The explosion in the cost of construction materials has caught out a lot of building companies using fixed price contracts that have no rise & fall or cost escalation causes.
This has led to an increase in the number of building companies now offering open book/cost plus contracts to their clients rather than the traditional fixed price option.
So which is best?
Does an open book/cost plus contract benefit both the builder and the consumer?
Or is there more to this argument than meets the eye?
Over the past 3 years, we’ve heard a lot of opinions from both builders and consumers, but we’ve also had access to a lot of data as well.
Additionally, we’ve heard a few myths about both options doing the rounds. Therefore, because our goal is to improve the industry for both builders and consumers, we thought we’d share what we know to be true so that you can make up your own mind.
The rise of cost plus contracts
Starting with the misconceptions regarding open book/cost plus contracts, the main one we are hearing a lot is that open book/cost plus contracts are better for consumers. We’ve heard that more and more consumers are now requesting open book/cost plus contracts.
However, the issue with open book/cost plus contracts from a consumer's perspective is that the builder has no incentive to negotiate the best rate for materials and labour. In fact, the opposite is true, because the more a builder pays out for materials and labour, the more money they make for themselves.
While it would be unlikely that a builder would deliberately inflate the cost of construction on an open book/cost plus contract, with all the other demands on their time it's unlikely they would be investing too much of it in order to negotiate the best possible price, its simply human nature.
So if an open book/cost Plus contract is a bad thing for consumers, then logic dictates it should be a good thing for builders.
However, it doesn't always quite work out that way.
Common misconceptions about cost plus contracts
Generally, we’ve seen builders that are just starting out on their own use open book/cost plus contracts in order to limit their risk before switching to fixed price contracts once they become more experienced and confident in their estimates.
The reason they switch is due to margins. It’s very difficult to convince a consumer that 33.3% is the industry standard markup for new construction when presenting an open book/cost plus contract.
Even if the builder adds their fixed expenses into the ‘costs’ of the open book/cost plus contract that are still around 15% before any profit has been added which once again focuses the client on the price rather than the value.
A recent survey by CoConstruct which analyzed the data from over 60,000 projects concluded that the average profit margin on a fixed price contract was 28% higher than a open book/cost plus contract.
The 2023 State of the Residential Construction Industry Report which contained data from over 1,000 residential building companies in four countries backed up that data by revealing that 30.8% of builders using fixed-price contracts were able to add over 25% gross markup to their projects while only 17.9% of cost-plus builders enjoyed the same margins.
Worryingly, 25.3% of cost-plus contracts were signed with less than 15% gross profit which is unlikely to cover the true fixed expenses for the business once the owners' salary at market rate has been factored in.
However, fixed price contracts are not without their pitfalls for both consumers and builders either.
The pitfalls of fixed price contracts
Because while consumers may enjoy a degree of certainty regarding a fixed price price contract, those contracts will generally include a cost escalation or rise and fall clause that protects the builder's margin against unforeseen price increases like we saw during the COVID boom from 2021-2022.
While this was an extreme and unusual event, it is still something to be aware of. Generally, builders will lock in their pricing as soon as a contract is signed protecting their clients from any future price increases even on materials that won't be delivered for another six to nine months.
However, business is all about pricing risk therefore those consumers that insist on having uncertainty removed from their contracts in terms of cost escalation clauses will normally have higher contingencies added to their contracts by the builder.
This is a perfectly reasonable practice given that construction costs increased by 20% a year for two years during the global supply chain crisis.
Despite the protection of cost plus and cost escalation clauses, builders can still come unstuck with fixed price contracts. Because just like a cost plus/open book contract, being legally entitled to pass on the increases in costs to a consumer is not the same as collecting the money.
If a consumer is not in a position to pay an extra amount that has not been budgeted for, they invariably dispute the amount regardless of the contract they have signed.
Additionally, a building company that lacks the systems and processes required in order to produce accurate estimates will be very exposed when signing a fixed price contract.
So in summary, fixed price contracts are generally cheaper for consumers while being more profitable for experienced, professional builders.
However, if you are just starting out or are transitioning into a new niche, cost plus may be a good stepping stone until you become more confident in your pricing.
Fixed price is just one component to consider when setting out the business model. Building company type, niche, target client and point of difference are all important aspects to consider BEFORE you spend a single dollar on advertising your services.
To gain a complete overview of how successful building companies are set up, and how they are able to generate more leads and more sales at higher margins while delivering a better building experience to their clients, check out this video.