In a recent article I gave an overview on how to put together an RFP for construction manager at risk. In that article I discuss several of the considerations and strategies behind the construction manager at risk model. Today I wanted dig a little deeper into the topic of cost plus pricing (also known as Cost Plus Fee).
Cost plus fee pricing is a reimbursable pricing model. This means that your contract will include a fee (which could be fixed or variable) plus reimbursement of incurred expenses.
Cost plus pricing works best when the cost of work is unknown. Under a cost plus price the vendor quotes a fee but will not quote the full cost of work. The cost of work is typically made up of subcontracted costs the vendor incurs on behalf of the owner.
It is possible to request an estimate for the cost of work as long as both parties are clear that the estimate is not a binding number.
The fee of cost plus fee pricing can either be solicited as a fixed fee or a variable fee.
Deciding which type of fee to solicit should be based on two factors.
Factor number 1 is the Owner’s tolerance for variability. An owner who is decidedly uncomfortable with variable pricing will prefer a fixed fee.
Factor number 2 is scope of services. In order for a vendor to quote a fixed fee, you will need to provide a clear and complete scope of services. You will also need to define a duration. Make special note of the fact that I said scope of services not scope of work. The difference being that services described the tasks the vendor will do, not the scope of construction.
If you go forward with a fixed fee, ensure that you agree on change order rates to address what you will pay if the project exceeds the duration.
If you plan to solicit a fixed fee, it is advisable to establish milestones of construction. You should solicit the fee by construction milestone.
The fee should be a fixed dollar value payable in accordance with each milestone on a monthly basis in arrears.
Your solicitation needs to clearly state that under a fixed fee arrangement, reimbursable expenses will be paid at cost with no mark-up.
Some vendors will object to this. You’ll have to strike a balance between covering the vendors legitimate expenses and double dipping on the fee. A vendor may have legitimate variable expenses which may require you to allow a small mark-up to be added. Finance fees from a business loan used to contract subs is one such legitimate variable expense. Use your judgments on how much of a mark-up to allow for this.
Regardless of what you allow the vendor to charge in the base contract, the use of a fixed fee means you also need to negotiate change order rates. The change order rate will need to be a percentage of cost of work rate. This works like the variable fee I alluded to earlier.
To solicit a fixed fee simply communicate your construction milestones and request a fixed dollar value for each milestone of construction. For change orders solicit a percentage rate.
The most common fee structure used in a cost plus fee arrangement is the percentage of cost of work fee.
The percent cost of work fee is popular because it relieves both parties of risk. However the Owner will have to endure complete pricing variability which may make some uncomfortable.
Under this model the vendor will quote a percentage rate which will be used to calculate the fee. I have seen this model used a number of different ways.
The AIA method
The American Institute of Architects (AIA) publishes a number of contract templates. Their Cost Plus contract assumes that every cost, except the fee is part of the cost of work.
Therefore general condition costs and trade costs are included in the fee calculation and are treated the same. The fee is calculated by adding all of the costs of the project together and multiplying that number by the percentage quoted.
If your construction manager plans to subcontract every aspect of the project this model works just fine. However, some vendors have their own in-house site supervision and in-house laborers. Some even have their own tradesmen.
There are some great benefits for both the owner and the vendor to have such in-house capabilities. The problem is that allowing a vendor to add mark-up on top of the costs of his own resources leads to a double dip by the vendor.
The term double dip refers to a vendor adding profit on top of profit.
Imagine a site superintendent who is a full time employee of your vendor. The site superintendent is charged at a billable rate of $80 to $120 an hour. General Condition costs include the site superintendents time.
The vendor charges for the site superintendents time in accordance with his billable rate, but what he pays the site superintendent is a lot less than what he’s billing you for. That billable rate often includes not just the benefits and overhead costs associated with the superintendent, sometimes it also includes a profit margin for the vendor. If you now allow the vendor to add a percentage markup on top of the billable rate you have effectively paid the vendor his profit twice.
While the AIA model is a nice and clean way of executing a variable pricing arrangement of a cost plus fee contract, it does not account for this potential over-payment.
To solicit a variable fee in accordance with the AIA contracts method, solicit a percentage rate quote. Any changes to the work will simply revert to the quoted percentage rate.
Alternative Method of Cost Plus Contracting
Another way of executing a variable pricing arrangement on a cost plus fee contract is to treat the cost of work and general conditions separately.
Defining what will be included in each cost category becomes extremely important.
In simple terms, to differentiate between these cost categories consider the following; the fee is the contractor’s profit and overhead, general conditions are the recurring expenses that facilitate the construction work, the cost of work are all the third party subcontractors hired by the vendor.
With these definitions in mind, we can proceed to structure the contract as follows; the fee will be calculated by multiplying the percentage quoted by the cost of work only, general conditions will be paid on a fixed weekly rate (which the Vendor must quote), the cost of work will be paid at cost with no additional mark-ups.
This nuance of quoting the general conditions on a fixed weekly rate ensures that the vendor is properly compensated for employing his resources to facilitate the work and avoids having the owner pay profit on top of profit. As you can imagine a construction schedule is absolutely critical in calculating general conditions. However the nice thing is that should the construction schedule change, the weekly rate makes reconciling the cost much easier.
You can reinforce all of this by requiring the Construction Manager to include third party invoices withe every payment request. This helps validate the cost of work and accurately calculate the vendors fee.
Control Estimates (for Cost of Work)
For all of these solicitations you can also request a control estimate. A control estimate is a non binding estimate of the cost of work plus a preliminary construction schedule.
Bear in mind, I am assuming that all of these solicitations are happening ahead of the drawings being completed. You will need to provide some information such as a schematic set of drawings to help the contractor’s understand the work, but the really nice thing about this model is you don’t have to wait until your drawings are 100% complete to solicit a quote.
I’ll write another article discussing open book bidding which is a variation on these and discuss the best way to solicit a control estimate in a future article.
I would love your feedback. Have you used Cost Plus pricing before? What was your experience?
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