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Fixed-Price or Cost-Plus Fee: Which is better?

Two paths- Fixed price vs. Cost Plus

My dear friend David reached out recently on the eve of starting a construction project on his home. He said that he’d received two quotes from reputable builders and that one of them wanted to work Fixed-Price and the other offered a Cost-Plus Fee model, and he wanted to know which I thought was better.

In full disclosure, I told him that we work *almost* exclusively in the cost-plus model, but that both models had their plusses and minuses. I then asked him a few questions to try to get a feel for which would be better in his case.

“So let me ask you this,” I said. “When you are analyzing information do you tend to prefer simplicity or detail?”

“Simplicity” he answered. And then he thought about it further... he spends his days working with very complex organizational problems and said, “No, if I’m being honest I prefer more detail. I want to know what’s under the hood”. “Pretty much always,” he added.

“Okay next question, if you have to choose between transparency and opacity, which to you prefer... in other words are you a ‘hire and trust’ buyer or ‘trust and verify’ type?”

“Easy, transparency,” he said. “Does anyone give a different answer to that one!?,” he laughed. “Shockingly, yes,” I offered. “Not often but some folks just don’t want to know. Usually though there’s a pretty deep sense of trust established in those cases, but most people will say they favor transparency.”

“Last question, and this is a tough one,” I said. “When you negotiate an agreement with a new vendor... deep down are you looking for a win/win or a win/lose outcome... presumably where you are on the “win” side,” I said smiling. “And, for the record, everyone says ‘win win’ at first so as not to seem selfish, but let’s face it... there are entire industries predicated on the win-lose paradigm... so you have to be really honest with yourself on this one.”

He had to think about that one for a second...

I’ll tell you what he said in a minute, but at this point I peeled back the curtain a bit and told him the most basic truth that I have discovered about construction in the last 15 years, and that is: There is NO SUCH THING as a Fixed Price. Never has been, and never will be.

At the most basic level, the difference between the Fixed Price (FP) and a Cost-Plus (CP) approaches is simply this: Take any set of Plans and Specifications for a given project, divide that set of plans into the various construction divisions (Sitework, Concrete, Framing etc), estimate the cost for each division of work, then add the cost of project administration and profit (aka the Builder Fee). Combine them and you’ll get a Total Projected Cost, or Estimate.

That Estimate represents the total amount you -- as the client -- will pay for the work represented by the plans and specs. When you sign a Fixed Price service agreement, in theory you are buying exactly what is represented by whatever documentation you’ve agreed comprises the Scope of Work, and that amount should be -- as the name implies -- fixed.

Fixed price vs. Cost PlusIn a Cost-Plus arrangement, these same basic assumptions apply with one key difference, and that resides squarely in how each one of these approaches relates to everyone’s least favorite subject: Unknowns.

To my knowledge there has never been, and will never be, a perfect set of plans. We’ve worked with some incredibly gifted architects over the years, and even the best of them will acknowledge this to be true. Whether you’re talking about what resides beneath the topsoil, what lies in wait behind your plaster walls, or what Mother Nature might dole out during the time your project is underway... there is never a shortage of factors that can impact the amount of time, energy and resources required to reach your final outcome.

Add to this the fact that there is usually a finite amount of time and money devoted to the design and planning process, and what you end up with is not a map so much as a beautifully rendered set of GOALS, with an implicit understanding that your Build Team will marshall all of their resources and experience to help you achieve them.

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Which is, frankly, just fine. Projects have been built thusly for as long as humans have been seeking shelter, so the point isn’t that the process is imperfect. Of course it is! The point is that unknowns are as much a part of your project as 2x4s and screws and the Cost Plus and Fixed Price models each have different relationships to this very real part of the job.

In either model, by the time a set of plans/goals has been established, the Builder’s job is to identify what is known and unknown about a given project. We seek cost-feedback from subs and vendors for the defined elements (SF of drywall, linear feet of gutter) and make educated guesses about the unknowns, which can range from the obvious items like “what is under the ground or behind the walls” to things that just haven’t been decided yet such as the kind of tile, type of flooring, or complexity of the crown moulding.

I can tell you friends that we’ve worked from 45 page plan sets with detailed elevations for everything from the crown moulding to the HVAC locations, and we’ve built from plans sketched on one 8 1/2 x 11 inch sheet of white paper. The range is remarkable. Almost anyone who makes their living this way can say the same thing. So what’s a Builder to do about all those pesky unknowns when giving an Estimate? Furthermore, considering the unknowns embedded in every project, how can one possibly give a Fixed Price?

Well we can’t. But we do. And this is where things get interesting.

When a Builder (or any service provider) agrees to work on a Fixed Price what they are basically saying is, “Look... there’s stuff we don’t know here. I’ve taken your goals/plans and I’ve put hard costs to the items I can safely predict. Windows, doors, the cost of defined materials... these costs are truly fixed barring major market shifts and they are what they are.”

“How long it’s going to take to frame or finish your project? The number of labor-hours needed to trouble shoot the endless list of challenges that will surely surface from the weather, or illness, or client decision making? No idea. So I’m going to use a multiplier by taking my known costs and adding a ‘risk factor’ for the unknowns to arrive at your estimated cost. And in return for absorbing that risk I’m going to keep any savings that I make over and above the actual costs. Likewise, if I underestimated the amount of time it takes to frame your building, or finish the job, I’ll absorb those costs.”

Sounds fair, right? And it is. When it’s true.

The reason I asked David about his feelings on the win/win v. win/lose approach is because whether we want to acknowledge it or not, the truth is the Fixed Price approach resides squarely in the realm of the latter. In every Fixed Price agreement someone comes out financially ahead of where they would have in a Cost-Plus Fee arrangement. Either the Builder underestimates the cost of the work, eats it, and the client ‘wins’. Or conversely the Builder successfully covers his costs, gets it right on the risk-multiplier, and comes out ahead (sometimes way ahead). Everyone who works Fixed Price in our industry knows that there is more money to be made on these contracts if you win more than you lose, and they also know that the industry is littered with the charred remains of the folks who don’t.

It so happens that I know David is one of the loveliest people you’ll ever meet. Successful, crazy smart, kind, and collaborative in all his dealings, so I knew this wouldn’t appeal to him. Once we arrived at this point in the conversation I said, “David be honest with yourself. Even assuming you weren’t the kind of person who wanted the other guy to win in equal measure to yourself, you’re doing this one project. What are the odds, do you think, that when the dust settles at the end of the job that the guy who’s been doing this for 20+ years is going to come out on the losing end of the equation? Nobody wins 100% of the time, but just play the odds... what do you think?”

“Duh,” he replied.

“Right,” I said. “Furthermore, let’s say that by some quirk of fate the guy was sloppy in his estimating on the “knowns”, and it looks like you’ve got him dead-to-rights and you’re going to win. How do you think that guy feels about being on your project? How much of his best stuff are you going to get? Let’s even assume that, like 95% of Builders that I’ve met over the years, the builder in question is a true and honest soul, doing the work for the right reasons. Where do you think your job slots into his priorities when the hard choices come up -- as they always do -- about what to spend time on that day. Which problems to tackle...?”

“Okay, Okay,” he conceded. “But I don’t get it, we signed a contract that said the price is fixed, surely that gives me some protection?” And it does. But don’t forget what we said about unknowns being present in every set of plans. Since the perfect set of plans has never been produced there are usually dozens of places where a builder can legitimately say... “this wasn’t in the plans,” and submit a Change Order. Since there is no transparency in the Fixed Price model, how do you know that the Builder’s losses in framing aren’t being covered by the Cabinet Change order? I did a postmortem for a friend on a 2.5mm dollar project a few months back and a blind man (who knew our business) could see that this was precisely what happened. He was none the wiser.

Anyway, I don’t want to make it sound like Fixed-Price Builders are sitting there twirling their mustaches looking for ways to game their clients! No way. Like I said, 95% of the Builders I know are good, honest people. Most of them are just trying to make a living and are -- frankly -- pretty bad at the estimating and administrative side of the work we do. The point is, there is no such thing as a Fixed Price, so at a minimum it’s worth looking at the dynamics in play honestly so you can make an informed choice about what will work best for your project.

Fixed Price is great for small jobs where all the variables can be defined, and where the duration of the project is short enough that human and non-human factors (like weather and client decision making) aren’t likely to move the needle as much. When projects get larger, or more complex, there are much better ways to assign and price the unknowns, and that’s where the Cost Plus Fee model becomes advantageous to -- in my opinion -- both parties.

In the Cost Plus approach we assume that there are both knowns and unknowns in every project. Our job, as your Builder, is to take whatever set of Plans/Goals you give us, and do our level best to give you a Good Faith Estimate of what that goal will cost. We all know that the price isn’t fixed, that things can change, and so our mindset in your service goes from “covering our butts” on a Fixed Price, to trying hard to set realistic expectations about what you should reasonably plan to spend on your project... unknowns and all.

This aspect of the approach makes ‘competitive bidding’ very challenging, to be honest, because let’s face it... In the Cost Plus model it benefits both parties if our estimates are wrong... in the HIGH direction! It’s better for everyone if we say “we all hope we can do the Scope of Work for x, but it’s possible based on our experience that it could be as much as y.”

In the Cost Plus model our entire process... Rates, Fees, Overhead, Costs, Invoices... the whole thing is 100% transparent and shared with the client. There are no sacred cows. Cost Plus clients trust their builder, of course, or they wouldn’t have hired them. But they get a chance to see for themselves how their resources were used, ask questions about how time and money were spent, and hold the team accountable to the shared goal. Trust and verify.

If you’ve had employees working on your team, or managed a budget for a complex project in your work, you quickly realize it’s basically the same paradigm. You ask your employee to set a Budget for your stated goal. You check in often to see how it’s going. If costs are changing in either direction, your employee (hopefully!) comes to you to say “this is what’s changing, and this is why,” and you get a chance to decide again if the person is continuing to earn your trust.

In the Cost Plus model the Builder spends more of their time solving problems on your project because they’re not *as* concerned about whether or not they covered their actual costs. There are finite hours in the day, and for my part I’d much rather my Builder have all their time and attention focused on getting my project done to the highest quality standard, in the most efficient way possible. Do I really want them worried about whether or not they’re going to make enough to feed their family?

In a Cost Plus model, saving money and being under budget are a win for everyone. There are *always* real savings to be had on any project. Whether it’s sourcing materials more effectively, running a schedule more efficiently or negotiating subcontracts successfully, we know that keeping clients happy means exceeding expectations... and you don’t need an MBA to know that means coming in under budget!

The fees Cost-Plus builders charge (usually between 10-25% depending on the size of the project and the size of the company) are a straight line function of your Builder’s Annual Construction volume, NOT a function of just your project. So even though we “make less” if a work item like framing costs less, it doesn’t matter to us because we know that as long as we are building X amount of work per year, at Y% average fee, we’ll have enough left over at year-end to keep the lights on and warranty the work we’ve already built.

Mouse_CartoonAt the end of my diatribe, David asked: “So where’s your risk in this approach? Sounds to me like I’m the one taking all the risk.” At that point I gave him my first puzzled, slightly abashed look and said, “My friend, we’re not writing code here. I work in construction. There is more risk in my profession than most others you can name. Come with me next time I meet my insurance agent and listen to the lectures we get. My risk is that one of my guys gets hurt; that something burns down; that the wind, rain, snow inflicts damage that destroys property and delays our schedules; that I make a legitimate mistake that I have to correct at my cost. I promise you, there are risks in my work far greater than whether or not the estimate was right!”

Your risk, as the client, is that the project will cost more than anyone thinks to complete. That’s about it. And there’s no clever spreadsheet, renaming of the fee or other contractual gamesmanship that can change that simple fact.

But here’s the good news: 

If the process is transparent, communication is timely and accurate, and the team works well together even that risk can be largely managed and mitigated.

Want to hear something funny? After all that, in the end, my friend ended up hiring the Fixed Price builder!! And this is the most important take away from the whole discussion:

Of the two options he had, the person he actually trusted the most worked that way, and *that* is where the rubber meets the road. He made the right choice for the right reasons. He knows he might pay a little more. And he’s not going to be surprised when he sees the change orders come, or put up a fight as long as the information is fair and delivered in an open, honest manner. But now he knows what he’s looking at, and hopefully you do too.

I’ve said countless times to my friends who ask, you’ve got to see your Builder in the same light as your Doctor, Lawyer or Accountant. We solve problems in a critical area of your life that you’re either not trained for or don’t have the time to solve because you’re making your living elsewhere. In the end, choose the most competent person you can find, hire someone you really trust, and stick with them.

Happy building! Do great work.

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Brian Roberts is a co-owner at Landmark Services, Inc. A high-end residential builder specializing in historic renovations, traditional building and property care for old homes and estates in the Greater Boston Area. Prior to joining Landmark, Brian was the VP of Client Service for Construction Recruiters, and served many of New England’s most reputable builders; helping them recruit, hire and retain the best players in the industry. He worked with a range of companies from small 1.5mm residential firms, to large national players like Shawmut Design and Construction and Suffolk. His primary focus was on serving high-end builders like Landmark, and that is how he began working with Mark Landry, Landmark’s founder and President. He lives in the Boston area with his wife and two young sons. Email him directly at: brian at landmarkservices dot com 

Topics: New construction, Renovations, Cost Plus, Fixed Price, Contracts