Why Cost Plus Contracts Should Be Banned 12

Friday, June 24th, 2016
liked this article
Allegion – 300 x 250 (expire Feb 28)
FavoriteLoadingsave article

A cost plus contract is a contract where the builder is paid the cost of the works plus a margin over and above the cost.

Cost plus (CP) contracts are entered into where the contracting parties have formed a view that it will not be possible to generate a fixed price for the building works. Sometimes, people enter into CP contracts because they think that it may be cheaper than fixed price. Another paradigm is where a builder has gone into liquidation, the project is half completed and it is nigh on impossible to fix the price, absent a hefty risk buffer being factored into the fixed price.

It is ironic that consumer legislation like the Domestic Building Contracts Act in Victoria is heavily geared around regulations that stress the importance of fixed price, fixed term contracts. The consumer protection thesis that is supposed to underpin this Act of Parliament, however, is undermined by regulations that permit CP contracting.

One of our lawyers recalls a well-known tribunal mediator from a Domestic Building List opining that “she hated cost plus contracts.” Those are strong emotions, and it’s a pretty strong indictment, but I can understand the sentiments. These contracts neither provide cost certainty nor provide completion date certainty. In fact, they provide anything but certainty.

So is it any wonder CP contracts frequently go off the rails and end up in litigation because the costs have a tendency to blow out?

It is interesting to examine the restrictions on CP contracts under the DBCA, which states that a builder can’t enter into a CP contact unless “it is not possible to calculate the cost of a substantial part of the work without carrying out some domestic building work” or the value of the work is more than $500,000. The builder also can’t enter into a CP contract unless he or she provides a fair and reasonable estimate for the cost of the works.

Note the term “estimate,” which is a very distant cousin of a fixed price. An estimate typically provides wiggle room so that if the as-built spend exceeds the estimate, the builder will be entitled to the additional spend. Conversely, if the as-built spend comes in under the estimate, the owner won’t have to pay the estimate; he or she will only have to pay the cost.

CP contracts generally have provisions that dictate that the contractor has to justify and prove the spend. This means the owner is entitled to ask for, and indeed in a court of law, compel the builder to produce invoices that verify that that which has been spent has in fact been spent (and, I might add, legitimately spent.)

The process has to be transparent. One area that is always very very murky is proving how much labor was deployed on a job; it is one thing to contend that 1,000 of labor was clocked up, it is another thing to prove it. Furthermore, were a contractor to be inclined to inflate the hours in circumstances where there was some economy with the truth, it could prove to be very difficult to refute the figures evidentially. When put to the test, hours spent on the job don’t necessarily add up. It follows that if  there is a disagreement about the spend, sometimes the only way one can extract the truth is via cross examination. The difficulty with this is that by the time a matter gets to trial, it will have cost owner and builder alike plenty, so it is best to ensure that the matter doesn’t get to trial and a deal is cut at mediation.

In CP disputes the process of discovery is critical

Builders operating under CP have to be fanatical about the records they keep for expenditure. If they don’t keep a record of all invoices and expenditures and there are expenditure holes, the owner will be entitled to ask the question. It follows that if a CP dispute is litigated, discovery is critical. Discovery is a process where all documents relating to the project have to be compiled and recorded in an affidavit of documents, after which the parties are at liberty to inspect them. Discovery is one of the most time consuming and costly litigation junctures.

Once discovery has been completed, a financial reckoning has to occur which entails marrying every invoice with the addition function in the calculator to generate a financial reconciliation.

We had one matter, a Canberra case where the builder’s solicitor refused to discover all of the builder’s documents and  proceedings had to be issued to compel discovery in the Supreme Court. Once the information was discovered, transparency finally materialised and some nine days were then consumed in a negotiation where solicitors and clients tediously ferreted their way through literally hundreds of documents to prove the as-built spend. The case settled, but the road to settlement was cumbersome and very, very costly. Alas, that is the nature of cost plus disputes.

The take out is this: be loath to enter into a CP contract. Although they are stacked in favour of builders on account of the lack of price certainty, this ostensible benefit to the builder is the very thing that gives rise to disputes, and that’s in no one’s interest. Furthermore, CP contracting does not sit comfortably in building regulation that purports to protect consumers. Policy makers should give serious consideration to banning these contracts outright.

FavoriteLoadingsave article


 characters available
*Please refer to our comment policy before submitting
  1. John Doyle

    I don't agree CP contracts should be banned. There will often be space for such contracts. I licensed in 1981 and almost every contract I signed since was CP. All the clients ended up satisfied. Partly they all loved the main tradesman I used who had a work ethic unique in my experience. There was never any whiff of concealment and the job could grow and change as we built.
    Being an architect as well meant we didn't have to have everything worked out before construction began which made the whole process more flexible. But it does depend on cast iron trust, although so should fixed price contracts.

  2. David Chandler

    Kim, I tend to agree. Everyone is better off with certainty from the outset. On the odd occasion that CP may be justified i.e a disaster recovery the lead procurement organisation should be limited in the physical work they may undertake and primarily tasked to defined work packages for complete design, pricing and contracting. While John Doyle may run an admiral operation the days of starting projects with a wistful eye to your favourite tradie or incomplete documentation are not sustainable. CP projects by their nature pass all costs back to the client, so as long as you can make the case for a cost up it goes to the customer. EBA's are a good example. Resist as you might, if you want the job you roll over. Here the costs become open ended as to all of the unanticipated affects. In an industry that is already too expensive, wasteful and mostly unaccountable CP fuels the fire. Another risk of CP contracts is when a smart-arse contractor bathing in virtually no risk then applies risk and blame to the supply chain in a unconscionable manner to show power and shield ineptitude. I agree CP as a very last resort.

  3. Thanks for taking the time to provide feedback John always good to have a different perspective. Your final statement that it depends on cast iron trust pretty much sums it up. Absent the "mortar" of trust all hell can break loose.

  4. kim lovegrove.

    Thanks for chiming in David as usual your comments are thoughtful and sanguine and your shouldering up with me lends weight to my reservations about CP. There are situations where CP may be unavoidable in cases such as multi unit development insolvency where a new builder has to quote on a hole in the ground or a half completed high rise or commercial development. The builder does not know what`s lurking or hidden and in this paradigm there is a place for cost plus. But where you get Jim and Jane Well Meaning from "punters cove" signing up a CP contract, things can really go awry particularly where the bank has lent a finite sum of money and the estimate blows out. Further to reiterate it does not bode well for the builder because as sure as day follows night there will be a dispute that will in my experience prove to be very costly and time consuming in its resolution. So I go back to my first premise policy makers may wish to consider whether cost plus contracts sit comfortably in the setting of consumer legislation.

  5. Emily Martins

    I agree Kim, cost-plus contracts are very risky in nature. Cost-plus contracts should only be entered into when the works are unable to be substantially costed from the outset, there is a builder with meticulous record-keeping, trust on both side and tailored special conditions.

  6. Anne Paten

    Kim, I think that CP contracts should be banned. They provide much opportunity to harm defenseless consumers. However, the 'standard' contracts are equally problematic because under Australian Consumer Law any contracts over $300,000 are exempt from unfair contract terms' law and this applies to most, if not all new building contracts. As a quick perusal of building contracts demonstrates, these contracts are very biased in favour of the builder – hardly surprising when the builder prepares and provides them to the consumer in most cases. The corollary is that these contracts make owners extremely disadvantaged. One example is being forced to pay stage payments for a defective stage. In the case of the base stage, if owners know it is defective, they are advised by Consumer Affairs Victoria that they must pay or they will be taken to VCAT. Thus, they are forced to pay, the building work continues and the end result is a defective building sitting on a defective base!

    As we all learned at a young age, if the base for anything is unsound, regardless of what goes on top (defective or not) the whole is worthless.

    Contracts are but the beginning of the disaster for consumers dealing with unscrupulous builders and 'consumer law' in relation to 'con-tracts' officially endorses the builders' right to act unfairly in these cases – this reinforced by the 'consumer protection' agency, CAV and if contacted by owners the VBA will also advise similarly in its role as the builder protection agency.

    There is something very warped about consumers being forced to pay for work the builder and owner know is structurally unsound, in breach of laws, codes, standards and regulations – and with the default position effectively fraudulent.

  7. Branko Mladichek

    Although I have no love for CP I tend to agree with John and I feel aversion for legislation telling consenting adults they cannot play (nice or rough). Legislation already has price limit $500,000 and a condition to allow CP only if work cannot be substantially costed. In my view, that makes CP very much an exception and it is. I have assisted with hundreds of building disputes and only a couple or so were CP. There are other considerations. Isn't CP just a series of lump sum contracts with subcontractors managed by the builder? What if I just want to use builder on an hourly rate? I think that instead , attention should focus on a robust accounting/monitoring system that prevents exactly the problems predicted together with performance/productivity benchmark to ensure value.
    What I think should be banned instead are owners who enter into building contracts thinking less than buying shoes, then in blind trust throw bags of money at a builder, in the naive hope that it will all be OK.
    You cannot legislate to save people from themselves. Perhaps it's time for owner education prior to entering into a building contract.

  8. Clinton Cole

    Negative views of CPCs tend to come from those who suffer from confirmation bias: projects which end up legal disputes are rarely going to be revealed as well run, regardless of contract type used. The scenario suggested for a CPC is that of a half completed project due to liquidation of the builder, confirming that lump sum contracts are not without their perils! The diversity of services many builders now offer; the innovative business models they operate through in today’s market & the broad cross section of consumers & their respective contract performance priorities is completely overlooked in this article. Under a CPC a client knows the rates they’ll be charged & margin they’ll pay…they have a right to enter a contract allowing them & their builder to manage the performance of the work in an efficient & fair manner (notwithstanding the builder’s obligation to obtain approval from the client at regular intervals with respect to total cost & time estimates). It’s their home & their money & contrary to some opinions there are many builders that respect that position & ask only to be remunerated fairly for the work they perform. No more, no less. It is interesting to note that there is essentially no difference between the manner in which lawyer’s charge their clients & how CPC operate except that builders are 300%-500% less per hour than a lawyer, builders are liable for their work for 6 years & builders must estimate the work they perform before it is performed. Some consumers don’t see the construction of their home as a cost cutting, pencil sharpening, penny pinching, bargain basement budget buying, ‘screw everyone involved’ opportunity but I appreciate many do…. there are also contracts for these people.

  9. Kim Lovegrove

    Anne we are on the same page with respect to cost plus contracts. In 25 years of practice I have never recommended an owner to go near one. Emily Martins wrote a very good piece for sourceable a few months ago and it's worth reading in conjunction with this piece. Yes to ban them would be the smart play as from a consumer protection point of view, they just don't cut it.

  10. Mark Sutherland

    Well said John, I also use a lot of cost plus contract and have never had a problem. My business runs on referral and when the last client informs a prospective new client about our integrity the new client is always happy to use a cost plus contract. When building architectural designed houses with plenty of detail it is always cheaper to use cost plus as the builder doesnt need to load the quote with a fear margin. We provide all invoices on a fortnightly basis and so the client always knows what is happening. It all boils down to trust and the legal profession are a leader in inflated invoicing and outrageous hourly rates.

  11. Brent Stone

    Cost certainty can only be achieved through thorough investigation and pricing, and even if a Builder or a Sub-Contractor invests enough time to ascertain the real cost, they'll still ultimately add in a risk factor. Each sub-contract has a risk factor and the overall building contract has a risk factor. This risk mitigation process cost the client money, fact! While I don't really disagree with what Kim's written, it's based on -and perpetuates- the idea that the construction industry is inherently secretive and adversarial. This is not something we should promote or encourage in any aspect of life or business. Every client should have the ability to choose their method of project procurement and the industry should allow a small space for Builders and Sub-Contracts who's genuine intention is to save -or at least attempt to save- their client money, earn a reasonable management fee and not risk the loss of their own money, business or home which is the reality for many small builders and contractors.