April 06, 2022
Author: Lorman Education
Cost Plus vs. Fixed Price Contracts
A cost plus and a fixed price contract are two types of construction contracts. Both are used frequently when entering into an agreement to build a home or other type of structure. Each has its own special advantages and disadvantages for both the contractor and the buyer. For the construction contractor, the choice depends upon the situation, the needs of the buyer and the risk inherent in the construction.
Before discussing the pros and cons of each, definitions are in order. A cost plus contract means that the price of construction is the costs plus an additional fee, normally designated as profit. The fixed costs include the cost of the materials and labor along with indirect costs known as overhead. It is simply an agreement to pay costs plus profit, all as defined in the contract. A fixed price contract, on the other hand, is an agreement to construct a building at a set price. That price includes all costs and profit.
For the contractor, the cost plus contract provides the advantage of a guaranteed profit. The contractor will receive reimbursement for all costs and still make a profit. Under a fixed price contract, there is the risk that the costs will be greater than the price and thus the contractor will take a loss.
For the buyer, the cost plus contract offers a better product since the contractor has no incentive to cut costs on lower end materials. In addition, there is no inflation of costs like sometimes occurs in fixed price contracts where the contractor overestimates costs in order to protect against the costs eating up all the profit.
The main disadvantage to the cost plus contract is the potential for disputes over what items are costs and how those costs are calculated. It is very important to have a comprehensive contract that covers all of the contingencies and defines in great and clear detail what is and is not cost and how to calculate indirect costs. A well thought out document can make life pleasant for both sides.
The buyer’s main problem with a cost plus contract is the uncertainty of the final cost. The way to avoid a price that exceeds budget is to insert a clause in the contract that maximizes the total cost plus feature of the project, thus protecting the buyer from a surprise at the end of construction. Again good planning at the outset avoids disputes later.