Pricing models what are they and when are they used?

Many property Owners and construction professionals have the misconception that the only way to solicit pricing for design and construction services is to request a fixed price lump sum quote.

There certainly are occasions when fixed price lump sum quotes are a good choice, but this should not be taken for granted.

In order to be sure you have selected the best pricing model for your project, you need to take the time to consider all of your options.

I really wish that the taxonomy of pricing models was simple and straight forward.  That would make this article far more interesting and quite frankly easier to write, but the truth is that there is tremendous inconsistency and a lot of misuse of terms within the Construction industry.

As such, the taxonomy of each term is also inconsistent.  I would confuse you even more if I tried to make any sense of it.

It is hard to say exactly how these terms came about, but the most likely scenario is that each of these terms derived from popular use and local customs.

Fixed price/lump sum/stipulated price

This is the easiest pricing model to understand.  As the name suggests it is a “fixed” price for a particular scope.  This pricing model is most often used with a Design Bid Build delivery model where you have an Architect and a Builder as two separate entities contracted directly to the Owner.

Fixed price models work best when the scope of work is well defined.

As such, it is important to allow sufficient time for scope development otherwise the Owner is exposed to change orders.

Avoid this pricing model if schedule is your top priority or if you expect to make design decisions on the fly.

Unit Price/Rate Based/Time and Material/Reimbursable Price Model

Unit pricing is when you take any measurable unit and apply a rate to it.  This can be applied to man-hours, square feet, or linear feet.  When the pricing is for an item that is well defined (like appliances or specific equipment) you can also solicit pricing on a per item or “each” basis.

Unit prices work well when the scope is not defined and you need the supplier to be flexible in the work performed.

This is a great way to get work started right away.  Typically quoting a rate takes very little time and you can engage a supplier quickly, but I would caution anyone from performing an entire project this way.

If you choose to begin a project on a unit price basis, add a time or spend limit to the engagement.  The goal should be to establish enough parameters to switch from a unit price basis to a fixed price.

Avoid this pricing if you don’t trust the supplier.  This form of engagement can be like writing someone a blank check.  It is too easy to abuse this, so even if you require the supplier to submit timesheets and third party invoices to verify expenses, your exposure is very high.  Use this only with suppliers you know and trust.  Even then you should verify all expenses.

Cost Plus Fee/Construction Manager at Risk/Open Book

Although this is very much like a reimbursable model, I’m listing it separately because the industry sees this as a standalone pricing model.

A “Cost Plus Fee” model simply solicits a fee for managing the construction work.  The fee can be quoted as a percentage of cost of work or as a fixed fee.

The “Cost” part of the model is where the reimbursable expenses come in.  The CM gets reimbursed for hiring the trade contractors necessary to perform the work.  This can model can work as an “open book” which means the Owner can see the costs of the trades, or it can work with a Guaranteed Maximum Price (GMP).

When used with an “open book”, this can be a very favorable model for owners because they get very good visibility into all of the costs that go into their project.

This model can work in a number of different scenarios, but it is very labor intensive.  Owner’s who chose to go down this path need to be prepared to invest some time to oversee the trade procurement and to review the CM’s payment application in detail.

Don’t use this model if you don’t have time to oversee the procurement.

Guaranteed Maximum Price/GMP

A lot of Owner’s have misconceptions about Guaranteed Maximum Pricing.  Many favor this type of pricing simply because it sounds so good to them.

Guaranteed Maximum Pricing is very much like a Lump Sum Fixed Price.  The differences are subtle and generally have to do with how you want to handle change orders.

Under a Lump Sum Fixed Price any work that is not depicted on your drawings is subject to a change order.  This means any deviation whether it’s a field condition or a design revision will result in a change order and your price will go up.  Each change order is priced and negotiated as it comes up.

Under a GMP you pre-negotiate a contingency sum.  This is a sum of money set aside for field conditions which would otherwise result in a change order.  If the contingency is not used, there are a number of options for addressing what happens to that money.

Owner’s should note that you can still have change orders under a GMP agreement.  Changes to the design are not covered by the contingency.

As such, a GMP does not insulate you from change orders if your design drawings are incomplete , there are errors in the design, or you change your mind about the design.

Use this model if you have a high level of confidence in the completeness of your design and if you don’t expect to make design changes.

Don’t use this if your design is fluid or you don’t have confidence in the completeness of the design.

So those are the most common pricing models in the construction industry.  Having also shared some recommendations on when and how to use them I will also tell you that there are a number of variations and ways to combine these all into a single contract.  I would not recommend trying to combine these without some experience, but just be aware that it can be done.

So which one of these pricing models are you familiar with?  Which ones do you favor?  Which ones do you avoid?  Tell me your thoughts.

Thanks for reading.  If you enjoyed this content, please feel free to browse my previous articles and please like, share, comment, and subscribe.  This helps promote my content and is greatly appreciated.

 

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