Should I Charge Cost-Plus or Fixed-Cost?
One of the biggest questions that many remodelers and custom home builders ask themselves is which of these two industry-standard pricing structures they should use: Fixed-Cost or Cost-Plus?
Answering that depends on many factors, the first of which is whether you want to charge a fixed fee for your work or your exact cost plus a percentage markup. Both methods involve some degree of risk for both the remodeler and the homeowner, which we'll discuss below.
It's important to carefully consider the pros and cons of both pricing structures and then determine whether a fixed-price or cost-plus construction contract best fits your residential construction business.
Transparency
Before we dive deeper into the two models, it's important to recognize that, at a high level, the main difference between fixed cost and cost-plus is the transparency of costs to the client.
When working with Cost Plus contracts, the client has more transparency than in a fixed-cost contract. The risk pendulum increases as you move from a detailed cost-plus model toward a lump sum fixed cost.
What is Cost-Plus Pricing
If you're using cost-plus pricing in your remodeling business, you are charging clients a percentage markup on top of each dollar spent on labor, materials, and trade partners on a construction project.
To a client, this means: "For every dollar we spend on your behalf, we charge $1.XX". (XX being the markup you charge).
This differs from a Time-and-Materials contract in which the contractor is reimbursed for direct costs without a markup.
The purpose of a cost-plus contract is to allow real collaboration on scope and price with all stakeholders, treating the project like an open book without a "guaranteed maximum price."
Benefits of Cost Plus Pricing
Cost Plus contracts can be beneficial in today's marketplace as it's increasingly common that projects are more customized, and they often start without most of the detailed plans fleshed out. In a fixed-cost world, that's a huge risk for home builders because there are so many unknowns that they can't assign hard costs to, which can translate into a loss of profit.
Unclear Details
The fixtures and finishes a client chooses for their home are things they will live with for the next 10-20 years, so, understandably, it may take time for them to decide - especially if they are working with architects and designers to turn their visions into reality.
We try to encourage clients to make as many decisions upfront as possible in order to provide a more accurate estimate and reduce reliance on construction allowances.
But some items will end up becoming allowances. Since it's always best to use cash allowances, fixed fee builders carry the risk of having to figure out how to work in their markup to those allowances without making it visible to the client.
Cost-plus operators, however, bill the exact costs at purchase time plus markup, so there's less risk in not making their margin.
Unknown Site Conditions
While we do our best to estimate both the scope of work and cost in pre-construction, unless we have x-ray vision, we can't truly know what's hiding beneath the walls and floors until demolition.
And that means we will encounter cost overruns based on hidden conditions on-site.
With a cost-plus contract, client conversations about unexpected costs that present themselves after demolition are easier to navigate because those costs are transparent. This can be a bit more contentious in fixed-cost because costs aren't visible, which can fracture trust with the homeowner.
To be clear, you need to be accounting for these direct 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
It's not uncommon to find prospective clients wanting to remodel a home they've just purchased. But when a client is reaching out about remodeling during escrow, there's a good chance they don't have a fully-formed design plan yet.
A thoroughly planned out design takes time, and if the client is in a rush to start demolition before that plan is finalized, it can be extremely difficult to accurately measure the scope of work and the exact costs in the original estimate.
In cases like this, cost-plus billing allows for the design to occur in real time without letting the project's total cost squeeze your profit margin based on a pile of assumptions.
You're Building A Prototype
A good way to think about your projects in the custom home-building world is that they are prototypes. And very often, when building a prototype, no two are the same. So it becomes challenging to properly estimate project designs you haven't built before, which is why it can be beneficial to use a cost-plus contract.
Using a "best-case" scenario when estimating labor involved in a complex project is very common, and if you have no basis for comparison and are using a fixed price contract, that is where your margin tends to be diluted. Learn more about how to estimate labor for your remodeling projects.
Caution: The Cons To Cost-Plus
One of the main pitfalls to avoid when using a cost-plus agreement for your jobs is the mindset that this removes your risk and liability. In actuality, it levels the playing field, assigning risk to both the contractor and the homeowner.
Homeowners Don't Like Uncertainty
Imagine you're buying a car, and the dealer says, "This is our best guess at the moment, but it could change." How would you feel? This is why homeowners might gravitate to a fixed-price scenario for their new home or remodeling project.
So it's 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 also why following a paid pre-construction process is critical to your success as a cost-plus remodeler.
Fiscal Responsibility
It's essential to recognize that with great financial transparency comes great fiscal responsibility.
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 all the extra costs you encounter regardless of how over budget you are.
Continuously tracking costs by category and reporting this to your client weekly allows them to make informed financial decisions in real-time. Ensuring you have this system in place is crucial for using this billing system to track the project's overall cost.
Limitations On Profit
To run a successful and profitable remodeling or custom home building business, you need to correctly estimate the cost of goods and charge the right markup to provide the right margin contribution to your overhead expenses and your company's net profit. Remember that markup and margin aren't the same things!
Depending on your overhead costs and net profit goals, that margin will vary from company to company. Generally speaking, you should aim for 30 - 33% in gross profit margin as a fixed-cost remodeler and 22 - 26% as a cost-plus remodeler.
Because your markup is visible to clients in a cost-plus contract, there is less risk overall but less opportunity for profit too. Not many clients will tolerate paying higher than 20% on top of each dollar spent on their project, so there is a gap to make up.
For insights on how to make up this gap in profit on cost-plus contracts, reach out and book a strategy session with me.
Scope Changes vs. Variances
It's inevitable that things will change from the planning phase to the actual construction phase of a remodeling project because no matter how well you try to account for every possible scenario:
Clients will change their minds
Hidden conditions will alter the project scope
Prices for materials or labor will fluctuate
I can't stress this enough; a cost-plus contract does not mean your client writes you a blank cheque. It would be best to treat the original estimate you prepare as the working budget and a floating target that you will be within 5% off (under/over), which you reconcile with change orders.
Variances on a cost-plus job can spiral quickly and fracture trust with your clients if you're not accounting for them with change orders. One of the common downsides homeowners will read about on the internet when entering into a cost-plus agreement is that the builder has little incentive to work quickly and keep a lid on final costs because they will make more money.
You can instill trust in the client-contractor relationship by working through a proper pre-construction process to determine the final price before you begin, having a robust job cost-tracking system, and reconciling variances with change orders.
Missing Job Costs
Project management time and site super time must be part of your labor costs.
With a cost-plus contract, it's common to think that your markup covers your project management and site supervision time. This is commonly what homeowners believe when it comes to reviewing your cost estimate. But project management and supervision are job costs and need to be allocated into the cost of goods before markup.
It's also critical that you factor this into each change order you create because when a project's timeline increases, so does the project management and supervision time.
What About Fixed Cost Contracts?
A fixed-price contract is more likely to create tension between remodelers and homeowners because the homeowners feel that they aren't getting the full picture of the overall cost, and remodelers often feel like they're getting squeezed.
But while a fixed-cost contract price does put remodelers at a higher level of risk, it can also yield more opportunity for profit.
A few variants of the fixed fee construction contract include lump sum, stipulated price, and guaranteed maximum price. But, essentially, they are all the same in spirit.
"For all of the scope listed in this contract, I charge you a set price of X dollars."
There is a modified version called "Fixed Cost plus Allowances," which involves the builder providing a schedule of costs assigned to products being installed (e.g., hardwood, tile, plumbing fixtures, etc.). This version helps to remove a bit of risk for the contractor but can also be a challenge to manage. Learn more about using allowances in residential construction here.
Pros Of Fixed Fee Contracts
Fixed price contracts can be used effectively to produce the right contractor's profit for your renovation company while also providing clients with that certainty about the final contract price they don't get from a cost-plus job. But managing alignments is critical when working with fixed fee contracts.
Opportunity For Profit
Every remodeler has a finite capacity for throughput and profit within a given financial year. The actual amount varies depending on whether you staff more projects with internal labor or rely on external trade partners, but essentially, you have a cap on how much work you can produce within a year.
A fixed-price contract gives remodelers the freedom to mark up hourly rates, materials, and trade partners, and it offers contractors a chance for a higher profit opportunity by adding "padding" or "cushion" in each pricing category.
As a fixed-cost remodeler, if your drywaller prices the work for a major remodel you're working on at $16,000, and you've priced $20,000 into that category, plus you are charging a 40% markup, that provides you with $4,000 in padding profit and $8,000 in gross profit.
As a cost-plus remodeler, you might have had $20,000 in allowable costs for drywall, but when the actual bill comes in, you are charging your client the $16,000 plus, say, a 20% markup. That means $0 in padding and $3,200 in gross profit.
Book a strategy session here to learn more about making up this profit gap using cost-plus contracts.
The Over/Under Game
Using a fixed-fee contract probably looks pretty attractive in that last example. And the truth is that, in general terms, you can stand to be more profitable using a fixed-cost contract, provided you use it correctly.
Inevitably, you will likely be higher on some costs than what you've allowed and lower on others. But with a proper job-costing system in place, you can use past results to ensure your projects never fall below your anticipated profit margin.
An advantage to the over/under game when estimating projects is that a fixed-fee contract can be more forgiving for maintaining your profit margin, provided you've diligently developed an accurately detailed scope of work.
I once had a client who commented that he was slightly embarrassed when his estimate for a trade was either way under or way over, which was why he liked using the fixed-fee contract type. It certainly does take the pressure off when the numbers are masked.
Clients Appreciate Certainty
Clients ultimately want to know how much their renovation will cost them and some certainty that this won't exceed that price.
This is why fixed-cost contracts can be appealing to them.
However, it requires diligence on your behalf to ensure you've captured all the actual costs in a remodel or custom home build. And if you do this correctly and continue to learn from your past results using your job costing, you stand to have an easier time selling projects.
On the other hand, a fixed-price estimate is typically higher than a cost-plus estimate, so you need a strong sales process that connects your value to your price to influence clients to sign with you.
Caution: The Downsides Of Fixed-Fee Contracts
While a fixed-cost contract can offer a higher opportunity for profit, there are several potential pitfalls to watch out for.
Increased Customization & Missing Details
There isn't much room for flexibility when it comes to allowances and customization in a fixed-cost estimate. Yet clients and design partners are often striving to create completely customized homes, and it can be challenging to price these accurately because each custom build is essentially a prototype.
And if the remodeler and homeowner aren't able to get truly aligned on the project details before it starts, it can lead to a slew of changes that leave the homeowner feeling trapped and the remodeler at risk of bleeding profit.
This is why every change needs to be captured and accounted for in real time so that those costs can be passed along to the client as a change order and not absorbed by you. But very often, there can be disagreements between what was included and excluded or new. And this can lead to massive profit bleeds for the remodeler.
The Relationship Can be Polarizing
We discussed earlier how fixed-fee contracts can create tension in the client-builder relationship because of cost conversations for changes as the project progresses. Often those changes are a result of the allowances that are made at the beginning of the project.
I once had a client say that the allowable amount we carried for their plumbing fixtures didn't provide them with options in their project. And that they'd have to spend a lot more to get what they wanted. Since plumbing fixtures are one of the first selections in the process, this set the wrong tone for the client for the remainder of the project.
This is why it's critical for remodelers and homeowners to use the pre-construction period to get as much clarity and alignment about the project as possible and set reasonable cash allowances for design items like fixtures and finishes - so the client has a more concrete sense of the total project cost and the remodeler isn't feeling like their profit is being squeezed.
Clients Have Less Control
Put yourself in your client's shoes for a moment. They likely don't know much about remodeling or custom home-building costs. Yet, they are bombarded with tons of BAD information about unexpected construction project costs.
Then they meet you, and you help them understand those costs, but only in a lump sum price, not with specific line items. So they don't know HOW you arrived at this final price.
In their minds, it should be as transparent as grocery shopping. Once the groceries are bagged, they're given a final bill, but they know by line item what made up that total cost.
With a fixed-cost remodel or custom-built home, they don't get that breakdown, making it hard for them to reconcile the final price, leading them to perform extreme mental gymnastics to figure it out.
It also means that when changes or new details occur, they don't know the financial impact, which leaves them feeling like a passenger in the car versus being the driver.
You Can't Compare Apples to Oranges
One of the biggest challenges any general contractor faces is the apples-to-oranges comparisons that clients will try to make with the estimates they receive. The homeowner will use competitors' prices to try and negotiate the "best price" for their project, judging your estimate on one final number instead of a detailed breakdown of the components that make up that number (materials, labor costs, overhead expenses, etc.)
But often, doing it this way only opens them up to incredible risk and disappointment as the project continues.
In order to alleviate this, you need to work through a solid pre-construction process that develops trust with the client by building a clear and comprehensive scope of work that everyone agrees on.
Remember: Changes Are Changes
In either pricing model, any changes to the scope of work are price changes. Provided you've been clear with the inclusions and exclusions in your scope of work, you must manage any changes due to site conditions and client requests in the form of a change order.
It means that you have to be diligent in detailing your clients' exact scope of work, including an expectation of what types of fixtures and finishing materials you've allowed.
It's common for clients to decide on a more expensive kitchen faucet, shower tile, or hardwood selection. And when they do, it's critical to create a change order for the increased cost in whichever contract type you're using and to ensure that the change order includes your markup too.
The added markup is critical because the cheapest time to make changes to a project is during pre-construction. Once the project moves to the actual construction phase, the impact of client changes on you is bigger, and starts to affect your overall profitability and throughput for the year.
Which One Should I Use?
Hopefully, you've gained a lot of insight into both fixed-cost and cost-plus options and have been able to think through which method is the best option for your residential construction business.
Deciding on which model to use revolves around how transparent you want to be with your clients. There's no right or wrong way to do it, but I encourage you to pick one model and stick with it.
It's not to say that you can't operate in both a fixed-cost and cost-plus manner. But adjusting your sales language, ongoing communications, and billing practices with each client becomes difficult.
It also becomes hard to optimize your profit model when mixing these two pricing structures, and the lines between them can become blurry. It's not uncommon to see fixed-cost remodelers start to provide line item pricing in their proposals, which creates confusion for clients and increases the risk of profit loss for the builder.
Pick one method and stick with it for a while because you can be very profitable with either. The grass is the same color green on the other side of the fence.
The Bottomline on Pricing Models
Your success as a remodeler or custom home-builder depends on your ability to sell your value to your prospective clients, regardless of which billing method you use. You have to help homeowners understand that you have their best interest at heart, and that's WHY they should work with you instead of someone else.
Your chosen pricing model, fixed-cost or cost-plus, is only a part of that sales conversation.
Fixed-cost contracts offer clients more certainty over the total project cost and can allow for a higher opportunity for profit. But they are also more rigid and remove some of the control away from the client, potentially creating difficult conversations and fractured trust.
Cost-Plus pricing offers more flexibility to clients and builders for dealing with unknown design decisions and unexpected site condition changes because every change or issue is billed individually, but it does remove the certainty for homeowners about the final cost of the project and can limit the amount of markup a builder can add, which can affect overall profitability.
You are a client's guide through a messy process they don't know much about. Selling your value is the key to being profitable in the construction industry. So whichever model you choose, remember that it's more important to be able to sell.
If you want to learn more about integrating a proven sales process for either pricing model, book a strategy session here.
