Understanding Cost-Plus Pricing

A cost-plus pricing structure essentially means you are charging a fee on top of each dollar spent in a construction project. You spend dollars on labor, materials, and trade partners. 

So the easiest way to explain this to a prospective client is that "for every dollar we spend on your behalf, we charge $1.XX". (XX corresponds to the mark-up you charge).  

A common misconception about cost-plus contracts is that these are open-ended. If you're using these contracts as a blank cheque with your clients, I hope to change your perspective by completing this article. 

Another misuse of these contracts is adding a 'guaranteed maximum price,' which adds more risk onto the remodelers plate. The purpose of a cost-plus contract is to allow real collaboration on scope and price with all stakeholders in a project. Adding a fixed component to this changes the dynamic. 

Let's Start With Why (The Pros)

Time and material contracts can be beneficial in today's marketplace as it's increasingly common that projects are more customized and that projects start without most of the details fleshed out. Homeowners follow the Amazon Prime Now model of racing to start, which leaves things unclear. 

Unclear Details

There are many reasons why details take a long time to get figured out. Homeowners are making decisions they have to live with for the next 10-20 years. Designers and Architects are trying to manage the exterior/interior space planning to ensure that it resembles a replica of what's in a client's mind.

And at the heart of it is that as humans, we take mental shortcuts, and despite knowing we need to plan out projects properly, we default to the process of 'figuring it out on the fly.'

We find that the design selections seem to get put on the shelf and often aren't decided until we are well into the project. This is a recipe for disaster for a fixed-cost remodeler and is one of the leading sources of conflict in the fixed-cost pricing structure.

Site Conditions

How many times have you said to a homeowner, "Well, we aren't sure what we're going to find until we get into it"? Those are probably the most used words by any remodeler. If we had X-ray vision, we'd start with a clear idea of exactly how far each of our trade partners would have to go to execute the design concept.

But we don't. Sure, we have our best guess of the estimated cost based on the scope of work we believe to be accurate. But inevitably, we will encounter cost overruns based on the site conditions.

Using a cost-plus contract can be very helpful to help account for the elements that present themselves after demolition. To be clear, you need to be accounting for these actual increased costs using a robust change order process. It's not a free for all, and if you're using cost-plus agreements in this manner, you're likely to land in a heap of conflict with your client.

Accelerated Timelines

For years I would field initial inquiries from homeowners who just purchased a home and wanted to start demo 60 days later (or sooner) as soon as they clear escrow. My initial questions centered around finding out where they were in the process of design. And typically, they were right at the beginning.

For a large-scale project - or even smaller ones - getting to a thoroughly planned out project within two months is aggressive. It isn't easy in a custom project to get any measure of accurate cost control on the cost of the work in such a tight timeframe. 

A cost-plus contract is a helpful tool to allow for the design to occur in real-time to ensure that the project's actual cost doesn't squeeze your profit margin. 

You're Building A Prototype

I heard this from a builder on social media, and it's stuck with me. Essentially you're building a prototype each time you approach a custom remodeling or custom home project.

As such, it's virtually impossible to understand what the actual cost of a project will be before a project starts.

I've built things I've never made before, so I had no basis for estimating the build's overall cost from my past job cost tracking and experience. If I was to give a guaranteed maximum price on a project, I was indeed setting myself up to have my profit margin squeezed. And if you've followed me for any length of time, you know I'm passionate about ensuring that remodelers and custom home builders get paid what you're worth. 

Caution: The Cons To Cost-Plus

One of the main pitfalls I want to steer you clear of when using a time and material price agreement for your jobs is that this removes your risk and liability. It would be best if you didn't approach these projects from this mindset.

Fiscal Responsibility

First and foremost, it's essential to recognize that with great financial transparency comes great fiscal responsibility. In other words, you need to have a rock-solid financial tracking system in place to track the actual costs versus the estimated costs in real-time.

You mustn't enter into a cost-plus contract with the mindset that the client will pay for every expense you encounter.  

You must continuously be tracking costs by cost category and reporting this to your client weekly. Yes, weekly. If you're doing anything more than this, you will leave your clients in the dark when it comes to making real-time decisions on their project.

Limitations On Profit

The other day, I was chatting with a remodeler who told me that he changes his trade partners' invoices before submitting them to his clients in his invoicing packages. It was part of a discussion on how to profit more in a cost-plus agreement. While I recognize that having your mark-up visible for clients reduces the amount you can add, I do not condone changing the transparency concept by altering someone's invoice to you. That is just bad business.

Yes, there is a limit to what you will find you can sell to a prospective client when making your mark-up visible. 20% is the threshold for what typical cost-plus remodeling and custom home building brands can typically sell in my region. It's not to say you can't charge more as I know many who do, but this would be what is typical around these parts.

As you might already know, remodelers typically need to be above 40% mark-up to be profiting as they need to. This leaves a significant shortfall. Part of this shortfall is accounted for by the hidden mark-up inside of your labor-hour rate. And depending on how you're structured, you could have a very significant "contribution of profit" from your team's labor.

This means you are charging X% on top of every dollar spent but are compounding on top of the profit built into your charge-out rate. This is one method to get around the limitation on the mark-up you charge.

For more insights on how to profit on cost-plus contracts, reach out and book a strategy session with me.

Story Loops

When you watch a movie, you want the guy to get the girl, or the girl to get the guy. If the movie ended before the final scene, you'd lie awake in bed dreaming of all of the possible endings. You'd feel unsettled.

This is precisely how a homeowner feels when it comes to a cost-plus project. They want upfront accurate information about the total cost of their project. Think of buying a car. If the dealer said, "this is our best guess at the moment, but it could change," how would you feel? This is why homeowners will naturally gravitate to a set price mentality regarding their new home/remodeling project.

This is why it is critical to ensure that you provide accurate figures for the cost of materials, subcontracts, and a realistic total of labor hours based on the information you have at the current moment. And even more, the reason why you need to be updating these costs constantly to keep your client clear with the running project cost.

Change Order, Contingency, Blank Cheques

If you've followed me for any length of time, you know that I can't entirely agree with the concept of baking in a "contingency" into your estimated costs. Drawing down on a contingency fund becomes a pattern you imprint into a client's mind. When that fund is empty, you now start doing change orders, and homeowners have a tough time understanding why you're currently doing this as they haven't experienced it to date.

Not using change orders is a prevalent mistake when it comes to a cost-plus project. Do not use contingency because you won't accurately account for every unique scenario when it comes to a custom remodeling/new home project. And that means that when you continue to attribute this and that to contingency, eventually it will run out, and you'll have failed at managing client expectations.

I can't stress this enough; cost-plus does not mean your client is writing you a blank cheque. It would be best if you treated the estimate you prepare as the working budget and a floating target that you will be within 5% off (under/over) that you reconcile with change orders. In other words, you provide realistic estimated costs and use change orders to account for the differences.

Missing Job Costs

Project Management time and Site Super time need to be part of your costs. With a cost-plus contract, you have to have everything in your cost estimate; otherwise, get ready to chow down on paying for someone else's home.

We talked a moment ago about how there is a limitation on profit. We also discussed how we make a compounded margin on the built-in profit in labor rates. So it follows that we must allocate inside of our cost estimate every single possible hour of work accomplished by you and your team.

This means we need to account for others on your team who contribute to the project - i.e., indirect costs. An example is your financial person, who manages the financial tracking and invoicing. They become a direct job cost in a cost-plus construction contract. 

And most importantly - regardless of the types of contracts you use, you must give the estimating process time and space to develop and be as accurate as possible.

The Bottom Line

Cost-plus contracts can be a very effective way of doing business provided you don't treat this like a blank cheque with your clients. There are pros and cons to this approach much like the fixed-cost approach (which we'll dive into next time).

As someone who operated very profitably in the cost-plus environment, it is possible to build a very successful brand in this method of operating. Follow the cautions in this article and you are well on your way to profiting as you should.

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