance that would be helpful.
buildingadvisor says
While both Superior Walls and SIPs have been around for decades, they are still considered innovative building systems and not part of mainstream construction. Contractors who are unfamiliar with these products may be reluctant to bid on them because they don’t know what to expect. They don’t know how much time it will take, what techniques to use for efficiency, what problems might crop up and how to avoid them. Every new building product has a learning curve – some steeper than others. For that reason, most contractors approach innovative products and systems with caution.
The first time out with a new product or building system always takes longer. If a contractor is interested in learning about the new system, he may bid the job in part for the learning experience, knowing that his profit may be small or non-existent. If he’s not feeling so adventurous, he may say “no thanks”. Or they may add a large margin on to their bids to cover the risks they perceive. It’s a way of saying, I don’t really want this job but will consider it if I’m paid enough.
A contractor new to these products is taking a risk, but so are you as the homeowner. An inexperienced contractor might make installation errors that cause problems that don’t show up for several years. For example, SIPs can have condensation problems at the panel joints if not sealed properly. No building system is immune to problems.
That said, I would find a contractor (or subcontractors) who have a strong track record with these specific systems, whatever type of contract you are using.
It sounds like you have found a builder who is willing to work as an owner’s representative, also called a construction manager. There are many variations of this arrangement. Is this builder going to perform some of the hands-on work with his own crew – or act exclusively as a manager, directing the work of other subcontractors? In that case, you typically become an owner-builder by default, and take on all or most of the risk of cost overruns, construction problems, and the various liabilities that go with any construction project.
Assuming you are using subcontractors to perform most of the work, will they be submitting fixed bids or working cost-plus, or some of each? Any portions of the project that are done cost-plus transfer all the risk of cost overruns to you, the owner. The contractor has little incentive to hold down costs. That is the main reason I try to avoid cost-plus contracts in most cases.
If you are using a variety of subs to do most of the work, why not have your construction manager get fixed bids from them? Also get a fixed bid, or at least a detailed estimated of the work he will perform. The more fixed bids, the less the risk of substantial cost overruns. Once you have actual bids, you can see whether your own estimate is realistic. Your “tight budget” may be more optimistic than realistic.
I don’t know the particulars of your arrangement with the owner’s representative. But some issues to think about are
– Who is responsible for cost overruns?
– Who is responsible for construction or design errors?
– Who is responsible for various types of liability? (Speak with your insurance agent.)
– Who will apply for the building permit? (Typically you, if you are acting as an owner-builder.)
Most likely, the owner’s representative will not take on any significant financial risk or liability for his 10%, which is a pretty small margin. There is a lot of risk inherent in any construction project. Much of the negotiation that takes place between 0wners, contractors, architects, and subs – often buried in the details of the contract language – is who assumes what risks.
In a traditional fixed-price contract, the contractor assumes most of the risks mentioned above, and wants to be paid enough to justify the risk. In more creative arrangements like yours, you may (or may not) save money, but you will probably be taking on a lot more risk. This is not necessarily a bad thing, but something you should go into with your eyes open.
Best of luck with your project. Hope all goes well!