Construction Contracts: Fixed Price Vs. Cost-Plus - DeMarque Finance

Fixed Price Contract

In a fixed price construction contract, the total cost of the project is agreed upon between the client (usually the owner or developer) and the contractor before the construction work begins. The contractor provides a detailed breakdown of the project’s scope, specifications, and associated costs. The agreed-upon price remains fixed throughout the project, regardless of any unforeseen circumstances or changes in material prices, labour costs, or project requirements. The contractor bears the risk of any cost overruns or delays, ensuring that the client’s expenses remain predictable and manageable. The contract structure you choose also shapes how lenders assess construction and development finance for the project — predictable costs make for an easier funding approval.

Advantages of Fixed Price Contracts

— Certainty of costs: The client knows the exact amount they will pay for the project, facilitating budgeting and financial planning.

— Contractor’s accountability: The contractor is responsible for managing costs effectively and delivering the project within the agreed price.

— Reduced administrative burden: The client doesn’t need to closely monitor or approve every expense, as the contractor absorbs cost fluctuations.

Disadvantages of Fixed Price Contracts

— Limited flexibility for changes: Any modifications or changes to the project may result in additional costs or negotiations.

— Contractor’s risk: The contractor assumes the risk of unforeseen circumstances, potentially impacting their profitability.

Cost-Plus Contract

In a cost-plus construction contract, the client agrees to reimburse the contractor for the actual costs incurred during the construction process. This includes the direct costs of labour, materials, and subcontractors, as well as overhead expenses and a predetermined fee or percentage for the contractor’s profit. The client pays for the project based on the actual expenses incurred, plus the agreed-upon fee.

Advantages of Cost-Plus Contracts

— Flexibility for changes: The client can introduce modifications or changes to the project scope, design, or materials without significant renegotiation.

— Transparent cost breakdown: The client can see the actual expenses incurred, ensuring transparency and accountability.

— Shared risk: The contractor and client share the risk of cost overruns or unforeseen circumstances.

Disadvantages of Cost-Plus Contracts

— Uncertain final cost: The final cost of the project may not be known until the construction is completed, making budgeting and financial planning more challenging.

— Client’s oversight responsibility: The client must actively monitor and approve costs to prevent excessive spending or disputes.

How the contract type affects your funding

Lenders read the building contract as a risk document, not just a commercial one. A fixed price contract with a reputable builder puts the cost risk on the contractor, which is why it is the structure most construction lenders are comfortable with — the total development cost in the feasibility is a number someone else has warranted. A cost-plus contract leaves the cost risk with you, so the lender has to decide whether your contingency and your equity are deep enough to absorb an overrun. That doesn’t make cost-plus unfundable, but it usually means a tighter contingency requirement, closer scrutiny of the feasibility, or a different class of lender.

The contract also drives the mechanics of how you get paid. Funds are released against progress claims verified by an independent quantity surveyor, and the lender applies a cost-to-complete test at each stage — see construction loan drawdowns and progress payments for how that loop runs, and construction finance costs and feasibility for how the contract sum feeds the feasibility the lender actually assesses.

Related reading: Construction & Development Finance · Commercial Property Finance

Disclaimer: It’s important to note that these are general characteristics, and specific contract terms may vary. Before entering into any construction contract, it’s advisable to seek legal counsel and engage in detailed negotiations to protect the interests of both parties.