While all construction contracts will stipulate timelines and requirements, the mechanisms by which you get paid can vary greatly.
Since billing methods in the construction industry take many different forms, it’s crucial to understand how different contracts operate. Mainly because different billing methods will affect your cash flow and decision-making in very distinct ways, making them an important part of your construction accounting process.
In this article, we will break down the five of the most common construction billing methods, taking a look at the advantages and disadvantages of each.
Fixed price billing method
Fixed price contracts, will see a contractor and a client agree to a set price for all services before the project begins. If it’s decided that a project will cost $20,000, you can expect the final project cost to amount to $20,000 (unless altered by change orders).
The basic procedure will see contractors estimate how much time, labor, and materials will go into a project according to the project’s scope of work. You should then prepare a well-thought-out budget that accounts for all costs that you expect to incur throughout the project.
From here, you can apply markup and submit your proposal with a locked in price for the client.
Advantages
- Facilitates the bidding process
- Gives more control over profitability
- Pairs well when consistently job costing
Fixed price (sometimes referred to as lump sum billing) helps facilitate the bidding process since the total contract price is visible from the beginning. This can help construction companies plan to come in under budget, ensuring a higher profit margin by the project’s end.
In addition, fixed-price contracts give contractors more control over their profitability than other methods. If a contractor’s job costs consistently and uses historical data to create accurate estimates, the more room they can leave themselves for job-level profit.
Disadvantages
- Requires high accuracy
- Unforeseen changes can impact profitability
- Requires accurate estimating
Any changes in labor hours or materials costs will not affect the client but will instead impact you as the contractor. Since you’ll agree on a price ahead of time, any unforeseen changes or complications can drastically cut into profits, resulting in cost overruns.
It’s crucial to spend the time to thoroughly estimate the major job costs (labor, materials, equipment, subcontractor costs) for fixed-price contracts to mitigate against these unexpected costs.
Accuracy is critical with fixed-priced billing methods. There is a high-risk, high-reward nature to fixed-price contracts. However, you can significantly reduce this risk through skilled estimating, consistent job costing, and strategic bidding.
Having a historical data set means you can adequately plan for and budget each job. Knowing the contract price upfront allows contractors to use job costing data and job cost reports to create precise budgets and effective markup percentages, ensuring your construction business is a profitable venture.
Cost-plus billing method
In the cost-plus construction billing method, contractors will get paid for all expenses plus a separate percentage, or set fee, to cover profit. Using cost-plus, a construction invoice will contain all costs associated with the project (i.e., materials, labor, equipment, and subcontractor costs); from there you’ll account for all costs and then mark them up with an agreed-upon amount to ensure you generate a profit.
Advantages
- Great for undefined contracts
- Flexible
- Reduced chance of overbidding
Cost-plus agreements can eliminate a certain level of risk for construction companies if a project has a considerable grey area. Cost plus is often used when it’s difficult to determine a project’s final scope and cost upfront.
With the absence of a defined scope of work, there is a high degree of flexibility, meaning you can make adjustments rather freely.
For example, if materials and labor costs start to increase, contractors can bill the client for these increases instead of absorbing the extra costs. Not all cost-plus contracts allow this, so be sure to negotiate this stipulation before signing anything.
Another benefit is the option to include a Guaranteed Maximum Price clause in the agreement, which will put a spending cap on the amount contractors can spend. This makes cost-plus contracts a budget-friendly option for project owners looking to reign in budgets.
Disadvantages
- Can lead to disputes
- Not all costs are guaranteed to be reimbursed
- Lower control of job profitability
Cost-plus can lead to disputes due to the unrefined nature of the agreements. In addition, reimbursement for every cost isn’t guaranteed. For this reason, you’ll have to justify and prove that an expense qualifies for reimbursement.
As a result, contractors must keep highly detailed records and detailed invoices to stay organized. If a contractor cannot provide adequate documentation to justify costs, it can cause serious problems. Another drawback can result from reduced cash flow, as cost-plus contracts require the contractor to front most project costs.
Another major disadvantage is that since profit is predetermined, there is no way to increase profitability by cutting costs or working more efficiently. This lowers the amount of profit a construction company can make since profit is obviously tied to your total project cost. Higher costs mean higher profitability. This can back a contractor into a corner in a way that a fixed-price contract would not.
Developing accurate budgets will also be difficult since you won’t have enough project information. Lack of project information can be the most significant disadvantage for cost-plus contracts. This can result in uncomplete plans, unclear payment schedules, and underdeveloped project scopes. Additionally, there is no industry standard or agreed upon structure for cost-plus contracts.
The lack of a standardization, can lead to confusion on terminology, terms, and conditions within the contract. While there are scenarios where a cost-plus contract can help facilitate a successful project, entering a project without key information should be done with caution and under the right circumstances.
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Time and Materials billing method
The time and materials construction billing method is similar to cost plus in that the final cost is left undetermined. Under a time and materials contract, the client and contractor will agree on the goal of a project and specify the final outcome. Once agreed upon, the contractor will establish hourly labor rates, cost of materials, and markup percentages.
From here you can invoice rather quickly since you’ve already agreed on rates. In terms of how this works, you’ll pass material costs directly to the client for payment and you’ll charge labor as your team clocks in and out.
Typically a contractor will provide the client with an hourly rate for labor and an estimation of how long project completion will take. This generally results in a rough price range for total cost.
Advantages
- Great for undefined contracts
- Benefits jobs with fluctuating material prices
- Doesn’t require extensive estimating upfront
Time and material billing approaches can provide less risk since contractors don’t need to estimate everything up front, and they can easily invoice labor through logged hours.
If you struggle to generate profit under fixed-price projects, you may want to consider time and material billing method for projects until you can consistently generate accurate estimates.
Disadvantages
- Cost can significantly exceed the original estimate
- Lower control of job profitability
- Requires extensive tracking
Some may find that there is no incentive to cut costs or labor hours since it won’t contribute toward higher profits for the contractor.
If the project comes in under the estimated price range, contractors may wonder if they would have made more if it were a fixed-price contract.
Unit price billing method
Unit-pricing aims to break down a project into quantifiable parts. Contractors will provide project owners with prices for each individual task or unit, and the owner will then pay for each unit expensed.
This works by dividing all work into quantifiable units. From there you’ll estimate the price for labor or material costs, equipment, subcontractor costs, and any additional project costs. This assigns a fixed rate for each unit at the start of the project. If additional work is needed at any time, you can add the additional costs to the appropriate unit, and the total cost will reflect that increase.
This can be another solid option for contractors if the scope of work needs to be clarified. If a project grows in scope, contractors can bill additional units as needed. For example, you can pay for certain materials, such as dirt, through a unit price since it can be tough to estimate the exact amount you’ll need at the start of a project.
In this scenario, unit price billing may be the best option since paying for dirt “by the truckload” can make more sense than bulk ordering.
Each unit price will include all job costs such as labor, material, equipment, in addition to profit. To generate a profit, contractors need to understand the costs associated with each unit. Therefore, contractors must mark a percentage of total costs to cover profit.
Advantages
- Straight forward billing process
- Flexible
- Good for material-dependant projects
With fixed rates billing procedures are rather straightforward. Another main advantage is that it provides flexibility as the project progresses. Suppose a project is long-term and expected to last several years.
In that case, unit pricing can be highly beneficial since contractors can expand projects and tasks midway through the project and keep their rates consistent from the start. Unit pricing can make sense for material-dependent projects where the exact amount of specific materials cannot be determined ahead of time.
For this reason, many large commercial construction projects take advantage of unit pricing.
Disadvantages
- Can be difficult to properly budget and plan
- Requires extensive tracking
- Requires extensive documentation
Although flexible, the ambiguity of unit pricing makes it challenging to properly budget and plan. Since you don’t know how a project will progress or grow, it isn’t easy to ensure that you will be profitable at the job level.
Changes in schedules and timelines will also come with a changing scope of work. As a result, this will require additional paperwork to properly document what work is being performed and what additional costs are expected.
Lastly, contractors may find it challenging to price units accurately. If you miss a measurement or have to go back and recalculate, your estimates can be severely off the mark. This can lead to further issues, such as delayed payments and costly rework.
AIA-style progress billing method
Progress billing will see contractors prepare and submit invoices at different project stages. This method is usually done on a percentage-of-completion basis following a payment schedule.
When you’ve hit agreed-upon milestones, you’ll send out invoices to cover that work. For example, let’s say you quote a job for $40,000, billed on a percent completion basis with a billing period occurring at the end of each month. At the end of the first month, with say 30% of the project completed, you’ll issue an invoice reflecting 30% of the total, reflecting $12,000.
Many contractors choose to follow an AIA-style progress billing method in their construction contracts as they provide a standardized set of invoicing forms. AIA billing typically requires two specific forms:
- G-702 Application and Certificate for Payment: This form provides basic project information such as parties involved, timelines, original contract sum, sum of previous payments, change orders, and outstanding payments owed.
- G-703 Continuation Sheet: This form will provide all relevant information needed for payment applications. Its primary purpose is to support the claims made in the G-702 documents.
These forms can be via the AIA Contract Documents website. However, most contractors will accept non-branded forms as long as they follow the same layout and structure of official AIA documents. These forms are different from a traditional invoice. They’re payment applications detailing the expected amount that you’ll invoice.
The basic structure will provide a summary of the billing progress of the overall job detailing that the contractor is entitled to payment when work is completed. Other important inclusions:
- Total contract amount
- Retainage
- Total amount billed to date
- Current completion percentage
- Remaining balance owed at the completion of work
A well-structured schedule of values will detail cost, level of completion, and the percentage paid for each task. Which helps contractors and subcontractors accurately monitor job progress and ensures work is progressing as planned.
AIA-billing is notoriously meticulous, and leaves little room for error. For this reason, construction management software that streamlines this process is a game changer for business owners who are still manually filling out payment apps. Software like Knowify turns this otherwise lengthy task into a process that takes just a few clicks.
Advantages
- Standardized
- Promotes steady cash flow
- Integrates well with construction software
The main advantage of AIA-style construction billing is its standardized structure. It also promotes a steady cash flow stream, as you don’t need to wait until the end of the project to receive payments.
If you use construction management software, this billing method can be extremely time efficient and ensure professional billing through an automated process.
Disadvantages
- Disputes can arise around the percentage of work completed
- Requires documentation
- Only makes sense if consistently job costing
A potential disadvantage of AIA-style progress billing will arise if you do not have a sound job costing system in place. This billing style will require you to track costs on a detailed and consistent basis.
If you don’t have an efficient way to job cost, this can complicate matters and convolute the entire process. Another issue that may arise is centered around disputes on the actual percentage of work completed. Another reason why it’s paramount to carefully document work and costs.
Takeaways
As you can see, construction billing methods come in many different shapes and sizes; each method has pros and cons that will work better for specific use cases. Because of this, there is no one size fits all solution.
Therefore, before taking on a new construction project, you’ll need to understand how each billing method will impact your operations and cash flow. With proper job costing and planning, however, you can take more control of your profitability no matter the method used.
To learn more about how you can get invoices out faster with unprecedented clarity and professionalism, sign-up for a quick 30-minute demo to learn more about Knowify’s invoicing tools.
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