by Michael Stone
The following list are some (but not all) of the major reasons that a contractor in a construction related business should not do Cost Plus or Time & Material contracts or billing to their customers.
There are two major reasons construction-related business owners use Cost Plus or Time & Material Contracts:
- Difficulty estimating jobs. Many contractors don't know or understand how to estimate, and others do not have a good estimating system in place that will allow them to accurately estimate construction projects. They default to Cost Plus because they believe these contracts will allow them to bill for all their job costs, all their overhead and make a profit. Unfortunately, this seldom happens. (For more on how to estimate a construction job, review our Profitable Estimating Training Class.)
- Not knowing how to establish a sales price. The book, Markup & Profit, A Contractor's Guide was written to help contractors know how to price their jobs to cover their overhead expenses and make a reasonable profit.
This list applies to all general contractors and most specialty contractors in the construction industry. An exception would be using Time and Material billing for service work such as electrical, plumbing or HVAC service calls. Those agreements should be kept to a maximum of $2,500.
- There is no universal definition of Cost Plus or Time & Material Contracts or billing, thus creating confusion and misunderstandings almost immediately in any contract. Attorneys practicing law in the same town will often have different definitions of what is a Cost Plus or Time and Material Contract.
- Lenders often will not lend on Cost Plus or Time & Material jobs unless there is a not to exceed clause. When the job goes beyond the not to exceed clause, you must have written authorization to do that work (signed, dated and completely priced out change work order) or your customer is not obligated to pay you for the work.
- Some states now have laws that specifically prohibit the use of Cost Plus contracts.
- Based on discussions with attorneys, and our work as an arbitrator, Cost Plus or Time & Material jobs generate lawsuits at a rate of 2 or 3 to 1 and arbitrations at 9 to 1 over fixed figure contracts.
- Cost Plus or Time & Material contracts are an easy way out of doing detailed project study and estimating. This increases the chances that the original "estimate" for work to be done will be low to very low. You risk accusation of violation of the GOOD FAITH & FAIR DEALING law for "Low Balling" estimates. An estimate below the actual price will lead to a fight over money when the real costs start coming in and the customer is requested to pay more for the job than the original estimate.
- Because of the perception that on Cost Plus or Time & Material contracts the Owner is required to pay for absolutely everything, many contractors do not write out change work orders and have the Owner sign them, falsely believing that they (the contractor) will be paid for all the work that they may do on that job.
- Owners often go into a Cost Plus contract thinking they have ample money to cover the job. When the job reaches the 60% to 80% completion point, and the owners have made multiple changes to the job increasing the cost, they run out of money. Their claim will be that the contractor overcharged from the start of the job, and the contractor will be expected to finish the job for the money that's already been paid.
- For your own protection, you must keep an accurate day to day log of all labor, materials, sub-contract and other fees or costs on the job to be able to verify your actual expenses to date. If you do not, depending on your contract, you may not be able to collect for undocumented expenses, regardless of what kind of or how much work has been done.
- In addition, you must have in your possession every document from the job that has incurred a cost. This includes all time cards, invoices, or any other papers related to the project. If you lose any item, you may not be paid for it.
- With the need to keep very careful records on the jobs, you substantially increase the amount of meeting and preparatory time necessary for the job. Often this time will be 3 to 4 times the amount of time necessary to complete a fixed figure contract. Cost Plus or Time & Material jobs require at least two and often three times as many meetings with the customer to review job progress, billings, invoices, labor, etc. Who pays for the meeting time and the extra administration time to prep all documents for labor and invoices from subs and suppliers?
- Who draws the plans and gets the permits on a Cost Plus or Time & Material job? If a mistake is made on the plans, who pays for the time it takes to redraw the plans, and who pays to tear out the mistake and rebuild it?
- Who pays for the Engineering if the Owner forgets to include it on the plans that they provide, and who pays for your down time while you wait for these revisions?
- Suppose Engineering on a portion of the job gets by the plans examiner, the inspector catches the problem, and the job has to shut down until the engineering is complete and new plans drawn and ready to use. Who pays for the new plans & delays? Who pays for tearing out the wrong structural work completed and the materials that are ruined due to tear out? Who pays for the additional labor needed to correct the problem? Who pays for the down time for you and your crew, driving time, re-start up time?
- Will the Owner be willing to pay for your travel time to and from your office for meetings or discussions on problems that might arise on the job, or from the job site to your suppliers and back to the job site for material pickup that either they or you forgot?
- If you make a mistake on a Cost Plus or Time & Material job, who pays for it? Do you donate your time or is the customer willing to pay for it? Who pays for ruined materials? Who pays to go get the new materials and the cost of the vehicle expense to do the pickup?
- Who makes up the material lists for jobs with Cost Plus or Time & Material contracts that are needed before the job starts? If you do, will you be paid for that time?
- Owners are far more prone to want to furnish some or all of the materials for their jobs when using a Cost Plus or Time & Material contract. The Contractor is expected to guarantee those materials when installed, not to mention losing the markup on those materials. Who pays for the time to replace defective materials supplied by the owner?
- What happens when the Owner is to supply some of the materials and they forget to buy a certain item or don't know what materials to bring to the job site? Who pays to get the forgotten items? What happens if it takes the owner two or three days (or longer) to get the needed materials to the job site? What do you and your crews do in the meantime and who pays for that down time?
- Owner goes to your supplier (with your permission) charges materials for the job to your account. What happens if you send the owner to a certain supplier you normally use for materials, they purchase the materials, and then later claim that they could have purchased the same materials at another location at a better price? You gave them the higher priced supplier to go to, so you are responsible for the difference in cost.
- Cost Plus or Time & Material reviews show the Owner what you are paying for materials. This will increase the probability of complaints from the customer that they could have bought the same item elsewhere for less money. It also leads to customer believing they only have to pay the amount that they could have bought the materials for.
- Owner expects you to be fully productive on their jobs for 8 hours a day. They will be looking over your shoulder constantly. You will seldom if ever get the job done as quickly as they are expecting you to do it. Will they be willing to pay for your State's mandated morning and afternoon breaks for your employees? Will they be willing to pay for smoke breaks, coffee breaks, mobile phone time? Will they pay for the time for you or one of your employees to escort an inspector through the job and answer questions? Who pays for the labor and materials to do required changes?
- Contractor must be far more diligent in policing employees so that they are productive on the job at all times, with no miscellaneous discussions or activities on or about anything other than the job they are working on. Again, this pertains to starting and quitting times, smoke breaks, coffee breaks, mobile phone time.
- It is very difficult to "compete" on Cost Plus commercial jobs because larger construction companies will take these jobs at cost, to build presence with corporations that allocate the multi-million dollar projects on assignment basis because of favorable past performance.
- From the customer's standpoint, Cost Plus contracts give the contractor little incentive to get in and get the job done. Instead, the contractor's incentive is to keep the clock running, especially if they don't have the next job lined up. Cost Plus jobs often run far longer than would be considered normal with a fixed fee contract.
- Owners believe that Cost Plus or Time & Material jobs will cost them less money to build their job. Therefore they expect you to charge them less money for the work that you do. ( i.e., less than your normal overhead and profit). In most cases, Owners believe that you should only make:
Remodeling = 10% Overhead and 5% to 10% Profit
New Home Construction = 10% Overhead and Profit
Specialty Construction = 6% to 10% Overhead and 5% to 10% Profit
This makes it extremely difficult for you to use your established markup on that job, especially when you have to show them your invoices at the normally required meetings to review the job progress and expenses to that date.
- Owners do their homework, put their job out for "Bids" @ Cost Plus or Time & Material plus 6%, 7% or 8% maximum markup. They tell you if you don't want to bid that way, don't enter a bid. They also tell you that "You're not going to make your normal markup on my job!", i.e. take it or leave it.
- One way many contractors handle Cost Plus or Time and Material contracts is to take items that are considered overhead and stuff those costs into the job cost section. In court, a sharp expert witness will find the overhead items listed under job costs and accuse the contractor of "double dipping" on the job. This immediately paints the contractor as dishonest, making a win in court even more difficult if not impossible.
- Most Cost Plus contracts give the Owner the right to either select the subs for their job from a list supplied by the General Contractor, or the Owner can hire their own subcontractors that the Owner will supervise during the job. What happens if subs hired by the Owner don't adhere to the General Contractor's time schedule? Who is responsible for delays and downtime caused by their lack of cooperation? What prevents the Owner from suing the contractor for lack of supervision and other damages caused because the job did not get done on time?
- When you have subs working on the same project, some hired and supervised by the General Contractor and some hired and supervised by the owner, what do you do if there is a scheduling or other conflict on the project? Who resolves it, how long will it take to resolve? If the General Contractor is responsible for supervising subs hired and paid by the owner, will the General Contractor be reimbursed for that responsibility (and liability)?
- If (for example) a drywall contractor hired by the owner runs a screw into copper pipe installed by the plumber, who takes responsibility? If it isn't discovered until water damage appears when the project is complete, who gets called for the warranty?
We are sure with a little research, there are more reasons Cost Plus or Time & Material Contracts can cause your business problems. But the reasons listed above should be enough of a warning to avoid Cost Plus or Time & Material contracts or billing.
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Jim Holman replied on 01/28/11:
Your "partial" list of the pitfalls of Cost Plus type construction contracts is humorous, gut wrenching, and all too true.
However, your setup for the list, the 'two major reasons' that Contractors use them is really missing THE major reason. That reason is the lack of complete, comprehensive, plans and specifications at the start of construction.
The majority of 'Architecturally Designed' plans for a remodel in our area provide just enough information for the Building Dept. to approve a permit. This results in a design that is more concept than detail with the onus on the Owner and Contractor to work out all the details during the construction process, which is VERY inefficient.
Drywall finish? Oak or maple floors? Light fixture schedule? Cabinet style? Countertop material? Backsplash? Casing style? Paint colors? Tile design? Plumbing fixtures? Well, we'll just decide on those when the time comes.
The Owners believe that they have already paid for design because they have a building permit, so, what is the cost of this job?
I don't know, but be sure to 'verify with existing'.
Roy Kennedy replied on 02/02/11:
I know some plumbers that hate to give a price but they want to do the job then bill its usually very high I always ask them the price 1st.
I agree 100% cost plus is nothing but trouble waiting to happen.
I give allowances on certain mechanicals electric x dollars built in to cover unseen wiring changes. "To be billed to customer as per invoice on the contract and the same on plumbing and heating.
Ill build in a close dollar cost and if its over for unseen reasons Ill tell them ist get a change order signed then do the extra work.
Geff Redick replied on 02/02/11:
31. Consider that when a GC works under a cost plus contract it does not necessarily mean that his/ her subs are working from a cost plus position. The reality of what happens here is the GC may get a little "lazy" with regards to how they manage the project knowing that they are supposed to be getting paid for all their time, etc... What happens when one of the subs is not performing as desired and causing delays? Delays that under a typical construction contract would have the GC dismissing that sub because it is slowing the project down too much. Since the GC is getting paid for each visit to the site, the normal urge to keep the speed going is not quite the same for him, but the subs are still working off a "fixed fee" basis and this slow pace is hurting them more. They are the ones suffering and loosing money. This suffering by your subs in turn causes them to reconsider your skills as a GC potentially impacting your long term relationships. Additionally this will cause the client to pay more money for the project than they should have to.
Eddie Schroeder replied on 02/16/11:
I have never understood how a customer accepts a "cost plus" price blindly. i always give a full breakdown estimate with the following rider
"This estimate does not include unforseeable concerns that may show up during scheduled work.
Concerns will be brought to your attention ASAP, code and safety violations MUST be addressed.
All other concerns are optional at your discretion."
in 7 years i have only had to use this once as a basement suite "clean-up" revealed an entire suite built with 3 foot and shorter scrap lumber and live wiring left loose in the walls all over the place required a full gut and rebuild.
martha montgomery replied on 02/13/12:
My question is not covered by the information which otherwise is very informative.
If my contractor set up the cost plus 10% and he asked me to pay a sub contractor immediately after the work was done------and also to pay a merchant for a product as soon as it was installed----can he count the full value of both these situations and also 10% of their costs ?
Since I paid for them up front they are not the contractors costs because he asked me to pay for them.
Therefore he should claim only 10& of the two costs on his expenses. Am I correct?
Jeff replied on 04/06/12:
Cost plus a fee contracts are done for one reason. There are no details before the contractors are picked. If they had true specifications and drawings every home builder in the country would be doing fixed price. Owners don't want to pay for up front costs when they have no idea if they can even afford the home they are specifying. Owners have no idea how long things are going to take and what they will actually cost. They hand us five sheets of paper at the beginning and ask how much the job will cost. They also ask three other guys. The low "bid" gets the job. In order to get the job, you have to assume the cheapest alternatives not specified or else you will be higher than everyone else. In order to cover yourself, you end up specifying in extreme detail the entire job for free, so you explain the overruns later. At this point, it goes back to the drawing board 80% of the time for a "redesign", because the costs were too high regardless. Often times they don't even pick a builder. The architect gets more fee for the redesign and the process repeats. To circumvent this problem, contractors settle for a cost plus and then do the job of the architect throughout the job constantly pushing for decisions to be made, so the project goes smoothly. In the end, we get blamed for the "slippage" and overruns, while the architect gets fees for multiple redesigns and the owner/architect struggle to make decisions. The best way to pick a contractor is to do it regardless of the plans or "bid". Negotiate the overhead and markup and then ask for random invoices or time sheets throughout the project. This will ensure they are giving you an accurate estimate and keep them honest will billing. We also have offered cost plus a fixed fee contracts. This fixes the oh&P, but allows us to transfer the costs through. No incentive to buy more expensive materials or take longer this way because we get more on a percentage basis if we are faster and under the estimate.