When embarking on a construction project, one of the most important early decisions is selecting the type of contract to use. Construction contracts provide the legal framework for projects. They outline payment terms, responsibilities, variation processes, and more.
The specific type of contract used also significantly impacts both parties’ incentives, costs, and financial risk. Two of the most common types of construction contracts are cost-plus and fixed-price.
There are trade-offs for each approach. So, you need to choose the one that suits your circumstances the most favourably.
Here’s what you need to know about how they differ and what you should consider before deciding.
What is a Cost-Plus Contract?
A cost-plus contract is an agreement where the contractor bills the client for actual costs incurred plus an additional pre-negotiated amount for profit. With a cost-plus contract, no final price is determined for the project until after completion. Rules governing cost-plus contracts vary between states and territories, particularly for residential building work.
Under this contract structure, the contractor tracks all direct costs related to labour, materials, equipment, subcontractors, and other project expenses. As the work progresses, the contractor submits progress claims to the project owner outlining these costs, who is responsible for reviewing and approving these applications.
On top of the actual expenses, the project owner also pays an agreed-upon profit margin, usually as a percentage of total costs. This additional amount is often referred to as a fee, which is intended to provide a reasonable profit for the contractor. For example, a contract might provide for actual costs plus an agreed percentage or fixed fee. The margin is set by the contract rather than by a standard national rate.
A key aspect of cost-plus contracts is that most of the financial risk sits with the project owner. Since the final price is unknown until the end, the project owner takes on the risk of actual costs exceeding the budget or original expectations. The contractor is guaranteed a fee and a reasonable profit regardless of whether the budget is met.
Pros of Cost-Plus Contracts
Cost-plus contracts offer some advantages that make them appealing for certain types of construction projects:
- Flexibility to change the scope of the project: With a cost-plus contract, it is easier for owners to modify project scopes and plans, even late into construction. Since the contractor passes through true costs, changes can be accommodated more flexibly.
- Incentive for contractors to not cut corners: When contractors are guaranteed profit percentages, they have less incentive to use cheaper materials or take shortcuts that could compromise quality. Owners benefit from higher-quality construction under cost-plus agreements. Some cost-plus contracts also include provisions for cost savings and award fees, which reward contractors for efficient project management and for exceeding performance expectations.
- Owners can closely monitor spending: Owners maintain close visibility into what is being spent on a weekly or monthly basis. They can request detailed expense reports from the contractor and scrutinise charges.
Cons of Cost-Plus Contracts
However, there are also several downsides inherent to cost-plus contracts that owners must consider:
- Costs can spiral out of control: Without a fixed price contract, the final cost can escalate beyond initial budgets, especially if project scopes expand and variations pile up. Owners take on greater financial risks.
- The administrative burden on the owner: Scrutinising contractor progress claims and assessing expense reports takes time and effort. The owner must actively manage the contractor to contain costs.
- Contractors have less incentive to contain costs: Since profit percentages are baked in, contractors have less incentive to operate efficiently or minimise expenses. Without a well-estimated budget, it becomes challenging to manage expenses effectively. The financial risk sits predominantly with the owner.
What is a Fixed-Price Contract?
A firm fixed price contract, also known as a fixed fee arrangement, is where the contractor is paid a predetermined total amount regardless of actual costs. The contract starts with an agreed price for the defined scope of work. However, the amount ultimately paid will still change where the contract and applicable building law allow adjustments, such as agreed variations, prime cost items or provisional sums.
The key aspect of a fixed price contract is a single, established price that all parties agree to upfront before work begins. The final contract price is agreed upon at the outset and does not change, providing certainty for both parties. For work that remains within the agreed scope, the builder generally carries more of the risk that its actual costs will exceed its estimate. However, permitted adjustments under the contract or applicable law will still change the final amount.
The contractor assumes full responsibility if expenses exceed initial projections by locking in one firm price. The owner is shielded from budget overages. A fixed-price contract generally gives the owner greater protection against ordinary cost overruns, but whether increases in labour or material costs will be passed on depends on the contract and the law in the relevant state or territory.
In essence, fixed-price contracts shift risk away from owners and place the burden entirely on contractors to accurately estimate all costs associated with the project scope before setting a price. The contractor has strong incentives to contain expenses and operate efficiently within the constraints of that firm budget. When a builder or developer runs into financial trouble, owners and buyers can face delays and extra costs to finish the work: see our article on the Bathla Group voluntary administration.
Pros of Fixed Price Contracts
There are some clear benefits that make fixed-price contracts advantageous for many construction projects:
- Cost certainty for owners: This generally provides greater cost certainty, although variations, prime cost items, provisional sums and other permitted adjustments will still affect the final amount.
- Contractors incentivised to contain costs: Contractors have strong profit motivations to find efficiencies and operate within tight budgets dictated by fixed pricing. They aggressively manage expenses.
- Less administrative burden for owner: Owners do not have to rigorously scrutinise expenses, variations, and progress claims like they would under a cost-plus contract. Oversight requirements are reduced.
Cons of Fixed Price Contracts
As with cost-plus contracts, fixed-price contracts also pose some downsides that must be weighed:
- Less flexibility to alter project scope: Variations under fixed-price contracts will increase costs or extend the completion date and usually need to be documented in accordance with the contract and applicable state law. Owners lose some flexibility.
- Quality/creativity may suffer if contractors cut corners: To protect profits within tight budgets, contractors may use cheaper materials or take shortcuts detrimental to quality.
- Possibility of disputes over scope changes: If changes in project scope are needed, both sides may end up dissatisfied with the inflexibility of the fixed pricing. Disputes can arise over responsibility for additional costs.
Key Factors in Deciding Between Contract Types
When deciding between a cost-plus contract and a fixed-price contract, there are several important considerations that should guide the decision-making process.
One major factor is the predictability and clarity of the project scope. If specifications, plans, and expectations are very well-defined upfront, a fixed-price contract often works best since the contractor can accurately estimate total costs based on the known parameters.
However, if the project scope lacks definition and is likely to change during construction, a cost-plus contract allows more flexibility to adjust as needed.
Additionally, the owner’s financial risk tolerance is key. Owners willing to accept the possibility of actual costs exceeding budgets can utilise cost-plus contracts despite the unpredictability. Meanwhile, owners who demand strict cost certainty will push for fixed-price agreements to control expenses.
The level of trust in the contractor and the working relationship between parties can also influence contract selection. Positive, collaborative relationships make unpredictable cost-plus contracts more workable. More adversarial postures may dictate fixed pricing.
Plus, the sheer size and complexity of projects also determine suitable contract types. Larger, multi-year projects with phases require the flexibility of cost-plus contracts. In contrast, well-defined projects of limited scope can leverage fixed-price contracts even if some variations arise.
Assessing all these dynamics allows owners and contractors to thoughtfully agree on contract structures tailored to their unique needs and circumstances.
| Feature | Cost plus contract | Fixed price contract |
|---|---|---|
| How the price is set | Actual costs plus an agreed fee or margin; the final price is known only at the end | One price agreed before work starts |
| Who carries the risk if costs rise | The owner | The builder |
| Flexibility to change the work | Easier to change | Changes (variations) can be harder and more expensive |
| Owner’s paperwork | More: you check the builder’s costs and progress claims | Less |
| Builder’s reason to control costs | Weaker | Stronger |
| Best suited to | Projects where the scope isn’t settled yet | Projects with clear, final plans |
Cost Plus and Fixed Price Contracts in Australia
Many home building contracts in Australia use standard forms published by industry bodies such as the Housing Industry Association (HIA) and Master Builders, and some state governments publish free templates too. These standard contracts come in different versions for different kinds of work, including separate fixed price and cost plus versions, and each is written for the building laws of its state or territory. Before you sign, check which type of contract you’ve been given and make sure it’s the one you agreed to.
Even a fixed price contract doesn’t always end at the contract price. Provisional sums are allowances for work the builder can’t price exactly when you sign, such as excavation, and the final amount is adjusted to what the work actually costs. Variations are changes to the agreed work, whether you ask for them or the building surveyor requires them after work starts, and they can add to both the price and the time. Ask for a breakdown of every provisional sum, and agree to any variation in writing before the work is done.
State rules for home building:
- Victoria: a cost plus contract for home building is allowed only if the work costs more than $1 million, or for the investigative part of a renovation (Consumer Affairs Victoria).
- Queensland: the home warranty scheme doesn’t cover non-completion under a cost plus contract (QBCC).
- NSW: home building contracts over $20,000 must warn the owner when the price isn’t known (NSW Government: home building contracts).
Key Takeaways
To recap the key points in this blog comparing construction contract types:
- Cost-plus contracts offer more flexibility for changing project scopes but result in less cost certainty for owners. Fixed-price contracts provide definitive cost predictability but with less flexibility.
- When selecting the right contract, owners must weigh their risk tolerance, trust in the contractor, and the project’s size and complexity.
- Contractors benefit from guaranteed profit margins with cost-plus but must rigorously manage expenses within fixed budgets under fixed pricing.
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FAQs
What Is the Difference Between a Fixed Price and a Cost-Plus Contract?
The key difference lies in how the final price is determined. With a fixed-price contract, the parties agree on a price for the defined scope before work begins, although permitted variations, prime cost items, provisional sums and other adjustments will change the final amount. In contrast, cost-plus contracts do not have a final set price.
The contractor bills the actual expenses incurred plus an additional pre-negotiated profit margin percentage. The final price is unknown until the end of a cost-plus contract.
What Are the Disadvantages of a Cost-Plus Contract?
Cost-plus contracts provide less certainty over the final project cost because there is no predetermined fixed contract price. Owners take on heavy financial risk and must closely scrutinise all contractor progress claims.
They also have less incentive to minimise costs and operate efficiently under open-ended cost-plus agreements with baked-in profits.
Are Cost-Plus Contracts Good?
A cost-plus building contract can be suitable for owners who are risk-tolerant about unpredictable costs and have the capacity to monitor contractor spending actively. They allow adjustments as needs evolve.
But the lack of a definitive cost ceiling puts all the risk on the owner. Fixed-price building contracts offer greater cost certainty but less flexibility. The best contract type depends on the specific project.
What is a fixed price building contract?
A fixed price building contract sets one price for the whole agreed scope of work before building starts. The builder carries the risk if their costs rise, so the price you pay doesn’t go up because materials or labour cost more. The price can still change if you ask for changes to the work (variations).
