Many years back a friend and I spoke at a convention on the topic of cost-plus. I spoke first and explained why I believe cost-plus jobs are a mistake waiting to happen. My friend, an attorney, spoke next and said he thought cost-plus contracts are a great idea. Then he smiled and acknowledged that it might not be a great idea for contractors, but they lead to more litigation and that was good for attorneys.
I thought of that reading a recent article titled Why I Switched to Cost-plus. I’m amazed that an industry magazine, which should be focused on helping contractors, would publish an article that begins, “All contractors deserve to earn a profit and cover their overhead, just as all clients deserve 100% transparency in how their money is spent.”
Someone tell me why clients deserve 100% transparency in how their money is spent. Do any of us get 100% transparency in how our money is spent? Do contractors only deserve to earn a profit and cover their overhead if they agree to provide 100% transparency in how the client’s money is spent?
Clients deserve 100% transparency in what they will get for the money they spend. They don’t deserve to know how that money is spent. The financial details of your business are private, just like the financial details of any other professional business owner.
Believe it or not, the author is a contractor. I think he’s been beaten up by clients and mistakes often enough that he’s taking the easy way out, and that will limit his profit and increase his risk in the years to come. It was an interesting article because there are some things I admire about how he does business.
Positive Business Practices
He talks about vetting his clients, “Not everyone who calls me is a good fit.” He gets paid to put together a written ballpark line-item proposal. He spends time on preconstruction planning and gets paid for that time as well. That’s what all contractors should be doing.
During the preconstruction planning, he writes, “We go through the plans with a fine-tooth comb, pricing everything from frame to finish. This includes selecting fixtures for pricing, receiving subcontractor quotes, and the like. Essentially, we run through the whole job on paper, while working together to make adjustments to maintain the bottom-line budget. This work is billed by the hour. Note: I have separate contracts for preconstruction and construction, in the off chance we don’t perform the construction. It ensures that the planning service is paid for and underscores my belief that builders deserve to make a profit when they perform services for clients.”
He talks about the value of job costing, although he speaks as though it’s unique to cost-plus projects: “Another benefit of working cost-plus and tracking a job from start to finish comes in the form of hard data about the performance and costs associated with specific tasks. Comparing the initial preconstruction job estimates with subsequent tracking of job costs during construction highlights the accuracy or inaccuracy with which you understand your business.”
With his attention to detail and level of preconstruction planning, which includes collecting quotes from subs, why not finish compiling the estimate and quote a firm fixed price? Two reasons came out: estimating labor, and the risk of hidden conditions.
Estimating Labor
He’d lost money on previous jobs by underestimating labor. The caption under one photo reads, “I wish this job had been cost-plus. This job was early on in my career and it took hundreds of hours to complete. Cost-plus shines on jobs like this where we have a lot of high-end details and fixtures that we had never done before. Instead of relying on my guess for how long it should take, we could have simply been tracking our hours and billing for them.”
He’s swapping one problem for another. Labor is the topic most apt to cause conflict on a cost-plus job. Clients can’t argue about material invoices or subcontractor quotes, but they can argue about why it took so long to frame the staircase. They aren’t happy to pay for training time. They aren’t thrilled with paying for bathroom breaks or multiple trips to a supply house when things are forgotten, or time spent on a phone call that pertains to another job or an upcoming birthday.
On the topic of labor, he also wrote, “A great selling point of cost-plus is that if things progress faster, they cost less and ultimately encourage efficiency on site. Cost-plus also ensures that detail-oriented and labor-intensive tasks are not subject to an educated guess of how long they might take.”
Someone needs to explain that to me. What’s the incentive to have things progress faster on a cost-plus job? How does cost-plus encourage efficiency? It’s easy in today’s environment to move a job along when five other jobs are waiting in the wings, but what about when business slows down? If your employees know they’ll be sitting at home once this job wraps up, they have no incentive to get things done on time or ahead of schedule.
Estimating labor can be difficult, and sometimes you miss. It takes time and practice, but if you want to make money in this business, it’s what you need to do. Your skills improve when you compare the actual labor to your estimates so you know where you fell short. That also gives you the info you need to adjust future estimates while you keep learning. In the book Estimating Construction Profitably, I give a few tips on how to estimate your labor time so you don’t lose your profit. Yes, estimating labor is an educated guess, but your education improves as you gain experience. In the meantime, as I explain in the book, include a buffer and be realistic.
Hidden Conditions
He also talks about hidden conditions costing him money when he built jobs on a firm fixed price. “After a few years of working with fixed-price contracts, I began to realize just how easy it is to miss things when preparing an estimate. It’s a fair assumption that most if not all builders have experienced the anguish of discovering they forgot to include something but being reluctant to ask the client for additional money. A large enough error can impose a significant financial burden on a builder, particularly one who’s in the early stages of establishing a business.”
There’s a difference between missing items on an estimate and hidden conditions. You’ll miss fewer items if you create a checklist and use it consistently when estimating. That’s a matter of discipline.
The author states that his business is primarily historical buildings, and older buildings are more at risk for hidden conditions requiring a closer look. Years ago, I took several sales calls in an older, wealthy part of Portland, where many of the homes began as vacation cottages in the late 1800’s. I was surprised to find 2×4’s used for floor joists in some of them. I didn’t discover the floor joists by accident after we’d started the job; I discovered the problem before estimating by crawling under the houses, often in tight spaces. Nothing worthwhile comes easy.
There are very few hidden conditions that are completely hidden. Almost always, you’ll see clues to rot or other problems if you look closely enough. If you’re still not sure, offer a Discovery and Demolition agreement. We explain how to present and write this type of agreement, and how to incorporate it into your overall contract, in the book Profitable Sales, A Contractor’s Guide.
Security vs. Profitability
You’d think with all the preconstruction planning and attention to detail he provides, a firm fixed price contract would be easy and far less risk. But he doesn’t see risk with cost-plus, he sees security. “It has the potential to be a great vehicle for ensuring transparency, financial balance, and shared risk on expensive construction projects.” “Since switching to cost-plus, the stress I used to carry wondering whether I made money has evaporated, replaced by the security of knowing we are earning the wages we want and my business is making money.”
The article wrapped up with this statement: “Cost-plus is adaptable: If I want to increase profits, I simply change my percentage. The same is to be said for increases in overhead costs or projects that require extra management.”
That’s a statement that requires testing in real life. Cost-plus means you need your clients to agree to your overhead and profit percentage. Why would they agree to let you increase your profit?
A firm fixed price quotation gives both you and your client the security of knowing what the finished project will cost. With a detailed estimate, using the correct markup, you’ll know you can make money on the project. With a proper payment schedule, you have the security of knowing you’ll be paid. With a written contract, you’ll both know the details of the job and what’s expected of each of you.
Both fixed-price and cost-plus contracts have risk. You can run a business and make a profit when you quote a firm fixed price for your work. With cost-plus, you’re working for wages. Do the hard work of estimating and build a profitable business.
The knowledge and experience Michael Stone gained in his 60+ years in construction has helped thousands of contractors improve their businesses and their lives. He is the author of the books Markup & Profit Revisited, Profitable Sales, and Estimating Construction Profitably, and is available for one-on-one consultations.
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