By Bob Hinz
The Cost-Plus Approach to Custom Home Construction Pricing
I had a conversation with a friend and superb builder some time ago regarding pricing. As a building veteran of many years he was fearless in his exchanges with clients, subs, colleagues, and banks. His is a mature, seasoned perspective developed over many years of building high-dollar custom homes. He and his company had developed a rock-solid pricing system, very predictable pricing, a suitable margin of safety in estimating, and an inviolable margin for profit. That’s how a business should be run right? What’s the point if you’re not in it to profit?
Denver Custom Home Builder: “What does it matter?”
He told me that he had a client once who insisted on knowing what his profit margin was. My friend was prepared to let the contract go if the client would not relent on this point. My friend’s point, and the argument he presented to his client was “What does it matter what my profit margin is, if you’re happy with the purchase price of the product?”
As a practical matter, the argument applies to just about anything you can name. If the airline ticket is the right price for the moment – then does it matter to the buyer whether the airline makes $100 or $2? If the big-screen T V is priced right, most of us don’t care whether Sony makes five bucks per copy, or five hundred.
Custom Home Profit Margins – Cost-Plus Defined
Another solid business approach to home building is the cost-plus approach. This is our approach whether our client is an owner builder, or whether we’re doing turnkey work. Cost-plus is very different from the fixed price model described above. Cost-plus means that the custom home builder shares cost information on virtually every item that goes into the project, then adds his or her margin to the deal. This approach is more transparent for the home buyer, and some might say, a bit riskier for the owner. I think it’s far more practical!
Cost-plus is a way to allow the owner to see how their decisions are helping or hurting the overall transaction. If a client wants to modify the design to include fancy rafter tails in the eaves, then the client should see how much that decision costs. If a client wants to simplify the shelves and coat hooks in the mud room, then the client should see how much he / she has saved.
Custom Home Building Lenders May be Wary
Cost-plus is sometimes viewed with a wary eye by lenders and some buyers, because it does not lock in the price of the product. This view is naïve and ignores the fact that building is a business and the builder is duty bound to make a profit, and sometimes, in order to guarantee that profit, the quote price just has to be inflated. Let’s say the cost of the sticks and bricks and windows and doors is projected to be $100,000 (keep the example simple). Remember that the project is likely to take about a year to complete.
From contract to house keys a lot of crazy things could happen. World events like trade wars, hurricanes, even civil wars in other countries impact the prices of lumber, concrete, copper, steel, etc. So, a good business person must factor in a little bit of uncertainty.
Why Builders “Pad” Their Estimates
That uncertainty shows its head in the form of a 5 to 7% margin added for cost inflation. If steel goes up, the builder is still going to make his or her profit. But…if steel goes down… the contract price is still fixed. The builder gets a bit more for his or her pocket. In the above example, the builder simply has to “pad” the estimate in order to allow for that uncertainty, and still guarantee a profit.
With the cost-plus model, if the cost of steel goes up, the owner pays more for the steel that goes into the house, and probably has the chance to review the invoice. If the price of steel goes down, the owner enjoys the savings. Both methods work. Both methods are honorable ways to do business in the custom home industry.
I’ll always argue that the cost-plus method is more open for the owner.