Building contract basics: Part 1
This series of articles is aimed at explaining some of the basics about how building contracts work, and some of the choices you will need to make when entering into a building contract, and how those choices affect what will happen on your build. In this first article, we explain some of the basic concepts dealing with how much you will pay. Please note that each State of Australia has different laws relating to various aspects of building, and particularly the construction of housing. These articles do not deal with the nuances of each State’s laws and systems.
How is the contract price to be determined?
The main choice you will face in deciding what the contract price will be (other than the amount of your budget) is whether the contract is to be a Lump Sum Contract (also known as a Fixed Price Contract) or a Cost Plus Contract.
Lump Sum Contracts
A Lump Sum Contract is one where your builder agrees a single lump sum for the works described in the contract. However, while this is described as a lump sum or a fixed price, it is often not the amount you will end up paying your builder. Why will that be different? There are three main reasons – Provisional Sums, Prime Cost Items and Variations.
A provisional sum is an allowance included in the contract price, for an aspect of the works that the builder feels it cannot accurately assess at the time of contracting (one common example is site works). This may be because that part of the works needs further investigation, or because you are still to make a decision about them. The actual amount that the relevant works cost, plus the builder’s margin, will replace the provisional sum.
That is if a provisional sum of $3,000 was included for the item, but the works actually cost $5,000, your contract price will increase by $2,000 plus the agreed builder’s margin. If the works actually cost less than the provisional sum allowance, your contract price should reduce. If you are comparing builders’ prices, pay careful attention to the provisional sums – if a builder has reduced its price by having a smaller provisional sum for an aspect of the work, this may not result in a lower final price.
So why use provisional sums? Because the particular part of the works cannot be properly defined, if the builder had to fix a price for that work, it would include an allowance for the risk that the works will be more expensive than anticipated. Using a provisional sum allows the builder to give you a fair estimate for the work, without it taking that risk.
Prime Cost Items
A prime cost item is an amount of money included in the contract to purchase a specific item, such as tiles, kitchen appliances and bathroom and kitchen fittings. These will usually be items that the owner will have an input into and may select later in the build process.
For example, the contract may include an allowance for 15 m2 of bathroom floor tiles at $40 per m2, giving a prime cost item of $600. If you end up selecting a tile that costs $60 per m2 (or a total of $900), the contract price will increase by $300. Again, when comparing contract prices and your budget, consider prime cost items carefully and whether they reflect the type of items you are likely to select – if you want designer appliances and the contract includes a prime cost for less expensive items, your final price will end up increasing.
Apart from delays, variations are probably the single largest cause of issues in building projects. You have been given a fixed price for your build. So why has the cost increased, often with the extra bill coming only at the end of the project?
The thing to remember is that the price you agreed is the price for the works as set out in the plans and specifications as attached to the contract. Any change you ask for, or which are required to address any other circumstances (eg your council requiring a change to the plans) is a variation.
Under nearly all building contracts, where a variation occurs, the contract price is varied either by an agreed amount (if you and the builder agree a price for the variation, either before or after it is done) or by the change in the cost of undertaking the works. Before instructing a variation, if possible, it is important that you either agree the price change or at least obtain an estimate. This allows you to determine whether the change is worth the cost and whether you can afford it.
Structural changes to the building plans (such as moving or removing a wall, or making a window or doorway larger) may have significant costs and could delay works. If variations are made at a relatively late stage in the works (compared to when the varied item would be ordered or started), there can be significant costs arising from even minor changes. For example, changing a paint colour or tile selection at an early stage might not add much cost, but changing it after the items have been purchased will have a higher cost.
A Cost Plus Contract does not have an agreed price. Rather, you agree to pay all of the builder’s costs, plus a margin to compensate the builder for their time, effort and expertise. The builder’s margin can be a percentage of costs, a fixed fee, or a combination of the two. The builder could also be incentivised to come up with cost savings, eg by being paid a percentage of any savings below an agreed price.
Under a cost plus contract, while you may be given an estimate of the cost of the build, this is not fixed and depending on how the build progresses, you may end up paying more than you originally intended. As a result, there should be strong oversight and administration to ensure that costs are kept under control and properly incurred. Often, this may involve engaging an architect or another superintendent to oversee the builder.
So why use one?
Cost plus contracts are often entered into where the design of the building has not been determined when the builder is engaged (for example, the builder is engaged under a design and construct contract), or where there are aspects of the build that have a higher than usual risk. They are more common in custom builds than in “off the plan” building contracts, especially ones with innovative designs. In those cases, a builder may not be willing to take the risk on cost, or may only take that risk in return for an unacceptable price.
In the right situation, a cost plus contract allows the owner to avoid that risk premium (but of course, takes the risk herself). A cost plus contract can be more flexible allowing changes to the specification, and if managed correctly, can allow an owner to take advantage of price savings if materials or services can be sourced more cheaply, or a cheaper method of building may be possible. Alternatively, if you are more concerned with the quality of works, rather than the price, a properly supervised cost plus contract avoids a builder trying to save costs (and improve its profits) on a fixed price contract.
Please note that in some jurisdictions the use of cost plus contracts for residential homes may be subject to limitations or additional regulations, or alternatively may not give you the same legal protections as a fixed price contract.
Gross Maximum Price
This is an unusual form of contract for residential jobs – it is more often used on larger projects. A GMP contract may be either a fixed price contract or a cost plus contract, but with an agreed maximum price. The GMP limits the additional amount the builder can charge for variations, or under the cost plus contract. Usually, as the builder is taking the risk of cost increases above the GMP, it will require protection from the owner requesting excessive changes to the works.
Our Guest Contributor:
Thank you to Andrew Throssell, Partner at Hotchkin Hanley Lawyers for sharing his insights into building contract basics. Andrew has over 20 years experience in commercial transactions and disputes and has dealt with a large number of commercial, construction and property transactions, often acting for developers, builders, building owners and shopping centre owners.
His areas of practice include commercial, industrial and retail property sales and leasing transactions, partnerships and joint ventures, construction law, business sales and purchases, franchising, information technology and intellectual property. Andrew has extensive experience advising on contentious and complex transactions.
Please note that any information in this blog is purely general in nature and provided as a guide only. Different States and Territories around Australia have different rules and laws that apply to building contracts. Professional legal advice should always be obtained if in doubt as to any contracts or agreements you are signing.