What Is a Cost-Plus Contract?
A cost-plus contract is an agreement to reimburse a company for expenses incurred plus a specific amount of profit, usually stated as a percentage of the contract’s full price. These type of contracts are primarily used in construction where the buyer assumes some of the risk but also provides a degree of flexibility to the contractor. In such a case, the party drawing up the contract anticipates that the contractor will make good on their promises to deliver, and agrees to pay extra so that the contractor can make additional profit upon completion.
Cost-plus contracts can be contrasted with fixed-cost contracts, in which two parties agree up front to a specific cost regardless of the actual expenses incurred by the contractor. Cost-plus contracts may also be known as cost-reimbursement contracts.
- In a cost-plus contract, one party agrees to reimburse the contracting party for expenses plus a specified profit proportional to the full value of the contract.
- Cost-plus contracts are often used in construction when the budget is restricted or when there is a high probability that actual costs might be less than anticipated.
- Contractors must provide proof of all related expenses, including direct and indirect costs.
Understanding Cost-Plus Contracts
Cost-plus contracts are generally used if the party drawing up the contract has budgetary restrictions or if the overall scope of the work can’t be properly estimated in advance.
In construction, cost-plus contracts are drawn up so contractors can be reimbursed for almost every expense actually incurred on a project. The cost-plus contract pays the builder for direct costs and indirect or overhead costs. All expenses must be supported by documentation of the contractor’s spending in the form of invoices or receipts. The contract moreover allows the contractor to collect a certain amount above the reimbursed amount, so they may be able to make a profit—hence, the “plus” in cost-plus contracts.
Some contracts may limit the amount of reimbursement, so not every expense would be covered. This is especially true if the contractor makes an error during the course of the project or is found to be negligent in any part of the construction.
Cost-plus contracts are also used in research and development (R&D) activities, where a larger company may outsource R&D activities to a smaller firm, such as large pharmaceutical company contracting to the lab of a small biotech company. The U.S. government also uses cost-plus contracts with military defense companies that develop new technologies for national defense.
Governments generally prefer cost-plus contracts because they can choose the most qualified contractors instead of the lowest bidder.
Types of Cost-Plus Contracts
Cost-plus contracts can be separated into four categories. They each allow for the reimbursement of costs as well as an additional amount for profit:
- Cost-plus award fee contracts allow the contractor to be awarded a fee usually for good performance.
- Cost-plus fixed-fee contracts cover both direct and indirect costs, in addition to a fixed fee.
- Cost-plus incentive fee contracts happen when the contractor is given a fee if their performance meets or exceeds expectations.
- Cost-plus percent-of-cost contracts allow the amount of reimbursement to rise if the contractor’s costs rise.
Advantages and Disadvantages of Using Cost-Plus Contracts
The pros and cons of using these types of contracts include the following:
They eliminate some risk for the contractor.
They allow the focus to shift from the overall cost to the quality of work being done.
They cover all the expenses related to the project, so there are no surprises.
They may leave the final cost up in the air since they can’t be predetermined.
They may lead to a longer timeline for the project.
Might lead to disputes when trying to recover construction-related expenses
Requires additional resources to reproduce and justify all related costs
Example of How a Cost-Plus Contract Works
Assume ABC Construction Corp. has a contract to build a $20 million office building, and the agreement states that costs cannot exceed $22 million. ABC’s profit is agreed at 15% of the contract’s full price of $3 million. Additionally, ABC Construction is eligible for an incentive fee if the project is completed within nine months.
ABC must submit dated receipts for all expenses, and the client will inspect the job site for quality to verify that specific components are completed to specification such as the plumbing, electrical, fixtures, etc. The contract allows ABC to incur direct costs such as materials, labor, and costs incurred to hire subcontractors. ABC can also bill indirect, or overhead, costs, which include insurance, security, and safety. The contract states that overhead costs are billed at $50 per labor-hour.
Special Consideration: Percentage of Completion in a Cost-Plus Contract
The above project uses the percentage of completion process to account for-profit and to submit bills to the client, and the contract provides specific percentages for billing.
Assume, for example, that ABC can bill for 20% of the full contract price once 20% of the materials are purchased, and the client verifies the concrete foundation is in place. At that point, ABC sends an invoice for 20% of the $20-million contract at $4 million, and posts 20% of the firm’s profit, or $600,000, to the financial statements.