Updated: Apr 13
And we're stayin' alive, stayin' alive, ah, ha, ha, ha, stayin' alive (sing it with us Bee Gee's style).
It’s been hard to miss the doom and gloom (insert big black cloud here) about the building industry in the media over the past 12 months. It’s fair to say that the industry has faced and continues to face challenges and the stats back that up with construction companies making up over 25% of all insolvencies in the 2022 financial year, and that figure increasing to nearly 30% so far in the 2023 year. However, like everything in life there is always 2 sides to every story and there are some building and construction businesses that are doing better than ever. So what is their secret sauce you ask?
It really is quite simple, they are actively monitoring their business, identifying issues when they arise and adapting the way they operate to best suit the current environment. These changes lead us to the concept of cost plus billing, so without further ado, here’s all you need to know about why you should be thinking less about fixed price and more about cost plus.
Cost plus billing, tell me more!
Cost plus billing is actually more simple than you would think. In its most basic form, you add all the costs of the job together, such as materials, sub contractors, levies, insurances etc etc and also add on the cost of your labour. You then add your fixed margin to these costs, which is a predetermined margin percentage. This percentage then becomes the profit you make on the job. Voila! For example if I spent $75,000 on materials for a job, and another $25,000 on labour, the cost would be $100,000. If my margin percentage is 15%, I would charge an extra $15,000 to the client, meaning the total amount charged to the client will be $115,000, and of that $15,000 is my profit. See, simple!
What are the benefits of cost plus billing you ask?
The first big benefit of cost plus billing is that you will always be able to charge more to the client than what the job directly costs you. Therefore, if you spend more than anticipated, encounter unexpected costs, or as has recently happened, if material costs rise halfway through projects, you can easily pass these price increases on to the client. Whilst I hear you saying, OMG this guarantees profit, sign me up now, it’s not quite that simple. The margin that you add to a job has to also cover all of your fixed operating costs such as admin expenses, employment costs, rent etc etc. So if your fixed operating costs are high, your profit on your jobs may not be enough to cover these expenses.
Cost plus billing is also great for cashflow. Unlike fixed price contracts when you would typically invoice large amounts at certain stages, the default stages in the HIA cost plus contract allows you to bill 2 weeks after the project starts, and then every 2nd Friday thereafter. This means that you will be invoicing your clients for the expenses you incur as you go, and does not leave you funding the cost of the project and waiting for stage completions to be able to invoice a client. Phew!
Another great benefit of cost plus billing that clients appreciate is the transparency of the process. The clients are aware of what they are being billed for and are able to see the costs incurred in their project. This allows greater transparency in the decision making process and also gives clients a level of comfort around the fact they are getting value for money and aren’t being ripped off!
Ok, so what’s the catch?
Like with anything, there are a few things you need to consider before switching the way you quote and bill. The first being that the administration side of running cost plus invoicing is much harder than fixed price contracts. Firstly, you need to be able to accurately keep track of every cost for every project. And then, as part of the cost plus contract, you need to provide the clients with evidence of the costs your on charging, this could be in the form of invoices, receipts and timesheets (but keep reading to see how to easily deal with this problem!)
Another difficulty with cost plus contracts is that, whilst you aren’t required to provide an exact price, clients will still want an estimate of the total cost of the project. Therefore you will still need to go through the process of preparing a thorough estimate and quote. With cost plus contracts, the cost of the project can easily escalate and if you are not keeping track and communicating that with the client, there is a possibility that the cost of the project will exceed what the client expects, or can afford and can result in potential disputes. It is always a good idea to closely monitor your cost plus projects against their budgets to ensure there is no cost blowouts, and if there are going to be, that this is communicated to clients early in the piece.
Another issue facing cost plus contracts is that with the lack of a fixed final price, banks are less likely to lend money in the same way they do for tradition construction loans. It is also more difficult to get the bank to release funds for lower invoices issued every 2 weeks. Therefore, if your client is relying on bank loans to fund their project, it may be more difficult for them to get approval and they may need to find alternative types of lending.
Ok you got me, what do I need to do get this off the ground?
First thing you will need to do is get your systems and processes sorted out. As mentioned, it requires more administrative work to operate on a cost plus basis rather than fixed price. So how do you do that simply and easily? YOU COME SEE US! We can help you utilise technology and software to devise a system that allows you to accurately quote jobs and easily record all your expenses and keep track of your project (seriously we are the bomb at this part). The upside to having these processes and systems in place is that you will then get greater oversight of the financial performance of your business and you will be better able to understand the true profit of your projects and your business as a whole.
You will also need to work out what your margin percentage is going to be, and how much you need it to be to cover your fixed operating costs. Keeping in mind that whilst the default margin percentage in the HIA contract is 20%, in South Australia the Building Work Contractors Act 1995 limits the margin added to the actual cost to 15%. Therefore, you need to decide whether a margin of 15% is enough to cover all your costs and leave you with the profit figure you are wanting.
Thirdly, you will need to cover on the legal side of it. You will need to ensure your building contract is compliant and that you are doing everything required by the contract. For instance, whilst a cost plus contract doesn’t require you to provide an exact price, it does require you to still include a thorough scope of work. Therefore, you sill need to identify exactly what work you are performing for the client and you must still have provisions for variations.
If you are interested in cost plus billing, the HIA website is a great place to start. We would also love to give you more info to find out if it is right for you cos anyone that knows Lee also knows she loves to talk all things accounting and also building, so this really is her jam!
Disclaimer: The information provided is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice