Construction is built around contracts; the word “contractor” itself is evidence of the pivotal role contracts hold. A construction contract is more narrowly defined as a written agreement between an owner and a bidder covering the performance of work, by which the owner is obligated to compensate the contractor according to the terms of payment. Two styles of contract are used almost exclusively in residential construction: Fixed Sum and Cost Plus Fee. These two styles have practical differences, and these differences may end up saving you or costing you lots of money. This article attempts to compare and contrast these two predominant contract types so that you can choose the one that best meets your project goals.
Fixed Sum Contract
A Fixed Sum Contract, also know as a Lump Sum or Stipulated Sum Contract, is a contract which provides that the home owner will pay the contractor a specified sum of money for the completion of a project. The amount to be paid is determined by the bid from the contractor. The bid is an official offer from the contractor to furnish all labor, equipment, materials, overhead and profit necessary to complete the specified project. For example, a remodeling contractor might offer a homeowner a bid of $30,000 to remodel their bathroom. This dollar amount is based on the budget a contractor plans for how much he thinks it will cost him to do the job and how much profit he wants to make on it. The homeowner can accept this bid, sign a Fixed Sum Contract, and consider the work done for $30,000.
Every Fixed Sum Contract is a small gamble on the part of the contractor. In an ideal world, a contractor would be able to estimate exactly how much time, equipment, material and overhead would be necessary to complete a project. In the reality of the residential remodeling world, surprises and unforeseen challenges are a regular occurrence. For this reason, a contractor must shield his business from the risk of loss by including money for contingencies and unexpected challenges in his bid budget.
Pros: In a Fixed Sum Contract, the homeowner knows exactly how much the project will cost up front. They have peace of mind knowing that once they pay the stipulated sum, the work specified in the contract will be completed by the contractor without additional costs.
Cons: Homeowners pay the amount the contractor budgeted for contingency plans whether or not they are put in place. This means a homeowner may pay for work that is not actually performed or for materials that are not installed. Contractors who intentionally or mistakenly underbid a project are more likely to cut corners and perform sub-par work to make up for their losses.
Cost Plus Fee Contract
Cost Plus Fee is a contract under which the contractor is reimbursed for their direct and indirect costs and, in addition, is paid a fee for their services. The fee can be stated as a stipulated sum, but usually is stated as a percentage of cost. For every dollar the contractor spends putting the work in place, he charges the homeowner a dollar plus his contracting fee. If the construction project is complicated or takes a long time to complete, the contractor may use progressive billing to charge the homeowner at regular intervals for whatever job expenses occurred during that billing period.
Even though a Contractor under a Cost Plus Fee contract is not legally bound to a final price for the work, homeowners should still require an accurate forecast of construction costs. For this reason, contractors still have to build a complete budget for how much they think the work will cost. However, unlike a Fixed Sum Contract, tasks or materials in a Cost Plus budget forecast that are not installed are not billed to the homeowner, and conversely, portions that end up costing more than expected will be charge to the homeowner above the original forecast.
For example, the same homeowner who had their bathroom remodeled for $30,000 in the Fixed Sum example above might choose to sign a Cost Plus Contract instead. In that case, the contractor might forecast construction costs at $25,000. The first month’s construction costs might add up to $5,000; month two at $10,000, and month three at $10,000, totalling $25,000. At the end of each month the contractor would bill the client for the construction costs listed above, plus his contracting fee, say, 20%. In the end, when the contracting fee is applied to each of the construction costs, the total cost for the project would be $30,000.
Pros: Time or material savings the contractor experiences on the job are passed on to the homeowner. When homeowners are offered a fair deal, they are more likely to have a good experience, recommend the contractor to others, and call them back for another project. With the security of knowing that every task will be paid for, contractors can do the job right without the pressure to cut corners in order to make a profit.
Cons: The homeowner has no guarantee of the final price of the project until it is complete. Additional costs due to complications or unexpected challenges are passed on to the homeowner.
Which Should I Choose?
As you may have noticed in the remodeling examples given for Fixed Sum and Cost Plus Contracts, though the contracts and billing procedures were different, the final cost of the bathroom remodel ended up being the same. So why does it matter which one you choose? A more detailed example will help clarify the differences between the two.
What if, in the $30,000 bathroom remodel listed above, the contractor predicted that demolition would take three days, for a cost of $1500. In both contract scenarios, $1500 would be budgeted for demolition. Now imagine the contractor finds the old bathroom materials were very easy to remove, and it only takes two days instead of three. The Fixed Sum Contract holder has already agreed to pay the full $30,000, so they do not experience any savings. On the other hand, the Cost Plus Fee Contract holder will save $500 because they will not be charged for a third day of demolition.
To be fair, this example could be reversed so the contractor estimates three days but it actually takes four to complete. Savings would then fall to the Fixed Sum Contract holder instead, because the contractor is responsible to complete the scope of work for the fixed sum. The Cost Plus Contract holder would most likely pay $500 above the forecasted cost for the additional work because it is necessary to complete the project correctly.
Unfortunately, some contractors are more concerned about making money than doing the job right. When faced with a shortfall in their bid, some Fixed Sum contractors will cut corners and perform tasks cheaply when it would cost more to do it correctly.
These examples illustrate an important point – the key to getting the best quality and value is to select an honest contractor with knowledge and experience who can accurately predict construction costs. This will help prevent the common pitfalls of incomplete cost forecasts or shoddy workmanship. A thorough contractor will help you determine which contract scenario best meets your goals. A company’s reputation and experience may be more important than initial cost forecast in the long run.
Provided to you by Olson & Jones Construction, Inc. We want to educate consumers in order to protect them from fraud and ensure that they are satisfied not only with their finished product, but with the process as well.