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 total price. These types of contracts are primarily utilized in construction, providing both the buyer and contractor a degree of flexibility, while the buyer assumes some of the risk.
In contrast to fixed-cost contracts—where both parties agree upfront on a specific cost regardless of actual expenses—a cost-plus contract allows for the reimbursement of virtually every expense, including direct and indirect costs, which offer the contractor a safety net to ensure project delivery. Companies can also encounter this term as ‘cost-reimbursement contracts.’
Key Takeaways
- In a cost-plus contract, one party agrees to reimburse the contracting party for expenses, plus a specified profit tied to the total contract value.
- Frequently used in construction, especially when budgets are tight or there’s a significant likelihood that actual costs might be lower than anticipated.
- Contractors are required to provide proof of all related expenses, including direct and indirect (or overhead) costs.
Understanding Cost-Plus Contracts
Cost-plus contracts are preferable when budget constraints exist, or the overall work’s scope cannot be carefully estimated beforehand. In construction, such contracts ensure contractors can be reimbursed for nearly every expense incurred. They also enable contractors to achieve profit by above reimbursement payments, elucidating the “plus” in cost-plus contracts.
Certain contracts may cap reimbursement, thus not covering every expense, especially amid contractor errors or negligence. Moreover, cost-plus contracts extend into research and development (R&D) scenarios, where larger companies outsource tasks to smaller firms for efficiency, including government applications in military defense procurement.
Types of Cost-Plus Contracts
Cost-plus contracts branch into four categories, each ensuring reimbursed costs atop an additional profit amount:
- Cost-Plus Award Fee Contracts: Allow contractors to earn extra for exemplary performance.
- Cost-Plus Fixed-Fee Contracts: Encompass both direct/indirect costs together with a fixed fee.
- Cost-Plus Incentive Fee Contracts: Bestow an incentive fee if contractor performance meets/exceeds targets.
- Cost-Plus Percent-of-Cost Contracts: Permit reimbursement to expand in correlation with rising contractor costs.
Advantages and Disadvantages of Using Cost-Plus Contracts
Exploring the benefits and setbacks equips stakeholders with insightful deliberation:
Pros
- Minimized risk for contractors.
- Enhanced focus on quality over total cost concerns.
- Comprehensive cost coverages precluding financial surprises.
Cons
- Variable, often indeterminate final costs.
- Potentially prolonged project timelines.
- Possible disputes in expense recoveries for construction costs.
- Necessity for supplementary resources to document and justify all costs.
Example of How a Cost-Plus Contract Works
Assume XYZ Construction Corp. takes a $20 million office building contract, with a ceiling of $22 million expenditure. Agreed profit is 15% of the $3 million total price. Additionally, XYZ could earn an incentive fee if they finish in nine months.
XYZ must submit detailed receipts for all their expenses. The project owner inspects the work for quality, verifying completed components like plumbing, electricals, fixtures, etc. XYZ incurs direct costs such as materials and labor and mid-contracts indirect costs—including insurance, and security—and bills overheads at $50 per labor-hour.
Special Consideration: Percentage of Completion in a Cost-Plus Contract
XYZ’s project uses a percentage of completion process for profit accounting and client billing. Assuming billing for 20% of the contract upon 20% material purchase and verification of the concrete foundation, XYZ invoiced 20% of the $20 million contract ($4 million), posting 20% profit, or $600,000, to financial statements.
Related Terms: fixed-cost contract, reimbursement, independent contractor, overhead costs, percentage of completion.
