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Risk and Reward

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Construction Practices

Risk and Reward

The risk-reward nature of fixed-price contracts may not be the best fit for today’s design-build market 

May 25, 2018

Near the end of the recession that hit New England in the early 1980s, I was one of three bidders on an architect-designed residential remodeling project. The bid documents were standard fare, except that all the prices for trade work were included as allowances. That turned out to have a surprising effect on the outcome: All three bids on the $125,000-plus project were within about $1,000 of each other; two were only about $50 apart. It was an eye opener, and it prompted me to start looking for ways to get out of the bidding wars.

When I finally did escape, it was on a project for which I was invited to provide cost consulting to the architect during the design phase, leading ultimately to a negotiated construction contract with the  client—very much like a design-build project, but with the architect in control.

We successfully used a fixed-price contract for that project, but I thought the fast-track process needed something more flexible. Traditional cost-plus contracts were too open-ended, so I sat down with my attorney and hammered out a hybrid arrangement that I called “Cost-Plus with a Guaranteed Maximum Cost and a 50-50 Split.” It’s not as complicated as its title is long-winded, and it has the advantage of providing both transparency—a valuable commodity in today’s marketplace—and incentive, which is missing from most cost-plus arrangements. Here’s how it works.

Cost + Fee = GMC

“Cost” is invoice cost from suppliers and subs, with copies provided with each scheduled payment; “plus” is a fixed percentage fee applied to all costs. Together they set the Guaranteed Maximum Cost (GMC), which is essentially a fixed price, subject to adjustment by change order. The contract’s main innovation is the 50-50 split, which establishes the incentive, because at the end of the project, any savings to the GMC are split equally between contractor and homeowner. 

I can hear the groans from fixed-price proponents who maintain that you can’t make any money working cost-plus. While it’s true that windfalls are rare with this cost-plus arrangement, there is plenty of opportunity to earn a decent profit. That’s because, much like the project management line-items in Michael Anschel’s system (see “The Big Reveal,” May/2018), billable costs include a number of expenses that are typically covered by markup in a fixed-price agreement. These include time spent estimating, procuring materials, scheduling and coordinating the work, even administrative tasks like preparing copies of invoices to submit with requests for payment. Hourly labor rates, including labor burden, are also listed for all employees working on the job. When all of this is billed as direct cost, the “plus” percentage is mostly profit. I say “mostly” because there is also a list of expenses that could not be billed, such as work required to correct mistakes, certain types of equipment purchases, and general overhead for a central office.

Pros and Cons

Like a fixed-price contract, this cost-plus hybrid requires close attention to plans and specs so that both parties can agree on what the GMC does and doesn’t include. On the downside, getting paid involves submitting copies of invoices and timesheets, and updating a cost-to-date summary. Windfall profits are rare because you can only bill for work that is actually completed, not for contingencies to cover work that might be needed. And there are still change orders, additional work orders, and allowances, although the time it takes to deal with them is a billable cost, and the GMC and the completion date can be adjusted accordingly.  

But there are plenty of offsetting advantages, beginning with the trust and confidence that stems from the transparency of the process itself. Clients like the way the incentive of the 50-50 split encourages efficiency and economy. For the contractor, it eliminates most of the risk, and, in my case, forced me to hone my estimating and job cost skills.

Today’s marketplace demands innovation. A new contract may not be the answer you need, but the answer is out there. You just have to find it. 

written by

Sal Alfano

Executive Editor

Sal Alfano is executive editor for Professional Remodelersal.alfano@gmail.com, 202.365.9070

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