Reasons to avoid Cost Plus Contracts and Time and Material Contracts in Construction #MarkupAndProfit #CostPlus #TimeAndMaterialContracts #MichaelStoneConstruction #Construction

There are many misconceptions and potential legal issues/dangers with Cost Plus contracts in construction. This type of agreement is not simple and has more difficult legal guidelines to document and manage. There is an embedded trust in a Cost Plus contract (sometimes called Time and Material contract or T&M) that puts contractors at a higher level of ‘reasonable care’ (the legal definition).

That said, some homeowners and contractors prefer Cost Plus contracts.

Reasons to use a Cost Plus contract

Owners

Homeowners and building owners often request a Cost Plus contract because they believe it will save them money. They don’t trust their contractor to provide a fair price, and cost plus allows them to see invoices and approve all of the project cost.

If the owner thinks there are likely to be several changes in design and material selections during the project, they may opt for a Cost Plus contract to enable periodic monitoring and adjustments to the agreement during the project. They believe this will avoid the confusion of constantly amending and re-wording the original contract by way of change work orders.

Contractors

Contractors often prefer a Cost Plus contract for two major reasons:

  1. They don’t know or understand how to estimate a project, or they don’t have an estimating system in place that allows them to accurately estimate a construction project. 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.)
  2. They don’t know 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.

Reasons not to use a Cost Plus Contract

Owners

  1. Because detailed project study and estimating isn’t necessary with a Cost Plus contract, there is an increased chance that the original estimate will be low, sometimes very low. When the real costs of the project start coming in, you will be requested to pay more for the job than originally expected.
  2. 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, and that means more expensive.
  3. Since these contracts are often structured such that, the higher the cost of the project, the more money the contractor can make, in effect, the contractor has less incentive to save the owner money. One of the ways around this scenario is for the owner to offer a bonus if the contractor can complete the project under a target dollar amount. However, a target can be difficult to meet if changes are made to the project.

Contractors

The following items are some of the major reasons that a contractor shouldn’t use a Cost Plus contract or Time and Material contract. 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 – $3,000.

LEGAL ISSUES

  1. There is no universal definition of Cost Plus Contracts or billing, thus creating confusion and misunderstandings almost immediately in any contract. Attorneys practicing construction law in the same city or town will often have different definitions of what is a Cost Plus contract.
  2. Lenders often will not lend on Cost Plus 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.
  3. “Not to exceed” doesn’t allow room for unexpected problems or unknown conditions. Even in a fixed price contract, you provide conditions and notes to protect yourself from unknowns. If you are accurately providing a not to exceed price that the client expects or accepts, you are basically just providing a fixed cost bid that can be reduced by cost savings along the way with all benefits going to the client, but all risk of cost increases is on you.
  4. Some states now have laws that specifically prohibit the use of Cost Plus contracts.
  5. Based on discussions with attorneys and our work in arbitration, Cost Plus jobs generate lawsuits at a rate of 2 or 3 to 1 and arbitrations at 9 to 1 over fixed figure contracts.
  6. Because detailed project study and estimating isn’t necessary, there is an increased chance that the original estimate will be low, sometimes very low. That increases the risk of being accused of violating the Law of Good Faith and Fair Dealing by low balling estimates, even if it wasn’t intentional. It can also lead to a fight over money when the actual costs start coming in.
  7. Because of the perception that the Owner is required to pay for absolutely everything, many contractors do not get written and signed Change Work Orders or Additional Work Orders before making a change. They operate under the belief that they’ll be paid for all the work that they may do on that job. This can also lead to a fight over money when the owner realizes how much they owe on the project.
    These changes to the original scope of work are ones where the clients rarely want to pay a fair price. This is particularly true when part of the original work has been completed. If the extra costs aren’t documented at that time (in a fixed cost agreement the funds would be collected at the time of the change), the chances of the client protesting later are much greater. If all else fails, the client will later come back with, “we had a verbal agreement you were going to furnish that at no additional charge.”
  8. Changes can also increase the timeline on the project, an issue that isn’t always documented. All changes to the cost and timeline of a project must be in writing and should be sent to the client the day the change was discussed. These issues can and should be addressed and clarified in the original contract documents.
  9. 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, often substantially, 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.

DOCUMENTATION REQUIREMENTS

  1. For your own protection, you must keep an accurate day to day log of all labor, materials, subcontract and other fees or costs on the job to be able to verify your actual expenses to date. The contractor should also keep a good set of before, during and after pictures to verify all work in progress or completed and all related expenses. 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. This exercise will increase the contractor’s expenses on the job in several different areas above what would be considered normal on a fixed price contract.
  2. In addition, you must have in your possession every document from the job that has incurred a cost. This includes all time cards, invoices, receipts, or any other papers related to the project. If you lose any item, you may not be paid for it.
  3. The client often will want a budget spreadsheet to manage the project by and a ‘not to exceed’ amount in the agreement, as well. They want the best of all worlds with no risk to them.
  4. Plan to be on email each evening to each of your clients regarding their Cost Plus project. These communiqués document the contractor’s process, what has been done, by whom, when and with pictures to later prove what happened if challenged in court. Again, Cost Plus agreements equate to voluminous documentation. That documentation is extra time and in actuality increases the contractor’s cost of doing business, particularly if the work is being done by a specialty contractor(s).
  5. Of further concern, they will generally want to control all construction funds and pay the invoices themselves. This assures the client of a tight hold on the costs but at the contractor’s risk.
  6. 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 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?

WHAT HAPPENS IF?

  1. Who draws the plans and gets the permits on a Cost Plus 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 time the contractor must spend to go to the building department and get a new or revised building permit that includes the revision? Who pays for the revised permit?
  2. 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?
  3. 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?
  4. Will the Owner be willing to pay for your travel time and mileage 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?
  5. If you make a mistake on a Cost Plus 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?
    Unless you have specific language, which precludes you paying for errors/mistakes, an owner can legally come at the contractor on this point. Leaving out the language about mistakes does not protect the contractor. In actuality, a court of law will likely make that decision for you. There is a legal concept called “reasonable care”. Contractors are held to a reasonable care mandate. Therefore, expect the Owner to be on-site more and be more scrutinous of the contractor’s process when using a Cost Plus agreement.
  6. Who makes up the material lists for jobs with Cost Plus contracts that are needed before the job starts? If you do, will you be paid for that time?

MATERIALS

  1. Owners are far more prone to want to furnish some or all of the materials for their jobs when using a Cost Plus 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?
  2. If the materials for the project are ordered through the contractor, they will actually be responsible for the financial payment to these suppliers as the contractor was the point of contact. If the owner does not pay in a timely manner or chooses to pay a reduced amount, the contractor is responsible for that payment. Specialty contracts should spell out who the parties are involved in the Cost Plus agreement.
  3. 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?
  4. 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.
  5. Cost Plus 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.
    Further, an owner can file a civil claim against the contractor alleging fraud by means of collusion with suppliers. Sadly, this actually does happen and all too often.

PRODUCTION ISSUES

  1. 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, bathroom breaks? 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?
  2. 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, gaming or texting.

PRICING ISSUES

  1. 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.
  2. Owners believe that Cost Plus 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.

  3. Owners do their homework, put their job out for “Bids” @ cost plus a 6%, 7% or 10% 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.
    The client will almost never agree to the contractor getting a reasonable margin on a Cost Plus agreement because most if not all of these clients believe that Cost Plus is a cheaper way to get a job done. If the remodeling contractor attempts to negotiate at least a 33% gross margin or the new home builder attempts a 21% gross margin, which is the minimum either should charge, the client will likely think the contractor is trying to rob them. There are many companies who are desperate and quoting such low numbers to the client that they will drive themselves and others out of business if you try to compete with those lower margins.
  4. One way many contractors handle Cost Plus 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.

SUBCONTRACTOR ISSUES

  1. 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?
  2. 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)?
  3. What does the contractor do when the subcontractors hired by the owner will not do as instructed by the contractor or adhere to the contractor’s time schedule? What does the contractor do when the sub wants to raise their price(s) during the job because their original estimate for the job was too low?
  4. 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?
  5. On Cost Plus agreements, the contractor is required to solicit multiple bids on each trade to document that he is getting the lowest price on every category. These bids are then provided to the client as documentation and the client awards the project to the lowest bidder. There is much time required in this process. This is not optional. Using massaged numbers is a quick way to a legal action by the owner against the contractor and the contractor being branded as deceptive.
    This may also result in the contractor having to try and manage small companies or “hobbyists” that do not know how to estimate or in fact, build the job they are bidding, or how to manage their own company. Additionally, they often don’t show up on time or at all and do substandard or just plain unacceptable work which the contractor then gets blamed for.
    There are no hidden profits to be realized in this form of agreement. You do not even know what company will be providing the services and they will have their number driven to their lowest margin. To further complicate the issue, these low subcontract bidders will be trying to get more money along the way to make their part more profitable for themselves (yet another time consuming problem to manage).
  6. Do you write a subcontract agreement for each contractor? How can you protect yourself if you do not? This is a good practice in all types of construction agreements but especially important in Cost Plus.
  7. There should never be any later discounts or refunds from a subcontractor or supplier directly to the contractor. If that should occur, the contractor is legally obliged to pay those to the Owner. Also, if one of those were to occur, the owner will then question how many more of those are out there leading to possible legal action against both the contractor and their firm?
    Again, is that aspect a component of the contract documents? Many contractors try to skirt that issue and attempt to get kickbacks after the job has been closed out. These are ethics issues as well. It is a form of stealing client funds. Just because one gets away with it does not change that it is a form of theft. Where does the contractor draw the line?
    It should be clearly stated that all quotations are at their net and noted as such to preclude the later discount problem, which again, would be a fast track to a legal problem. The contractor, via your contract, must assure the Owner there will be no additional monies exchanged.

An important question to ask contractors is why would you choose or accept a Cost Plus agreement over a fixed cost/fixed scope of work contract? After all, you must know your overhead costs and material/labor costs no matter what type of agreement you use. In a Cost Plus agreement you are held to higher level of accountability than on a fixed price agreement. There is huge case law that determines what levels a contractor is held to for a Cost Plus agreement.

Previous legal advice suggests that an owner wanting a Cost Plus agreement will be the most likely to take legal actions against a contractor either for real problems or a perceived bargaining wedge to get the contractor to lower his fee. They are more interested in a lower price rather than a fair price.

A proper construction agreement is always essential in our business. In theory, this legal instrument should fairly represent both the owner and the contractor/construction entity. This agreement should always follow the unwritten rule that almost all judges and arbitrators look for and that is the law of “Good Faith and Fair Dealing.” This definitive legal instrument describes the scope of work, the value of that work and the points at which the owner pays for work completed/product ordered, etc. The contractor’s business consultant/attorney is a must to assist with a well thought out, fair to both parties and yet protective (if all the rules are followed) agreement. The threat of legal action is very real and all projects should be managed to protect the company and individuals in the firm. In addition to legal actions, the contractor’s reputation is at least equally important.

What’s the alternative to a Cost Plus contract?

The best alternative to Cost Plus contracts are fixed figure or lump sum contracts. In that type of contract, the contractor clearly defines the work to be done, and quotes a firm, fixed price to do that work. The only thing that will change that price are changes to the work, and those changes are only made after the owner knows what the change will cost them, how it will increase or decrease the fixed price, and has signed their agreement to the change.

The advantage to home or building owners is the certainty of knowing what the job will cost once it’s completed.

Often material or installed allowances are required to handle selections, and if the actual selections differ from the allowance, a change work order is written for that change.

Properly written, a fixed price contract will greatly reduce the potential problems that are inherent in Cost Plus contracts and get the job built at a fair price.

Thank you to Michael Beck, senior partner at Beck Design Group, Inc., Atlanta, Georgia, for your assistance in expanding this document. (updated June, 2020)

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