What is a cost-plus contract?
A cost-plus contract is an agreement to reimburse the company for expenses incurred add Profit of a specific amount, usually expressed as a percentage of the full contract price. These types of contracts are primarily used for construction where the buyer takes some risk but also provides the contractor with a degree of flexibility. In this case, the party drafting the contract expects the contractor to fulfill its delivery commitments and agrees to pay an additional fee so that the contractor can earn additional profits after completion.
A cost-plus contract can be contrasted with a fixed-cost contract in which both parties agree on specific costs in advance regardless of the actual costs incurred by the contractor. A cost-plus contract may also be referred to as a cost-recovery contract.
- In a cost-plus contract, one party agrees to reimburse the contracting parties for a fee plus a specified profit proportional to the full value of the contract.
- Cost-plus contracts are often used in construction when budgets are constrained or actual costs are likely to be lower than expected.
- Contractors must provide proof of all relevant costs, both direct and indirect.
Understanding Cost Plus Contracts
Cost-plus contracts are often used if the party drafting the contract has budget constraints, or if the overall scope of the work cannot be estimated correctly in advance.
In construction, cost-plus contracts are developed so the contractor can reimburse nearly every expense actually incurred on the project. A cost-plus contract pays the builder both direct costs and indirect or indirect costs. All expenses must be supported by contractor expenditure documentation in the form of invoices or receipts. In addition, the contract allows the contractor to charge a certain amount above the reimbursement amount, so they may be able to make a profit – hence the “plus” in cost-plus contracts.
Some contracts may limit reimbursement amounts so not all expenses will be covered. This is especially true if the contractor has made mistakes during the course of the project or is found to be negligent in any part of the construction.
Cost-plus contracts are also used for research and development (R&D) activities, where larger companies can outsource R&D activities to smaller companies, such as large pharmaceutical companies contracting laboratories of small biotech companies. The U.S. government also has cost-plus contracts with military defense companies that develop new defense technologies.
Governments generally prefer cost-plus contracts because they can choose the most qualified contractors rather than the lowest bidders.
Types of cost-plus contracts
There are four types of cost-plus contracts. Each of them allows for reimbursement of costs as well as an additional profit amount:
- Cost Plus Incentive Fee Contract Allowing contractors to usually get paid for good performance.
- cost plus fixed fee contract In addition to fixed costs, direct and indirect costs are also included.
- Cost Plus Incentive Fee Contract This happens if the contractor’s performance meets or exceeds expectations.
- Cost Plus Percentage Contract If the contractor’s cost increases, the compensation amount is allowed to increase.
Advantages and disadvantages of using cost-plus contracts
The pros and cons of using these types of contracts include:
They remove some of the risk for contractors.
They allow to shift the focus from overall cost to the quality of the work being done.
They cover all costs associated with the project, so there are no surprises.
Since they cannot be predetermined, they may leave the final cost in the air.
They can cause the project to take longer.
Disputes can arise when trying to recover construction-related costs
Additional resources are required to reproduce and justify all associated costs
An example of how a cost-plus contract works
Assume that ABC Construction Corp. is contracted to construct a $20 million office building and the agreement stipulates that the cost cannot exceed $22 million. ABC’s profit is 15% of the full contract price of $3 million. Additionally, ABC Construction is eligible for incentive fees if the project is completed within nine months.
ABC must submit dated receipts for all charges and the customer will inspect the quality of the job site to verify that specific components are completed to specification, such as plumbing, electrical, fixtures, etc. The contract allows ABC to cover direct costs such as materials, labor and the cost of hiring subcontractors. ABC can also account for indirect or indirect costs, including insurance, security and safety. The contract states that overhead is billed at $50 per hour worked.
Special Considerations: Percent Complete in Cost-Plus Contracts
The above projects use the percentage of completion to calculate the profit and submit the bill to the customer, and the contract stipulates the specific billing percentage.
For example, suppose ABC can bill 20% of the total contract price after purchasing 20% of the material, and the customer confirms that the concrete foundation is in place. At this point, ABC invoices 20% of the $20 million contract for $4 million and credits 20 percent of the company’s profits, or $600,000, to the financial statements.