Cost-plus or time-and-material contracts. In a cost-plus or time-and-material contract the client reimburses the builder for all costs plus a markup or fee. Typically, this type of contract, if executed properly, affords the builder with the lowest risk since the customer usually reimburses any amounts over the original estimate. As a result of lower risk, anticipated margins on cost-plus contracts are usually lower than those on lump-sum contracts.

The key to success in a time-and-material contract is to have a system that tracks and bills for all costs. These tips will help you improve profitability on cost-plus contracts.

• When presenting your “plus” use a margin instead of a markup approach. Instead of quoting a job to be cost plus 20%, which results in a margin (gross profit) of 16.67%, present your proposal showing cost plus a 20% margin (obtained by dividing the costs by .80, or 1 – 20%). This would result in a 20% margin. Make sure you explain that you are using margin so that you do not get into a disagreement with your customers when they receive their first bill in which you divided by .80 instead of multiplying by 1.2.
• Another method of presenting a cost-plus job is to show separate markups for overhead and profit. This may enable you to justify a higher markup percentage as well as compounding your markup. If you were to present your 20% markup as 13% overhead plus the 7% profit you will actually be obtaining, your markup on $100,000 of costs would be $20,910 ($100,000 x 1.13 + $113,000 x 1.07) instead of $120,000 ($100,000 x 1.20).
• Make sure you get as many items as possible defined as costs. Here are some often-overlooked cost items that can be passed on to the customer: general liability insurance (I have seen builders obtain a markup on their actual insurance rate), cell phone, travel, postage, and copy charges (if you are duplicating all invoices for the customer).
• Establish billing rates for all employees who will be working on the job. In addition to carpenters and laborers you may want to establish billing rates for your project manager, superintendent, selection coordinator, designer, and administrative staff. These rates should include gross pay, labor burden, and a profit. Don’t be afraid to ask for a billing rate that includes a profit. The amount of profit should be based upon what the market is willing to pay. What billing rate is being charged in your market for plumbing and electrical work? I find this is usually much higher than the rates a builder charges for his carpenter. Is your trim carpenter less skilled than an electrician or plumber? If not, why are you getting less money for his or her services?
• If you establish labor rates within your contract you may want to consider changing the terminology of your contract from cost-plus to time-and-material. Recently a builder I know was challenged on his billing rates in a cost-plus contract. The client asked for justification of the billing rates. As a cost-plus contract the customer requested support for the actual labor cost, which was different than the billing rates.
• In addition to establishing billing rates for their labor I have seen many custom builders also apply their markup to their labor billing rates which will incorporate the overall profit earned on the labor. The markup is applied to the billing rate; for example if you are billing 10 hours at $50 per hour the client is billed $500 plus the markup within the contract.
• Avoid taking a cost-plus job with a guaranteed maximum. You take on all of the risk with no potential rewards.
• Avoid taking a cost-plus fixed-fee job unless you have a clause in your contract that allows you to increase your fee if the job exceeds an originally contracted timeframe.
• Even though your contract is cost-plus, it is important to track costs against your original estimate and keep the customer informed of changes to the budget. I suggest implementing a system in which the customer signs off on all changes. (One custom builder I know has customers sign an authorization letter every time they make a change from the original scope of work.) The last thing you want is a customer who’s surprised and upset that the budget you quoted has been exceeded.

Steve Maltzman, CPA, is president of SMA Consulting in Colton, Calif. Visit him at www.smaconsulting.net.