What Is a Cost-Plus Contract?
A cost-plus contract is an agreement to reimburse a company for expenses plus a specific amount of profit, usually stated as a percentage of the contract’s full price. Cost-plus contracts are also referred to in the business world as cost-reimbursement contracts.
These contracts are in contrast to fixed-cost contracts in which two parties agree to a specific cost regardless of the expenses incurred by the contractor.
Cost-plus contracts are primarily used to allow the buyer to assume the risk of the success of the contract from the contractor. So the party drawing up the contractor assumes that the contractor will deliver on his or her promises, and promises to pay extra so the contractor can make a profit.
Understanding Cost-Plus Contracts
Cost-plus contracts are drawn up so contractors can be reimbursed for almost every expense incurred on a project. The cost-plus contract pays the builder for both direct costs and indirect or overhead costs. All expenses must be supported by documentation of the contractor’s spending.
Some contracts may limit the amount of reimbursement, so not every expense may 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.
The contract also allows the contractor to collect a certain amount above the reimbursed amount, so he or she may be able to make a profit—hence, the "plus" in cost-plus contracts.
Cost-plus contracts are generally used for several reasons. They may be used if the party drawing up the contract has budgetary restrictions or if the overall scope of the work can't be estimated.
Cost-plus contracts are commonly used in research and development (R&D) activities. They are common in the construction industry to reimburse contractors for building expenses. 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 different categories. They all 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 his or her performance meets or exceeds expectations.
- Cost-plus percent-of-cost contracts allow the amount of reimbursement to rise if the contractor's costs rise.
- In a cost-plus contract, a party agrees to reimburse a contractor for expenses plus a specific amount of profit, usually stated as a percentage of the contract’s full price.
- Cost-plus contracts are primarily used to allow the buyer to assume the risk of the success of the contract from the contractor.
- Contractors must provide proof of expenses, including direct and indirect costs.
Advantages and Disadvantages of Using Cost-Plus Contracts
The pros of using these types of contracts include the following:
- They eliminate the risk for the contractor.
- They allowing the focus to shift from the overall cost to the on the quality of work being done.
- They cover all the expenses related to the project, so there are no surprises.
On the downside, these contracts may also do the following:
- 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.
Example of 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% 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, 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 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.