Contracts without a fixed price, Part 2

Contracts without a fixed price, part 2

Shared Savings

Shared savings is something to consider when approaching an open book agreement. Most contractors will understand their fiduciary responsibility to the owner and will act responsibly with spending the owner's money. But to ensure the process is adequately incentivized, the owner and contractor sometimes agree to share the savings on the project. Essentially, they agree on an initial budget, and if the project ends up being less than the budget, the savings are shared.

Typically, the savings split is between 60%-40% to 75%-25%, with the more significant portion going to the owner. This can be anything you like, and there can be no shared savings. For shared savings to work, the initial budget must be established based on proposals and substantiated cost estimates. The "savings" comes from the contractor's diligence to keep costs down and employ cost-effective building strategies. Typically, the savings do not apply to contingencies and allowances. If the owner selects an inexpensive faucet, all those savings belong to the owner (although the owner may decide to use those savings from the kitchen faucet to increase the allowance for another item they may wish to upgrade). But, if the contract price increases for added scope via a change order, that amount should be used when calculating the shared savings. 

Billing

Billing is the more complicated part of an Open Book, as the contractor has to justify or support every cost. That is the nature of the contract: cost, plus. Each bill must have all the relevant invoices attached. If there isn't a cost to the project, then the project can't be billed. This is pretty easy for direct work as the subcontractor invoice is evidence of cost. But what about those indirect costs? As an owner, you should also expect justification for those. If vehicle fuel is an agreed cost to the project, you should see actual receipts for each billing cycle to justify the cost. It's not uncommon that on some jobs, the owner and contractor agree that receipts less than $100 to $500 need not be provided because it adds immensely to the paperwork burden. The owner and the contractor may also agree on a standard monthly indirect cost amount, which gets applied to each month's invoice. To do this, the owner and contractor must review the indirect cost budget in detail and then agree in writing on the monthly amount. The monthly bill should include all invoices from subcontractors, material suppliers, and direct labor for direct costs. A lien release for each should also be included. 

Billing packets take a lot of time and work on the contractor's part to assemble, and the cost of preparing this is a project cost. For example, on a large home, the billing packet can be six inches thick of backup documents submitted each month for review by the owner. That is also a lot of work for the homeowner to review, and the homeowner must still commit to paying the contractor timely, despite the burden of review. On large commercial cost-plus projects, I've seen the pay application delivered in multiple monthly boxes. The contractor and the owner had a team dedicated solely to the billing preparation and review, and all of these costs were billed to the project. Remember this as you decide the level of detail you want to see with your contractor.

Sometimes during billing, the owner unfairly challenges a cost item and then holds up payment. This is a rare but unfair tactic that some owners try to artificially drive the price lower to the detriment of the contractor and the agreed process. For an Open Book contract to work, the owner and the contractor must TRUST each other to behave ethically, and then the contract must clearly articulate the process. Without trust, this process will never work. If an owner does not believe the contractor will act in their best interest or if the contractor doesn't think the owner will trust them, then neither should enter into an Open Book agreement. One may even argue that they should not even do a project together as, without trust, the project is doomed to have disagreements plague the process.

The contractor's fee is one billed line item that won't have a backup. More on this below, but the fee is typically billed at the same rate as the job progress. So, if an owner receives a pay application for 25% of the project costs, the contractor will bill for 25% of the fee, less any previous payments.

Indirect Costs

What should be included as an Indirect Cost? Simply said, everything that affects the project. We've previously discussed cell phones and vehicle costs. There are also home office staff and costs that may be assigned to each project, such as a Project Manager or Project Administrator. Sometimes, the home office staff is included as a percentage of the total budget; other times, it's a fixed billing rate that gets billed each month. Perhaps 1%-3% of the budget should be allocated here, depending on the circumstances. 

Insurance will be a large portion of the indirect costs. As an owner, you'll see General Liability, Builder's Risk or Course of Construction, and vehicle insurance. You may also see software as an indirect cost. Remember, the nature of Open Book is to bill based on all costs to the project, so any means the contractor uses to help the project is a project cost. Some contractors use cloud-based software, and the project-specific fee to use this software is an indirect project cost. Also, printing for plans, paper for copies, or time supervisory staff spends reviewing the project. Also, the contractor may allocate some or all of an administrative assistant to the project to ensure the paperwork and documents flow correctly and timely. The paperwork needed to collect bills, validate bills, issue and collect lien releases, prepare invoices, and ensure the project paperwork runs smoothly would be a high burden without somebody dedicated to managing it.

As discussed above in billing, it's not unusual for the owner and contractor to agree upfront on the sum of the indirect costs for the project and then bill a portion of that amount each month.

Contractor's Fee

The contractor and the owner must agree on what the fee for the project will be, expressed as a percentage of the project. The contractor will then apply this fee to all direct and indirect costs to the project. The fee doesn't get charged on the fee. Still, everything else does get the fee applied, even design and engineering costs, so the builder is fairly compensated for their time reviewing and coordinating the drawings. The actual fee varies greatly. I've seen it range from as low as 3% on substantial commercial projects up to 40-50% on residential remodels. As the owner, use your best judgment and openly discuss the fee with your contractor. The fee is not the contractor's profit. It is the gross margin for your project. 

As we discussed in Part 1, the contractor still must pay home office costs that are not related to the project, such as office equipment/rent/staff, marketing, licensing, insurance, training, and a whole host of other items that general contractors must do to be properly licensed and trained. And the contractor must still make a fair profit, which comes from the fee. The fee breakdown is typically outside the scope of a cost-plus contract. If the owner has selected their contractor well and has built a relationship on trust, the owner should discuss and negotiate the fee in good faith and expect the contractor to do the same.

Another thing to understand is how the fee will be calculated. Some contractors use Markup, which is easy to understand; multiply the markup times the cost you'll get the fee. But many contractors use margin, which is calculated differently. The industry standard GAAP formula for margin is Gross Margin = (Revenue – Construction Costs) ÷ Revenue. Neither way is better than the other, but be sure you understand which method your contractor will use.

Summary

A properly managed Open Book contract is a good method to keep project costs as low as possible. With an Open Book project, both the contractor AND the owner benefit from lower costs. But, both parties must trust one another and agree on, upfront and in writing, what the indirect costs are. I've rarely seen disagreements over direct construction costs; the times I have, it's been an owner trying to understand the scope of work. By far, more disagreements are about indirect costs. It may be beneficial to both the contractor and the owner to avoid these types of conflicts if a hybrid approach is used. One hybrid method we've already discussed is where the monthly indirect costs are listed in detail at the beginning of the project and the contractor then bills a set amount each month based on the previously approved schedule of costs. There are many other different ways to contract to build your home. If you choose Open Book, remember that this type of contract is very collaborative between the owner and contractor and only works when mutual trust exists. But if you establish that trust and both parties continue to work together throughout the project openly, then there is a great potential that the owner will benefit from a lower-cost project. But, without trust, or without maintaining budgetary discipline, or without everything in writing, this method is doomed to cause conflict and grief.

To refresh your knowledge, go here to read Part 1 of Open Book Contracts for home building.