At our most recent ‘Ross Living’ event in San Rafael, California; questions about construction costs were asked:
“It seems like there’s a few ways that General Contractors charge for their services: fixed price, T&M, etc. Can you clarify what these terms mean?“
Designer/builder John Fraine of Building Solutions replied with:
“Wonderful question! There are 5 pricing strategies to reduce construction costs on any project. They can apply to General Contractors as well as Sub-Contractors (like painters, roofers, plumbers, etc.) Let’s break down the price structure in order of how they are risk-and-benefit weighted”:
- Fixed price for a fixed scope of work: Easy enough but If the actual job costs incurred by the provider exceed the contract price, too bad for the service provider (contractor). However, if they come in under the price, the provider makes money above and beyond the expected profit margin, and that makes for a very happy provider! For the owner, either way is good for them because they know up front what their costs will be.
All the risks (and all the benefits) are assumed by the service provider.
- Not-To-Exceed (NTE): If the actual construction costs come in under the contract price, the owner only pays for the actual costs (plus a mark-up for profit and overhead, typically). Good for the owner! If the actual construction costs come in over the price, still good for the owner! That’s the nature of this agreement. A service provider would enter into this kind of agreement typically to sell jobs and It’s just a little added bonus for the owner!
In this scenario, the risk is borne entirely by the provider, and any benefit is completely realized by the owner.
- Aggregate Not-To-Exceed: A slight variation on the above. Let’s say that the provider has given you a breakdown of the project into two sections: one for doors, another for windows. They do the doors first, then the windows. If the actual costs for the doors is under the contract price, the provider can apply that underage to any potential overage that may occur on the windows later on.
This incentivizes the provider to perform well on each section of the project, because they may need that underage to cover additional costs on the other sections later.
The risks and benefits are the same as an NTE except this arrangement helps the provider to manage their risk, since different sections of the project are almost always done at different times.
Variation: The owner and provider split the aggregate underage in some fashion. This adds extra performance incentives for the provider, which could benefit the owner.
- Time-and-Materials (T&M): We all know what this means. Unknown price for a (possibly) unknown scope. The provider is paid an agreed upon hourly rate with an agreeable mark-up on sub-contractors, materials and labour. There is no cap, but there are hopefully regularly scheduled check-ins to track both job progress and costs to help the owner manage those costs. This is sometimes the only workable arrangement if the scope of work is unknowable at the commencement of work. Dryrot, termites, or other conditions that make estimating the costs difficult at best and impossible at worst are good candidates for this arrangement. This is because the provider does not have to give a significantly inflated fixed price to cover unknowns.
Another candidate for this arrangement would be a long list of small items that make estimation difficult.
Another reason to do this is because the cost for researching, estimating, creating documents, presenting, etc. exceeds any potential profit for the job. In other words, it actually costs the provider to finish the job. Smart providers usually see this coming and ask the owner if they feel that these costs are worth paying for. If not, T&M is the best option.
These risks and the benefits are entirely borne by the owner. The assumption is that the price will be what it will be, and the provider is paid a fair price for the labour required. No risk or benefit for the provider either way. The risk for the Owner is that there is no cap, and an undisciplined party (owner or provider) can run up the bill higher than desired. Again, the benefit for the owner is that the provider is for sure not going to make an extra dime of profit for the hours worked.
- Allowance: This is a variation on the T&M arrangement, where the specification or scope of work is known generally and there can be some kind of number tentatively assigned to the specification or scope. The provider gives their best estimate to what that price may be, however it is still essentially a T&M arrangement with no fixed price and maybe no fixed specification or scope. Quite often used for unknowns like the exact style or model of sink, window, doorknob, etc. It is great to prepare for extras that may not have been included at the time of estimation.
The risks and benefits are the same as #4, with a little better risk-management to the owner.
Variation: The owner and provider may again agree to split the underage in some fashion to give the provider an incentive.
Any or all of these pricing structures can be built into a typical construction contract and be assigned to various components of that contract. This is called a “Negotiated Contract” structure. For example, The plumbing fixtures may be a strict allowance, and the suspected dryrot damage may be on a straight T&M, but there is a fixed price for the electrical work and an aggregate NTE on some or all of the carpentry portions.
Whichever situation works best for all parties involved is the recommended agreement to enter into. I’ve seen owners who want a fixed cost for everything, even though they know they will likely pay more for the less-defined parts, and I’ve seen owners who will ONLY do things on a T&M basis.
The two questions for the owners are: How risk-averse are you? …and… How much freedom do you want within the structure of the project to “make-it-up-as-you-go”? Everyone will have different answers for these questions as they apply to different parts of the project and the Negotiated Contract structure can create a win-win for everyone!