Cost-Plus ContractExplained, Advantages & Disadvantages, and Examples

Written By:
Lisa Borga

Cost-plus contracts, also known as cost-reimbursement contracts, are a type of contract in which the cost of providing the good or service will be reimbursed plus a specified amount of profit.

These types of contracts are often used in construction projects and other situations where the cost of completing the project is restricted and some degree of flexibility can benefit both parties.

However, this does place greater risk on the buyer who agrees to pay for the cost of completing the contract plus an additional percentage for profit.

Understanding a Cost-Plus Contract

With cost-plus contracts, the contractor will be paid at the completion of the contract for all associated costs, including the direct and indirect costs as well as overhead, plus an additional fee which represents the profit the contractor receives for performing the job.

This requires the contractor to keep detailed records of all expenses incurred in completing the contract in order to prove the actual cost.

In some cases, the cost-plus contract may include some sort of limitation on the amount of reimbursement that will be provided.

These will often take the form of clauses limiting reimbursement in cases of errors or negligence on the part of the contractor, as well as additional fees for exceeding a certain cost.

The contract may also include incentives for completing work for a lower cost, ahead of schedule, or in excess of minimum specifications.

Though certain clauses can limit the risk of the customer in crafting cost-plus contracts, these agreements will typically shift more of the risk from the contractor to the customer, who typically will be responsible for covering the cost of increased expenses.

Due to the ability of these contracts to be used in cases where the actual cost of a project cannot easily be estimated with a high degree of accuracy, they have gained traction and are often used by governments, construction companies, and for research and development activities.

How Are Cost-Plus Contracts Different from Fixed-Price Contracts?

A fixed-price contract requires both parties to agree on a specified cost for the project upfront.

This amount is all that the customer will provide the contractor for the cost of completing the project regardless of the actual expenses that the contractor may incur.

This contrasts with a cost-plus contract where the actual costs of completing the project will be added up at the end and paid for by the customer.

As a result, a fixed price contract requires far more caution on the part of the contractor in estimating the cost of completing the job to ensure that a mistake in planning does not eliminate their profits.

However, customers often may have a preference for fixed-price contracts because they provide them with a guaranteed cost for completing the project

Limitations on Cost-Plus Contracts

In a cost-plus contract, the contractor will bill the customer for all expenses, both direct, indirect, and overhead, plus an additional fee for profit, which allows for a strong degree of flexibility in determining the final sum the customer will pay.

Despite this, a cost-plus contract rarely works as a blank check.

In most cases, the contractor is required to provide a detailed estimate of the cost of completing the contract before it is ever signed, and the customer will agree to cover certain increases in the cost of completing the contract.

Often cost-plus contracts leave room for increases in the cost of purchasing materials such as metal and lumber, which often face highly fluctuating costs.

Additionally, many will leave room for additional overhead, such as R&D, which is necessary to complete the contract’s intended outcome.

However, cost-plus contracts will rarely cover significant errors in estimating the costs, as well as additional expenses incurred due to mistakes or negligence.

Additionally, some customers may demand a cap on the total costs that may be charged.

Lastly, in some contracts, which are expected to continue for an extended period of time, the contract may call for the customer to make interim payments throughout the course of the contract to cover some of the contractor’s expenses.

What Does a Cost-Plus Contract Include?

Regardless of the exact details of the contract, a cost-plus contract will generally include these three basic categories.

Direct Costs

This typically includes the costs that relate directly to the performance of the contract.

This is often known in other applications as costs of goods sold and includes components such as the direct labor costs and direct materials needed to complete the project as well as any equipment and outside contractors that are needed in the course of the project.

Overhead Costs

Overhead costs are the various expenses that are incurred in the course of the company’s operations.

These are typical business expenses such as insurance, licensing, office rent, utilities, and often many others.

A cost-plus contract typically covers a given percentage of the contractor’s overhead expenses which will depend upon the length and size of the project being contracted for.

Profit

This is the amount the contractor will be paid for the completion of the contract.

This could be based upon a percentage of the total cost, or it may be a fixed fee depending upon the contract.

It may also include additional incentive payments, such as a bonus for early completion.

Types of Cost-Plus Contracts

There are several different types of cost-plus contracts, and these generally depend on the kind of business using the contract as well as the service or product the business is offering.

Some of these contracts are:

• Cost-Plus Fixed Fee: This contract is the standard cost-plus contract. It involves the buyer paying a flat fee in addition to the costs that are agreed to in the contract.
• Cost-Plus a Percentage of Cost: With this type of contract, the fee the contractor receives is a percentage of the total costs the contractor incurs. This means that as costs increase, the fee paid to the contractor increases as well. This type of contract can be useful to protect contractors in situations where costs are rising quickly. However, government agencies, as well as large businesses, generally prefer to avoid this type of contract as it gives contractors little reason to keep costs down.
• Cost-Plus Fixed Rate: This rate is very unusual, and if it is used, it is by contractors that already know their labor rates as well as their costs. With a cost-plus fixed-rate contract, the labor rates are set in advance. This type of contract does not allow much flexibility.
• Cost-Plus Incentive Fee: With these contracts, the contractor receives a higher fee if they either meet or exceed certain performance objectives set out in the contract. These objectives generally consist of certain completion dates, but they could also involve other goals such as lower costs.
• Cost-Plus Award Fee: Cost-plus award fee contracts pay an extra fee that depends on the contractor’s performance. As an example, the fee may be earned by delivering an item that exceeds the expectations that were set out in the contract.

Example of a Cost-Plus Contract

Many industries make use of cost-plus contracts, but the construction industry is one of the heaviest users of these contracts.

As an example, suppose ABC Construction has taken a job to build an apartment complex that is estimated to cost $10 million.

ABC Construction enters a cost-plus contract in which it agrees that costs will not go over $13 million.

So, for the buyer, costs will not go beyond $13 million, thus providing them some protection.

ABC Construction will also receive a $1.7 million fee as part of the contract regardless of the total costs for the project.

This is approximately a 17% fee.

Although, even 20% fees are not unusual.

The total cost of this project for the buyer will be at least $11.7 million, which includes the estimated costs and the fee that will be paid to the contractor.

The buyer has also included an incentive fee in the contract in which they agree to pay the contractor $1.3 million if the total costs are not more than the estimated costs of $10 million, and the job is finished at least 30 days early.

In order to ensure compliance with the contract, ABC Construction carefully tracks all the resources they use at specific intervals of time as well as turning over any documentation or receipts necessary to show expenses.

ABC Construction is also required to meet certain periodic targets, which need to be substantiated by a consultant inspection or the buyer.

The construction company also sends bills to the buyer at certain agreed-upon points, which provide the construction company with funds to continue the project as well as a percentage of the estimated profit.

Using Cost-Plus Contracts

Businesses that perform long-term projects in which the total expenses of the job cannot be precisely determined due to a lack of information can benefit from using these contracts.

By using a cost-plus contract, a buyer can start a project quickly without the contractor needing to be concerned about excessive risk.

Important Considerations for Cost-Plus Contracts

There are some things that should be kept in mind when entering into a cost-plus contract.

Make sure to include a clear list of what costs will be included in the work so as to avoid any confusion.

Also, make it clear in what situations the buyer or seller will be permitted to terminate the contract.

It is also important to itemize any overhead in such a way that it will be easy for any clients to understand.

It’s also important not to give a total price in writing, or the customer could claim that that is the full cost of the contract.

Also, give accurate estimates even if that requires research.

It is important in cost-plus contracts for both the buyer and the seller to be aware of the costs as well as the profits.

Advantages and Disadvantages of Cost-Plus Contracts

Advantages

There are a number of benefits to using cost-plus contracts, such as:

• It allows contractors to use high-quality materials.
• Contractors have a decreased risk of having to accept unexpected costs resulting from price inflation.
• The responsibility of managing costs is split between the buyer and contractor.
• Contractors can concentrate on the quality of their work instead of cost-cutting.

Disadvantages

There are still some disadvantages to using cost-plus contracts, such as:

• Careful attention to costs is necessary, or the buyer’s costs can quickly increase.
• The project’s final cost isn’t set.
• This type of contract requires careful management as well as tracking of all expenses and resources.

Safeguarding Your Company

Cost-plus contracts have a lot of benefits for businesses in industries such as construction.

These contracts work well in these businesses because direct costs make up a lot of their work, and yet they cannot control these costs.

Additionally, these costs can vary considerably due to changes in demand and supply.

But, it is essential for businesses to maintain meticulous accounting records in order to ensure that their company is protected by a cost-plus contract.

If a business fails to keep good records, it may not be reimbursed for all of its expenses.

The best way to do this is to have a system that keeps records in real-time.

By keeping constant track of any expenses, a business can better control its costs and is less likely to forget to record any costs.

It also makes it easier for businesses to provide documentation to their clients.

Cost-Plus Contracts in the Past

Frank B. Gilbreth was the first person to publish the idea of a cost-plus contract.

He discussed the concept in an article in 1907.

He also used these contracts in his own construction business.

This type of contract became more common during World War I and World War II.

The contracts were used as a way to promote quick production in order to satisfy the military’s demands.

These contracts also helped technology firms by allowing them to charge their research and development costs to the defense department and come up with products they might not have been able to otherwise.

Common Uses of Cost-Plus Contracts

The defense industry commonly uses cost-plus award fee contracts.

They were heavily using this type of contract by the first part of the 2000s.

Before this time, they favored cost-plus-fixed-fee contracts.

Cost-plus contracts were frequently used in businesses that did a lot of research, with service-oriented businesses being the next largest users of these contracts.

However, this changed early in the 2000s when service-oriented companies began using cost-plus contracts more frequently.

This is apparent in the construction industry.

Using a Cloud-Based Financial Management System for Cost-Plus Contracts

It is essential that contractors properly account for a project for which they have a cost-plus contract in order to make the project a success and avoid additional overhead.

This is important for the business and also as a way to document and substantiate any costs to any buyers.

One way to make this easier is to use a cloud-based financial management system that can keep track of any resources inventory, as well as deal with billing and other financial tasks associated with the job.

These systems have automated record keeping and expense tracking, which is a great way for a business to help control costs.

It’s also useful for employees on the go when they need to keep track of resources or expenses or need to notify someone from the worksite that they have completed some work.

All they need to do is access the cloud.

Cost-plus contracts are useful in a number of different types of projects but are particularly common in construction.

In situations where costs are uncertain, cost-plus contracts provide assurances for contractors while allowing buyers to see what the actual costs are.

However, it is essential for businesses to carefully track costs when using these contracts.

FAQs

How do cost-plus contracts operate?

The seller and buyer in a cost-plus contract agree to certain expenses that the buyer will reimburse the seller for as part of the project along with paying a fixed fee which will provide the contractor with a profit.

What are some of the benefits of a cost-plus contract?

The biggest advantages to a cost-plus contract are the protection they provide against inflation as well as the way they more easily allow a business to take care of unexpected outside engineering and consulting fees.

Additionally, in cost-plus contracts, the buyer and contractor both have the responsibility of cost management.

Are there disadvantages to a cost-plus-fixed-fee contract?

One part of cost-plus contracts that most customers consider a disadvantage is the lack of a specific final cost.

One thing some contractors do to help with this concern is using a system that allows them to manage and track expenses and overhead, thus reducing the customer’s concerns by giving them thorough timely information.

What is an example of cost-plus pricing?

For an example of cost-plus pricing, suppose a business entered a cost-plus contract, and the plumbing project was expected to have a total cost of $7 million along with an $840,000 fixed fee as profit for the plumbing contractor.

This would mean the total cost to the purchaser would be about $7,840,000, which includes the cost and the fee.

It is possible that the contract will apply a cap to the total expenses as well as an incentive fee in the event the project is completed early.

Key Takeaways

• Cost-plus contracts are an agreement by a buyer to pay the costs of completing the contract plus a specified percentage of profit.
• Cost-plus contracts are often used in construction and similar situations in which the budget is restricted, or the actual expense may be lower than estimated.
• Cost-plus contracts require the contractor to provide proof of all associated expenses.
• A cost-plus contract shifts the risk in completing a contract from the contractor whose profit is guaranteed to the customer, who cannot be certain of the final cost.