Cutting off the nailing fin (the flange) will limit you flushing and weatherproofing options. Since this is a full frame replacement window, you were probably ordering it based on the assumption that the existing trim and sill would need to be removed - there could be rot or other issues with it. The sill is sloping down to the outside, you would have to rest the window at the top of it which may make it pushed inward too far. I would remove the sill and build the opening up 7/8" or just about. The solution they offered does not really take care of the side jamb gaps - are they proposing 3/4"Â shims on the sides? I don't know if you planed on doing so but none of the inside trim can be reused.
Anyhow, the essence of the changes needed is that you pretty much need to build up each window's opening to the smaller size frame and that's quite a bit of additional work multiplied by the number of windows. If your contract allows, I would have them come out and re-measure and redo the windows. You may want to let them remove interior trim this time so they can measure existing frame directly. Which supplier, I wonder?