How Cost-Plus Fee Contracts Put Owners at Risk

Key Takeaways:

• Cost Plus Fee construction contracts for custom remodel and custom home construction projects have undetermined costs
• In Florida’s inverted construction market, cost-plus fee contracts create greater risks for owners.
• Under the cost-plus fee contract structure, higher construction costs equate to greater profits for contractors.
• NCHCC Construction Management Services help protect owners from the risks associated with Cost Plus Fee contracts.

If you were to buy a new, typical home to be built, you would purchase it at a certain Fixed-Price. Let’s say your home will cost $100,000.

For that $100,000, you – now the “Owner” – get a defined home built to defined plans and specifications. For example, your house will have wood-framed walls, a metal roof, and tile floors.

Builders can offer you a Fixed-Price because they are building a defined product. They determine the cost to build it and add in a figure for their overhead and profit. Traditionally, that figure is about 18%.

The Typical Setup

So, the Builder expects your $100,000 Project to cost $82,000 to build, and that they will earn about $18,000, or 18%, overhead and profit. To keep it simple, let’s suppose that the calculation looks like this:

Now, if it ends up costing more than $82,000, the Builder loses profit. If they manage to do it for less than $82,000, they make more profit. Whichever the case, the Builder is obligated to construct your home, as per the plans and specifications, for that Fixed-Price of $100,000 – not a penny less or a penny more.

This is the “risk/reward” system that drives Builders to do everything they can to control THEIR construction costs. With Fixed-Price Contracts, the Builder, not the Owner, takes on the risk for all of the Project costs – no matter what they end up being.

The Unknown Variable

If, however, you were to build a new, “high-end” custom home or remodeling project – like those common in Florida – the work would almost certainly be done under a Cost Plus Fee Construction contract.

“Custom” homes and remodeling projects are complex and (usually) large. The plans and specifications for them are always changing. They are never really “final”. Still, most Owners want to get their Projects done as soon as possible. They have a budget in mind for the Project and believe that, ultimately, it will cover the total cost of the work.

So, at some point during the Pre-Construction phase, preliminary plans for the Project are issued to as many as 3 or more Builders for pricing, even though the Builders lack the information that is needed to properly price the work at the time.

As they lack final plans and specifications, none of the Builders can be certain what the ultimate cost to build the home will be. Since they can’t determine a definite cost, no one can offer to do it for a Fixed-Price. Instead, they will propose to do the work on a “Cost-Plus-Fee” basis.

Each will offer to build your home for a lower overhead and profit figure – or “Fee” – than the typical 18% they would expect to make on a Fixed-Price job. Say, 16%. 13%. Sometimes even less.

In exchange for the lower Fee, the Owner agrees to bear the risk for all of the costs of the Project, instead of the builder. Sounds reasonable – right?

The issue isn’t the Fee, it’s with the Project costs. The problem? The owner doesn’t know what they are! Builders may provide them with “preliminary” cost estimates, but none of them are accurate, because they can’t be. As the information necessary to construct the Project is still incomplete, so are the estimates. In short, estimates from Builders for Cost Plus construction contract jobs are invariably much too low because they CAN be.

The tables have been turned. Not only is the Owner now responsible for all of the Project costs, they can’t know, for sure, at this point or at any point over the entirety of the construction process, what the true costs are or will be! Now, the calculation looks like this:

With Cost-Plus Fee Contracts, the Owner, not the Builder, takes on the risk for all of the Project costs – no matter what they end up being or how they come to pass.

Inevitably, Budget Creep (in tandem with “Scope Creep”) begins. Project cost increases seem to sneak – or “creep” – up as the work moves along, often as small increases, over time, over several cost line items. By the time the owner realizes their costs have spun out-of-control, it’s too late.

Owners with Cost Plus Fee Construction Contract agreements are exposed to a higher level of risk than they may think, especially in the “inverted” Construction market. They can’t know what their Project costs are, or will be, with any certainty, at any time. They can’t know from or control how hard their Builder is really working to manage their costs for them.

Naples Custom Home Cost Consulting CAN know all of these things and offers a full range of Construction Management Services to assist clients, including contract compliance and cost audits. When hired as an Owner’s Representative, we work to prevent Owners with Cost-Plus Fee Contracts from unnecessarily overpaying for their Projects by mitigating their risk and “pushing back” on their behalf.

Summary: Mitigate Cost Plus Fee Contract Risks with NCHCC

In addition to the many unknown costs of materials, expenses, and labor, cost-plus fee contracts in the Florida market are also prone to other avoidable construction costs. Fortunately, owners can act to mitigate these risks by hiring a company that specializes in doing exactly that: NCHCC.

Owners with the cost-plus-fee construction contracts trust NCHCC to help them avoid financial pitfalls an manager their risk by acting as their owner’s representative. We perform contract compliance audits, cost assessments, and other project management to protect every owner and their investment. Before signing that contract, talk to an owner’s representative at NCHCC. You’ll be glad you did!