Recently, I was in a matter before the Victorian Civil and Administrative Tribunal (VCAT) regarding a million dollar cost-plus contractual dispute.
The well-known and well-regarded tribunal member presiding over the hearing stated to the parties that aside from license-lending, their least-favourite matter to preside before in the building list were matters involving cost-plus contracts.
The member was of the view that parties who entered into cost-plus contracts often did so without receiving the necessary legal advice, doing so at their own peril, making cost-plus contracts troublesome for owners and builders alike.
The member’s words were particularly poignant for all at the hearing, particularly given that the parties were heavily invested financially and emotionally in a project that had not gone accordingly and considered the member’s “pearl of wisdom” too little, too late.
The member’s statement however, leaves us with an unanswered question, are cost-plus contracts ever a good idea?
Fixed-price contracts vs cost-plus contracts
The most common type of building contracts entered into between parties are fixed-price contracts for a set sum, which offer greater certainty to owners on the overall cost of the building works to be performed.
Fixed-price contracts give builders an incentive to finish the works on time and under budget, as they subject the builder to the maximum risk and the full responsibility of costs escalating above the fixed price. Accordingly, builders often overprice fixed-price contracts to allow a margin for any variables throughout the construction process.
Alternatively, a cost-plus contract in the building industry is a contract where a builder is paid for all allowed expenses to get the job completed to a set limit, plus an additional margin to allow for a profit.
The cost-plus contract price is not fixed and the builder only has to give the owner a reasonable estimate of the works. The estimate is ascertained by adding a profit margin to the actual cost of direct materials, labour and expenses. Essentially, in cost-plus contracts, builders get paid for all of the actual works completed and all the actual costs incurred without a fixed price.
Cost-plus contracts are also an “open book process,” as owners are entitled to receive progress payment claims with all of the supporting invoices or satisfactory evidence for each item of expenditure/direct cost as charged by the builder. With every single cost needing to be accounted for, cost-plus contracts are naturally much more administrative in nature than fixed-price contracts.
Laws and regulations in Victoria
Pursuant to the Domestic Building Contracts Act (DBCA) and the Building Regulations 2006, all domestic building contracts must be fixed-price except for certain circumstances.
A builder must not enter into a cost-plus contract unless:
- the reasonable estimate of the contract is over $500,000 or more
- the work to be carried out under the contract involves the renovation, restoration or refurbishment of an existing building and it is not possible to calculate the cost of a substantial part of the work without carrying out some domestic building work.
Further, should a builder enter into a cost-plus contract that does not contain a fair and reasonable estimate of the total money the builder is likely to receive, the DBCA states that the builder cannot enforce the cost-plus contract against the owner.
If it can be successfully proven that a builder has not provided a fair and reasonable estimate, the VCAT has jurisdiction to award the builder the cost of carrying out the work, plus a reasonable profit if the tribunal considers that it would not be unfair to the owner to do so.
In theory, the owner and builder advantages and disadvantages of cost-plus contracts are as follows:
- An owner should be able to benefit financially from a cost-plus contract as a builder has no need to overprice a job to cover profit for any unknowns. Accordingly, the builder’s profit margin can be less, making it cheaper for the owner
- The owner only pays for works that are undertaken by the builder
- The “open book process” of cost-plus contracts is a regular monitoring system to ensure the builder is keeping good records and is billing the owner properly for works completed, materials purchased and direct labour costs
- The owner should receive the benefit of a higher quality job as a builder does not have to cut corners if they know they will be paid for all expenses that they incur in addition to a profit margin
- There are options for greater flexibility for the owner and there is a greater potential for the owner to have control in the decision making process with the constant monitoring of monies spent and documentation supporting the progress payment claims
- The owner can also take advantage of the builder’s discounts on materials and trades
- Owners take an incredible risk that the works will not spiral out of control, albeit even legitimately and there is very little incentive for the builder to have the job done quickly and inexpensively
- As owners assume almost all of the risk of a cost blow out, it requires a high level of trust in the builder
- Owners will not know exactly how much a project will cost from the outset, making it difficult to budget
- The works can drag on over an extended period of time with no ramifications if the builder does not finish the project in a timely manner
- Every single item of direct expenditure for the project, if it can be satisfactorily evidenced, is an allowable charge, from petrol to and from the project site to the purchasing of materials
- As the builder is to be paid for all works that are completed, there isn’t a great need to cut corners, and builders can deliver a better quality product in the marketplace
- Builders can take on unfinished design works as there is less risk that an agreed sum won’t lead to a profit, and this accords greater flexibility
- Essentially for builders, cost-plus contracts with all the costs and profit risks covered they are ‘ideal’ contracts with minimal risk
- Builders potentially have no loss from changing prices, giving wrong estimates or underpricing as in fixed-price contracts
- There are no bargaining issues and no need to give competitive quotations
- As owners are entitled to progress payment claims from the builder in a cost-plus contract, it makes them inherently more adversarial in nature and a builder has to maintain meticulous records. This high standard of administration must be maintained throughout the project and even the most diligent builder, who is genuinely attempting to complete the works at the lowest cost to the owner, can be brought unstuck without diligent record keeping
- As owners are entitled to satisfactory evidence of every single item of expenditure, it then follows that some owners may refuse to make payment for items where record keeping has not been meticulous. If items of expenditure cannot be supported, they are not allowable under a cost-plus contract, even if the charges are valid
- The builder’s profit margin can be less
Despite the advantages and disadvantages for both parties, it appears in light of the above, cost-plus contracts are inherently more builder-friendly.
A builder with good record keeping has considerably less financial risk under a cost-plus contract than a fixed-price contract and the disadvantages for the builder are far fewer.
Can special conditions make cost-plus contracts a win/win?
Where there is a relationship of trust between the parties, good communication and above all good record keeping, could it possibly ever lead to a win/win outcome for both owner and builder? In theory it should be possible, but is such a scenario too good to be true?
One way for owners, who have the greatest risk under cost-plus contracts, to protect themselves better is to have special conditions drafted into the cost-plus contract.
Special conditions can be tailored to suit the parties and the individual circumstances of the project and general examples of special conditions are as follows:
- The builder will do everything that is reasonably possible to ensure that the work will be carried out in a timely manner and in accordance with a projected timeline
- The owner may terminate the contract should the builder exceed the budget cost estimate by 20 per cent or more
- The builder is to accept responsibility for some or all of the excluded items by way of variations to the scope of works
- The builder must not accept responsibility for any excluded item unless the owner gives the builder a signed consent or request for the variation. The amount payable to the builder for accepting responsibility for an excluded item is the cost of the additional work plus the builder’s margin
Pursuant to the relevant legislation and building regulations that govern cost-plus contracts in Victoria, they should only be used for domestic building works over $500,000 and when a substantial part of the works cannot be reasonably estimated. Examples of such building works that are unable to be estimated include works on a hard-pressed metal ceiling in historic heritage homes or works involving subflooring from houses built early in the last century. The cost of said works could potentially not be substantiated until the works had begun, and only then could it be ascertained what works were required.
Although builders still have to give a fair and reasonable estimate of the works, this may be difficult depending upon the project and an estimate can still leave the owner without any idea of the final cost of the project.
Despite the advantages and disadvantages for both parties, the owner assumes greater risk than the builder for less benefit.
Parties considering entering into cost-plus contracts need to take into consideration the local legislation and regulations, as the building requirements for domestic work in a residential setting are highly regulated.
To limit risk, owners can have a specialist construction lawyer draft special conditions to be included in the cost-plus contract and should enter into them with a degree of caution and only after obtaining the said necessary legal advice. Special conditions however, will still not offer any guarantees.
In light of the above, cost-plus contracts may only be of a benefit to both parties if they are used for their designed purpose (works that are unable to substantially costed) and should only be entered into where there is a builder with meticulous record keeping, trust on both sides and tailored special conditions.