Making Cost-Plus Contracts Work for Everyone

Until recently, I could count on one hand how often I had come across "Cost Plus" building contracts. I knew they existed, but they were pretty rare. The reason? They tend to put most of the risk on the buyer, and buyers weren’t interested in that. But after COVID, things changed. Two big shifts in the market brought these contracts into play:

• Massive supply chain disruptions and labour shortages; and
• Increased demand for building services.

Suddenly, builders had more control over the market. Many refused to bear the risk of unpredictable material and labour costs and began insisting on cost-plus contracts, especially for small- to medium-sized projects.

Now, even as the market starts to ease, I’m still seeing some smaller projects using this contract model.

WHAT IS A "COST-PLUS" CONTRACT?

If you haven’t heard of a cost-plus contract, here’s how they work. The contract sum paid to the builder is the aggregate of:

• All the direct costs like labour and materials (often known as the "actual costs"); and
• A "builder’s margin" (the "plus").

The builder’s margin covers the builder’s overheads—such as wages, insurance, and equipment—and their profit. This margin is often a percentage of the direct costs, although it can sometimes be a fixed fee. Costs that fall into the "direct costs" category are usually clearly listed in the contract. There are also general rules about what the builder can charge for, especially if they’re doing part of the work themselves rather than subcontracting it out.

WHY IS THIS RISKY FOR THE BUYER?

In these contracts, the project cost estimate is just that—an estimate. It’s not a cap or a fixed price. So, if labour or material costs rise, the buyer shoulders the risk of the increases. This is different from traditional lump sum contracts, where the builder is locked into a price and takes the risk of cost inflations during the life of the project. When the builder’s margin is a percentage, it can also mean the builder isn’t highly motivated to control costs. The higher the project cost, the higher the margin they earn.

HOW CAN BUYERS MANAGE THE RISK?

There are a few ways to help keep costs under control in a cost-plus contract:

• Open Book Accounting: The buyer should have full visibility of all costs, including by seeing invoices for materials and subcontractors as part of the builder’s payment claim process. This ensures transparency and helps the buyer ask questions if costs seems off.
• Approval Process: Buyers can also insist on approving any subcontractors or suppliers before they’re engaged. However, it’s worth remembering that the builder was hired for their expertise. Too much oversight may slow the project down and strain the relationship.
• Strong Relationship: A cost-plus contract works best when there’s trust between the buyer and the builder. Buyers must vet their builder carefully, asking for references from suppliers and past clients.
• Complete Design: Before work starts, make sure the project design is fully fleshed out. Changes in scope during the project can lead to extra costs that would otherwise be avoidable.

MAKING IT WORK FOR BOTH PARTIES: AGREED TARGET COST AND SHARED SAVINGS

A great way to align both parties' interests is to introduce an incentive for keeping the project under budget. You can do this by setting a target cost. If the final cost comes in under that target, the savings can be shared between the builder and the buyer.

For this to work fairly, there need to be clear processes for managing changes to the project’s scope or timeline. If there are variations, the target cost should be adjusted accordingly.

HOW I CAN HELP WITH YOUR COST-PLUS CONTRACT TERMS AND CONDITIONS

Whether you’re a builder considering using a cost-plus contract, or you’re a project owner negotiating with a builder who wants to use a cost-plus contract, it’s important to fully understand your rights and obligations. There’s no Australian Standard cost-plus contract. Most Australian Standard contracts are drafted with lump sum projects in mind. However, if you prefer to use these forms of contract, they can be adapted for cost-plus arrangements. The MBA and HIA both offer cost-plus contracts to their members. As these are building industry associations they tend to favour the builder. They are also quite simplistic so may not have adequate contract administration processes to suit larger projects. If you wish to use a cost-plus delivery model on your next building project, I’m here to help with drafting, amending or reviewing the contract. I’ll make sure it is clear, fair, and protects your interests, no matter which side of the transaction you are on.

FIND OUT MORE

Get in touch for a free 15 minute discovery call to discuss how we can help.

About Gemma

I help construction, engineering and consulting businesses create and negotiate clear contracts so they can make more profit and achieve great project outcomes.

I founded SoundLegal to help SMEs in the engineering, construction, consulting and light industrial sectors manage their risk to support business growth, by finding practical, common sense solutions to contractual and other legal challenges.

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