by Quenda Behler Story
My observation has been that customers like cost-plus
contracts. Even though a cost-plus job and a fixed-price one
cost the same — in theory, anyway — many homeowners
are happier with a payment term that says they'll pay the
direct job costs plus either a certain percentage or a fixed
fee for the contractor's overhead expenses and profit. They
seem to feel they're getting a better deal that way —
regardless of whether they actually are.
Before I go any further, let me point out what a bad idea I
think it is to agree to work for cost plus a fixed fee. It's
just asking for trouble. Suppose — and this is just one
of the many things that can go wrong with a fixed fee —
the job takes twice as long as scheduled. The fixed fee, which
includes your profit, could turn out to be one reason you are
in the red at the end of the year.
So let's concentrate on cost plus a percentage. We'll start
with an important lesson in math. Your customer agrees to pay
all the direct costs plus 15 percent of those costs as overhead
and profit. If your direct costs are $1,000, you will collect
$150 on top of that as overhead and profit. If that $1,000 in
direct costs goes up to $1,500, you will collect an additional
$75 of overhead and profit. That means there's a real
motivation to keep your books in such a way that every cost
that could legitimately be a direct job cost is accounted for
Put another way, the more items you move from overhead to
direct job costs, the more profit you will make on cost-plus
jobs. Sounds pretty simple, right? But it has been my sense
that small construction companies err in the opposite
direction: They count things as overhead that could or should
be attributed directly to the job.
Direct Expense or Overhead?
Here's an example of the kind of decision you can face. Suppose
the company consists of you and another carpenter, and you're
present on the job as a lead carpenter. Yet it's your company.
So when you're functioning as the lead carpenter, should your
time be attributed to overhead or labor? My opinion is that
every time you pick up a hammer, it's labor. I don't care if
you are the boss.
In fact, I'll go even further than that: I believe that every
time you're on the job site — unless you're just dropping
by to say hello to the customer — it's labor.
However, your customer may say, "Hey, wait a minute. That's
part of the 15 percent I'm paying as overhead and profit." And
why would he say that? Because for him, that would probably be
the better deal.
How would you defend yourself if this issue came up in
arbitration or litigation? By looking at the same kinds of
things you should have looked at back when you initially
decided what qualified as direct costs and what qualified as
What's in the Contract?
You would begin by examining what the contract actually says.
Is there a definition of "direct costs" in the contract? If the
payment term is clear and detailed, the argument ends right
there. (So when you write the contract, be sure to mention
issues like lead carpenters.)
But what if the contract isn't clear enough or detailed enough?
Suppose the contract just says "direct costs," without defining
the term? Or what if the contract includes the correct
language, but you and the client disagree on what exactly that
language means? Suppose the client says, "Hey, ‘lead
carpenter' doesn't mean you, it just refers to when you have to
bring in somebody else to run the job."
To address such issues, the court or the arbitrator will
— once again — look at the contract. If the
contract clearly provides an answer, great. If it doesn't, the
next step is to try to figure out what was in the parties'
minds when they made the deal. What did you and your customer
think those words meant when you signed the contract?
Evidence in Your Favor
How do we figure out what was in people's minds? A moment of
quick brain surgery performed with a circular saw may be
tempting, but it won't work. We want to know what was in their
minds then, not now.
A better place to start is to look at what the parties have
done in the past (assuming such information is available). If
you've done business with this customer before, and you've
always billed your time on the job site as labor, you're in
good shape. If the customer says, "You never itemized before,
so I didn't know you were including that as a direct cost,"
you're still in decent shape, but on slightly less firm
Beyond past practices, what other evidence might exist to
clarify what you and your customer were thinking when you put
the contract together?
One possibility is notes that you made at the time about what
you explained to the customer. (The lesson here being that you
should spend some time explaining to your customer up front
what direct costs include — and then make a brief note
about the conversation in your daybook or calendar, or even on
the contract itself.)
Another resource is what's customary in the industry. You can
bring in expert witnesses or published material from the
construction industry, or even get someone who's running a
business like yours to testify. Remember that "expert" doesn't
necessarily mean someone with a degree after his name —
it means someone in a position to know. Other people in the
industry who negotiate construction contracts can testify about
what they understand those contract terms to mean.
Above All, Be Clear
With all of these dire examples and warnings, do I think you
should just avoid cost-plus payment terms altogether?
No. It's simply a reality of the marketplace that many
customers prefer this approach. But I do urge you to attribute
as many expenditures and activities as possible to direct job
costs, and to explain the concept clearly and thoroughly in
Quenda Behler Story has practiced and
taught law for more than 25 years.