What is a Cost-Plus Contract
A cost-plus contract is an agreement typically used in the construction industry by a client to reimburse a company for building expenses stated in a contract, plus a dollar amount of profit over and above expenses, usually stated as a percentage of the contract’s full price. To protect against cost overruns, many contracts state the reimbursement cannot exceed a specific dollar amount. 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.
BREAKING DOWN Cost-Plus Contract
Cost-plus contracts are commonly used in research and development activities because it is difficult to determine in advance how much a job should cost. The U.S. government uses cost-plus contracts with military defense companies that develop new technologies for national defense.
How a Cost-Plus Contract Works
Assume ABC Construction has a contract to build a $20 million office building, and the agreement states that costs cannot exceed $22 million. ABC’s profit is 15 percent of the contract’s full price, at $3 million, and the construction firm is eligible for an incentive fee if the project is completed within nine months. ABC must submit receipts for all expenses, and the client will inspect the job site to verify that specific components are completed, such as plumbing, electrical, etc. The contract allows ABC to incur direct costs, such as materials and 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.
Examples of Contractor’s Insurance
ABC Construction purchases contractor’s insurance for work performed on the office building project. The insurance covers both damages and the risk of worker injuries while on the job site. Since the project requires millions of dollars in costs, the firm has liability for errors made during construction that must be corrected after a building inspection. ABC also has dozens of workers on the job site, and the company carries insurance to protect it in the event of an injury. While ABC requires all subcontractors to carry insurance coverage, it pays for its own policy to protect against any gaps in subcontractor coverage.
Factoring in Percentage of Completion Accounting
The 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 percent of the full contract price once 20 percent of the materials are purchased and the client verifies the concrete foundation is in place. At that point, ABC sends an invoice for 20 percent of the $20 million contract, at $4 million, and posts 20 percent of the firm’s profit, or $600,000, to the financial statements.