Cost Plus Contract: What it Is and How it Works

A cost-plus contract is ideal when trying to accommodate client needs or working within specific industries. Think about this: Consider that you’re attempting to build something conceptual and abstract, but you only have a rudimentary understanding of how to proceed. You’ll want to hire an experienced contractor with this type of work and is familiar with the specific procedures to follow.

If this is your first time undertaking this project, you cannot be sure of the costs. If this is the case, you may wish to consider entering into a cost-plus contract. Let’s take a closer look at how these contracts work for construction and engineering projects:

What is a Cost-Plus Contract?

A cost-plus contract, also known as a cost-reimbursement contract, is a legally binding agreement where a client agrees to reimburse a contractor for project expenses and additional fees on top of a proportionate profit. They typically define cost-plus percentage or fixed-fee terms . A cost-plus contract also shifts the financial risk from the contractor to customers, who usually have lean budgets or may finish the project for less than initially thought.

This article also defines cost-plus contracts.

How Cost-Plus Contracts Work

A cost-plus contract provides considerable flexibility and support profitability. They are not, however, blank checks. The contractor must provide an up-front, detailed estimate of anticipated costs, and the customer must agree to the proposed terms.

Typical price fluctuations covered by these contracts include the cost of commodities, such as lumber and steel, that may see demand spikes. Expenses may also include overhead, such as the cost of research and development required to meet contractual obligations.

However, most cost-plus contracts do not cover estimating errors, mistakes, or costs incurred due to negligence. The customer may occasionally request a cap on total chargeable expenses. Finally, when a cost-plus contract lasts for extended periods, it typically includes interim payments to reimburse the contractor for intermittently incurred.

Advantages of a Cost-Plus Contract

Cost-plus contracts are popular with contractors, but they benefit customers just as much. Without taking risks, there are no high payoff rewards. However, you should always have a cost-plus contract in place for the correct type of project when taking one.

Advantages of a cost-plus contract include:

• Advantage 1 . Contractors have an incentive to complete the project professionally
• Advantage 2 . Buyers do not face typical project over-and-under bids
• Advantage 3 . Less expensive for clients due to predictability
• Advantage 4 . More assurance when taking on a less-defined project scope
• Advantage 5 . Contractors can make more profit from performance

However, there are drawbacks associated with cost-plus contracts, which means that you should consider your options carefully.

Cost-Plus Contract vs. Fixed Price Contract

Fixed-price contracts offer predictability since both the contractor and client understand all costs involved. However, they usually sell at a premium price since contractors add a percentage to mitigate their risks and cover unexpected expenses not included in the initial bid. Cost-plus contracts tie into profitability, incentivizing a contractor to take on projects that may have lower costs or smaller budgets.

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Types of Cost-Plus Contracts

Cost-plus contracts compensate the contractor for expenses and then add fees for the customer’s profit. As a result, the client bears the most risk, making this type of contract more or less desirable, depending upon the situation. They are more suitable in cases where there is no clear statement of work or other risks preventing the client from working at a fixed rate.

Below, we’ve outlined the five types of cost-plus contracts that you may want to consider:

Type 1. Cost-Plus-Percentage of Cost Contracts

Cost-plus percentage of cost (CPPC) contracts require the client to cover all contractor’s project costs, plus a profit margin. This type of contract is appropriate when transferring risk from the contractor to the client and for research & development and construction contracts .

Type 2. Cost-Plus-Fixed-Fee Contracts

Cost-plus-fixed-fee (CPFF) contracts are cost-reimbursement agreements in which contractors receive a fixed rate. Although fixed rates don’t vary with expenses, you can adjust them if the scope of work changes through a change order . This contract type also provides for otherwise risky activities for contractors to handle while still providing them with a compelling incentive to control costs.

Type 3. Cost -Plus-Fixed-Fee with Guaranteed Maximum Price Contracts

Cost-plus-fixed fee with guaranteed maximum price agreements are a hybrid of project reimbursement and lump-sum payments. The contractor receives reimbursement for costs incurred on an as-needed basis, which helps with cash flow. However, the contractor must limit these costs to the guaranteed maximum price (GMP) defined in the agreement.

Type 4. Cost Plus Award Fee (CPAF) Contracts

Cost-plus-award fee (CPAF) contracts are agreements where the contractor receives reimbursement for work completed plus compensation for exceptional performance. The contract’s particulars determine the fee amount and are typically non-negotiable. Contractors bear slightly more risk under the agreement since total profit hinges upon performance and unknown variables.

Type 5. Cost Plus Incentive Fee (CPIF) Contracts

Cost-plus incentive fee (CPIF) contracts permit negotiating initial fees based on the relationship between total allowable and target costs. The client reimburses the seller for actual expenses and then pays a predetermined fee for meeting established objectives. Among all the cost-reimbursable agreements, this one involves the most significant risk transfer for both parties.

Image via Pexels by Cleyder Duque

What’s Included in Cost-Plus Contracts?

A cost-plus contract works best when they are precise, and there is no such thing as too much detail when it comes to contract law . Additionally, the most well-written contracts detail how contractors should document expenses and resolve disagreements if they arise. This strategy can mitigate the chance of a misunderstanding or dispute in the future.

You should include the following terms in cost-plus contracts:

Term 1. Direct Costs

Direct costs include all materials, supplies, labor, equipment, rentals, consultants, and any other subcontractors. You can discuss your anticipated direct costs with clients, but ensure you estimate them accurately since the terms are usually non-negotiable. Upon signing, you must meet the terms and conditions of the contract.

Term 2. Overhead Costs

Overhead costs are the expenses incurred by a contractor to operate the administrative side of the business. Rent, insurance, communications, office supplies, salaries, licenses, legal fees, and travel expenses are all fall under this category.

Term 3. Profit

Profit is the compensation your business receives for completing the project. This compensation can be a flat fee or a rate that varies according to overall costs or specific incentives. In some cost-plus contracts, you could obtain additional revenues for completing the project faster than expected, as an example.

You can review an example of a cost-plus contract here .

Who Uses Cost-Plus Contracts?

You can use a cost-plus contract when facing constrained budgets or potential in final production costs. Cost-plus contracts are preferred when there is insufficient data to perform a detailed estimate of the work or when the design has not been completed. Construction agreements most often use cost-plus contracts, including renovation contracts and roofing contracts .

Additionally, government agencies prefer this method since they can choose a contractor based on their qualifications rather than the lowest bidder. Cost-plus is frequently used to perform research, development, and design-build contracts since the contracting party can control risk better.

Get Legal Help Today

Do you need a cost-plus contractor agreement? Speak with construction lawyers in your state today. We can help you develop the proper agreement for your needs.

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