This is going to get a little complicated, but it is vital that people understand the pros and cons between cost-plus and fixed price contracts before they choose a builder. We’ll cover the definitions first and then walk through a few scenarios. We’ll end with the best question you can ask a cost-plus builder.
What is Cost-Plus? When you contract with a builder to build you a house and he will charge you whatever it costs to build the home plus his fee (usually 15-20%).
What is Fixed Price? When you contract with a builder to build you a house for a fixed price.
Let’s consider three scenarios of the same house being built by three different builders. The first builder (Scenario A) is cost plus, but is either bad at estimating or is giving a low-ball estimate. The second builder (Scenario B) is cost-plus and is good at estimating and gives an honest estimate. The final builder (Scenario C) is fixed price and is good at estimating. You get the three bids and they are $316,250 from the first builder, $345,000 from the second, and $345,000 from the third. The house’s actual cost to build is $315,000, but no one knows this when contracts are signed and construction begins.
The first builder estimated his costs to build the house at $275,000 then added his 15% margin to come up with a price estimate of $316,250. As the build progresses, the builder informs you of more and more cost overruns. You begin to wonder if you’ll go bust before completing the home. The house ends up costing $315,000 to construct plus the builder’s 15% ($47,250) for a grand total of $362,250. This means you were hit with $46,000 in unexpected costs!
The second builder estimated his costs to build the house at $300,000 then added his 15% margin to come up with a price estimate of $345,000. As the build progresses, the builder informs you of a few cost overruns, but it’s not too horrible. Just as in scenario A, the house ends up costing $315,000 to construct plus the builder’s 15% ($47,250) for a grand total of $362,250. This means you were hit with $17,250 in unexpected costs!
The third builder signs a contract with you saying the house will cost $345,000. As the build progresses, there are a few cost overruns, but they come out of the builder’s pocket instead of yours. Just as in scenario A and B, the house ends up costing $315,000 to construct. The builder had planned on profiting $45,000 on the job, but the $15,000 in cost overruns came out of his margin so he ends up making $30,000 (10% instead of 15%). You’re total unexpected costs are zero!
Here are all three scenarios’ financials summarized:
|Cost Plus||Cost Plus|
|Bad Estimate||Good Estimate||Fixed Price|
|Estimated Cost||$ 275,000||$ 300,000||$ 300,000|
|Estimated Price (Cost + 15%)||$ 316,250||$ 345,000||$ 345,000|
|Actual Cost||$ 315,000||$ 315,000||$ 315,000|
|Actual Price||$ 362,250||$ 362,250||$ 345,000|
|Builder Gross Profit||$ 47,250||$ 47,250||$ 30,000|
|Builder Gross Margin||15%||15%||10%|
|Homeowner Surprise Costs||$ 46,000||$ 17,250||Zero, Zilch, Nada|
If you go with scenario A or B, you have no idea what your house is going to cost to construct until you’ve completed the house. Plus, the builder get his 15% no matter what. This is the biggest problem with building a home cost-plus.
Other items to consider
There are ALWAYS cost overruns. Why? Because no matter how hard you try, you miss something… or a few somethings. It’s human nature. Have you ever counted a large amount of money and come up short then recounted and got the amount right? It’s easy to miss something. But the opposite never happens. You never count a stack of 100’s and come up with one extra. That’s why there are always cost overruns.
Beware of cost overrun fatigue. What is this? When you’re building your house and costs are going up and up and your stress is going up and up. Then as the end of the build nears, you have something that was a high-priority to be included in the build. But now you have to choose between getting that thing and costs continuing to rise or removing it to try to get costs back in line. We’ve seen too many jobs run out of money at the end and homeowners not getting the things they wanted most in their new home.
If you ever encounter a builder with a cost-plus margin below 15% be very careful. A builder won’t stay in business at lower margins. There are dishonest builders that charge a lower percentage, but then play games, like getting kickbacks, to recoup the lost margins.
Cost-Plus motivated to up-sell. Why? Because they make their margin on every dollar they upsell. Their motivated to upsell you until you get uncomfortable/unhappy.
Cost-Plus is motivated to optimistically estimate. Why? Because the lower the estimate, the more likely they are to win the job. Plus, If their estimate is off, the difference will be paid by the homeowner not them.
Fixed price builders are extremely motivated to accurately estimate. Why? Well if they are too pessimistic, their estimates will be too high and they will lose business. But then again, if they are too optimistic they will lose their margin and may even lose money on a job. For those reasons, no builder is going to estimate as accurately as a fixed price builder.
Best Question to Ask a Cost-Plus Builder
So what is the best question to ask a cost plus builder? When they give you their bid, ask them to convert it to a fixed-price. They either won’t do it, or will run the price way up to cover their risk. Either way, you know they aren’t confident in the bid they’re giving you.