Lifting the lid on construction contracts and fees
Since we wrote this blog about why we favour cost plus contracts more than a year ago a lot has changed in the construction industry in Australia. Material supply, epic climate events and labour shortages have plagued the industry and the price has escalated at an unprecedented rate.
Interestingly open book contracts have seemingly grown in popularity in the last 12 months as even builders that traditionally did work on a fixed price contract refused to do this and insisted on open book contracts because of price instability.
In the blog we explained why we favoured open book contracts rather than fixed price contracts. Since then we have been asked by several clients what it would cost to fix the contract price. This comes at an additional cost (price escalation risk premium) because as a builder we need to factor in potential price rises and generally project price risk over the timeframe of the contract in an unstable and uncertain environment. Many builders have come unstuck by mispricing this risk.
We decided to just be upfront with what we think the price escalation margin should be and put this option back to our clients. This enables us to have an open conversation with clients but also lifts the lid on what they might be paying as an undisclosed premium to other builders that offer fixed price terms.
We have chosen to disclose our schedule of standard rates, which we believe are in line with the industry standards based on credible evidence.
Here’s the blog published in late 2021
In the building industry, there are two ways of billing clients. One is an open book contract, also known as cost plus, in which the client and builder agree on which costs are remunerable and the margin that the builder can add to these costs. The project is then invoiced to the customer based on the actual costs incurred, plus the agreed margin. The other is a fixed price contract, in which the builder agrees to perform building work for a set sum. At Ballast Point, we favour open book contracts. So, we were interested to see research emerge from construction management software company CoConstruct recently that found that projects using fixed price construction contracts had 28 percent higher average profit margins than open book contracts. In analysing more than 60,000 projects completed in CoConstruct, the company also discovered that profit margins for fixed price contracts have grown over the past three years, while open book margins have either shrunk or stayed flat.
At Ballast Point, we strongly believe that open book contracts are fairer. The customer knows how much things cost upfront, and can rest assured that they are getting what they are paying for. The designer and builder can also discuss the cost implications of decisions directly and precisely with the client. It also reduces pressure on the builder to use substandard suppliers and sub-contractors when their budget is pushed, or to increase their profit margin. Energy that may have been spent administering variation is instead spent on creating a better product.
While open book contracts are fairer, there are some drawbacks clients should be aware of. Firstly, the budget is not fixed and can increase (as well as decrease). The price of timber or labour hire, for example, might change over the course of the project, and the client takes on that risk. Secondly, if you’re paying incompetent people by the hour (as you do with open book contracts), it’s a disaster every time, so you have to be confident from the outset that the people you are engaging know what they are doing!
At Ballast Point, we prefer open book contracts because we believe they are more transparent, enable us to work in partnership with the client, and ultimately deliver a better all-round result. It tends to be a more positive experience that makes our clients part of the team and enable us to focus on return on investment. It also provides the client with the flexibility to make changes without time and cost penalty associated with a fixed price contract variation process, and time that would otherwise be spent in administration to the contract scope is more likely to be put into making the final product better.
Checklist for successful open book projects:
1. Adequate budget – the most common reason for budget blowouts can be traced back to an inadequate budget to begin with. Getting an independent estimator is a good way to ensure that the budget is realistic.
2. Competent staff and quality sub-contractors
3. Budget tracking – giving clients the flexibility to make changes and site conditions can put pressure on the budget. Effective systems for tracking the budget are essential to prevent surprises.
4. Adequate contingency – building (and particularly renovation) doesn’t always go to plan, whether because of service upgrades or unexpected repairs. We recommend a 20 percent contingency allowance on all projects.
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