Cost-Plus Contract: Definition, Types, and Example

Cost plus contract work–plus contracts offer a unique approach to project management where contractors are reimbursed for their expenses plus an additional profit margin. This type of contract benefits projects with undefined or evolving scopes, allowing for flexibility and adaptability. The cost-plus model covers both direct and indirect costs, and its variations include fixed fees, incentive fees, and percentage-based profit margins.

While cost-plus contract can foster high-quality work and transparency, they also come with challenges like budget uncertainty and administrative complexity. Understanding these contracts helps stakeholders make informed decisions and manage projects effectively.

 

What Is a Cost-Plus Contract?

A cost-plus contract is an agreement where a contractor is reimbursed for all construction-related expenses plus an additional payment for profit. These are a type of cost reimbursement contracts, which cover direct costs like labour, materials, and equipment and include indirect costs such as other overhead costs.

The “plus” part refers to the contractor’s profit, a fixed fee or a percentage of the total costs. Cost-plus contract provide flexibility, making them suitable for projects with uncertain scopes or variable costs. However, they require detailed record-keeping and can lead to higher costs if not managed properly.

 

What Is Included in a Cost-Plus Contract?

A cost-plus contract includes several key components to ensure that both the contractor and the owner are clear on the terms and scope of the total project together. Typically, the contract breaks down into three main categories:

Direct Costs: These are the immediate expenses directly related to the project. They include labour costs, materials, equipment purchases or rentals, and fees for any external specialists or consultants needed for the project. It is crucial to provide an estimated cost for these direct expenses to help in project planning and budgeting.

Indirect Costs (Overhead): These costs are associated with the overall business operations that support the project but are not directly tied to it. This can include administrative expenses, office leases, insurance, licensing, utilities, and transportation expenses.

Contractor’s Fee: This fee represents the contractor’s profit and can be calculated as a percentage of the project’s total costs or as a fixed amount. The fee compensates the contractor for their time and effort and ensures they are incentivised to complete the project efficiently.

 

Cost-Plus Contract Variations

It comes in various forms, each with distinct features tailored to different project needs:

Cost-Plus Fixed-Fee (CPFF) Contracts:

The contractor is reimbursed for all allowable expenses and receives an additional flat fee for profit. This fee does not change regardless of project costs, providing a predictable profit margin.

Cost-Plus Incentive Fees (CPIF) Contracts:

Besides reimbursement for costs, the contractor earns an incentive fees based on performance metrics such as cost efficiency or schedule adherence. This aims to encourage better performance and cost savings.

Cost-Plus Award Fee (CPAF) Contracts:

Similar to CPIF, these contracts include an award fees for excellent performance determined subjectively by the client. This fee incentivises high-quality work and adherence to project objectives.

Cost-Plus Percentage of Cost (CPPC) Contracts:

The contractor is reimbursed for costs and receives a profit based on a percentage of those costs. This type can sometimes lead to higher project costs, as the contractor’s profit increases with expenses.

 

Types of Cost-Plus Contract

Fixed Fee: The contractor is reimbursed for all direct and indirect project costs plus a predetermined fee in this arrangement. This fee is fixed and agreed upon at the beginning of the contract, providing a stable profit margin regardless of the project’s actual costs.

Award Fee: Contractors are reimbursed for their costs and can earn an additional award fees based on their performance. This award fees is contingent upon completing the project within budget and on time. If the contractor exceeds the budget or deadline, the award fees may be reduced accordingly.

Percentage of Cost: In this model, contractors receive their agreed-upon fee plus a percentage of the project’s cost. If the project becomes more expensive, this can result in higher earnings for the contractor, provided they can justify the increased costs and time. This model incentivises contractors to manage project costs effectively.

Incentive Fee: This type of agreement allows contractors to earn extra money by meeting or exceeding specific performance criteria outlined in the contract. Contractors can receive additional compensation for completing the work early or adhering strictly to the contract terms, thus encouraging efficiency and high-quality performance.​

 

Advantages and Disadvantages of Using Cost-Plus Contract

Advantages of Using Cost-Plus Contract

1. Flexibility:
   • Scope Changes: Cost-plus contract are ideal when the project scope needs to be clearly defined or is expected to change. They accommodate modifications and adjustments without the need for contract amendments.
2. Transparency:
   • Cost Visibility: Clients have visibility into the actual costs incurred by the contractor, as they are reimbursed for all allowable expenses plus an agreed-upon fee. This transparency helps build trust between parties.
3. Risk Management:
   • Shared Risk: The risk of cost overruns is shared between the client and the contractor. The contractor is reimbursed for actual costs, reducing the pressure to cut corners to stay within a fixed budget.
4. Quality Assurance:
   • Focus on Quality: Since the contractor is reimbursed for actual costs plus a fee, there is less incentive to compromise on quality to reduce costs. This can result in higher-quality work and materials.
5. Encourages Innovation:
   • Open-Ended Solutions: Contractors are incentivised to explore innovative solutions and efficient methods, as they are compensated for their actual expenses rather than being constrained by a fixed budget.

 

Disadvantages of Using Cost-Plus Contracts

Budget Uncertainty:

• Cost Overruns: Without a fixed cost limit, the final project cost can be significantly higher than anticipated. This can lead to budgetary surprises and financial strain for the client. Additionally, the final cost may be higher than initially estimated due to the nature of cost-plus contracts, where the total expense includes the cost plus the fee.

Limited Cost Control:

• Monitoring Costs: Clients must closely monitor and audit expenses to ensure they are reasonable and necessary. This can be resource-intensive and require additional administrative oversight.

Potential for Disputes:

• Expense Disputes: Disagreements may arise over what constitutes allowable expenses, leading to disputes between the client and contractor. Clear definitions and documentation are essential to mitigate this risk.

Less Incentive for Efficiency:

• Cost Management: Contractors may need more motivation to control costs efficiently, as their compensation is based on expenses incurred. This can potentially lead to inefficiencies and higher overall costs.

Complex Administration:

• Record-Keeping: Cost-plus contracts require detailed record-keeping and documentation of all expenses, which can increase the administrative burden and complexity for both parties involved.

 

Example of How a Cost-Plus Contract Works

A cost-plus contract is an agreement where the contractor is reimbursed for all project costs plus an additional fee or profit margin. Here’s a detailed example of this contract type how it works:

Agreement and Contract Terms: A property developer (client) wants to construct a new commercial building, but the scope still needs to be fully defined due to potential design changes. They agree to use a cost-plus contract with a construction company (contractor). The contractor will be reimbursed for all costs and a 15% profit margin.

Cost Estimation: The contractor provides an initial estimate based on preliminary plans, forecasting that the project will cost around $1,500,000. The estimated profit margin would be $225,000 (15% of $1,500,000).

Project Execution: As construction progresses, unforeseen conditions and design changes require additional labour and materials. The contractor keeps detailed records of all expenses.

Invoice Submission: Upon project completion, the contractor submits a comprehensive report detailing all actual costs, which total $1,750,000.

Payment: The contractor invoices the client for the actual costs plus the agreed profit margin. The total invoice is $2,012,500 ($1,750,000 + $262,500).

Client Review and Payment: The client reviews the detailed report and finds the expenses reasonable, proceeding to pay the contractor.

 

Benefits Of Using Cost-PlusContracts

Using cost-plus contracts offers several benefits for both owners and contractors. Here are some key advantages:

Flexibility in Scope: Cost-plus contracts are ideal for projects without a defined scope. This flexibility allows for adjustments as the project progresses without renegotiating terms.

Quality Assurance: Contractors are reimbursed for actual costs and typically receive a fee for their work. This arrangement encourages using high-quality materials and skilled labour without the pressure to cut corners and stay within a fixed budget​​.

Reduced Risk of Overbidding: Since contractors are reimbursed for actual costs, there’s less likelihood of overbidding to cover unexpected expenses. This can result in more competitive bids and potentially lower overall costs for the owner.

Encourages Transparency: Cost-plus contracts require detailed documentation and tracking of expenses, promoting transparency between the contractor and the owner. This helps build trust and ensures that the owner only pays for the costs.

Incentive for Performance: Some variations of cost-plus contracts, such as cost-plus incentive fee contracts, include performance-based incentives. This motivates contractors to complete the project efficiently and on time, potentially earning additional rewards​.

Adaptability to Changes: These contracts are beneficial in projects with high uncertainty or complexity. They allow for changes and unforeseen challenges to be managed without significant financial penalties or project delays.​

 

Challenges Of Using Cost-Plus Contracts

Using cost-plus contracts can present several challenges such costs:

Lack of Cost Control: Since the client agrees to cover all costs plus an additional fee, the contractor can have less incentive to control costs. This might lead to higher overall project expenses than initially estimated​​.

Administrative Burden: These contracts require meticulous tracking and documentation of all expenses. This can result in increased administrative work for the contractor and the client, potentially slowing the project​.

Disputes Over Costs: The transparency required in documenting costs can lead to disputes between the client and contractor over what expenses are allowable under the contract. This can create friction and delays​​.

Risk of Overpayment: Clients may pay significantly more than expected if the project scope changes or unforeseen issues arise. This can be particularly challenging if the initial budget is tight​​.

Complexity and Legal Compliance: Ensuring that cost-plus contracts comply with legal standards, such as those in specific states like California, can be complicated and time-consuming. Non-compliance can lead to severe penalties.

 

When To Use Cost-Plus Contracts?

Cost-plus contracts are particularly suitable for projects with uncertain or evolving scopes, such as large-scale construction projects or research and development activities. They are beneficial when it’s challenging to estimate the full extent total cost of the work required at the project’s outset.

When to Use Cost-Plus Contracts:

Uncertain Project Scope: Cost-plus contracts are ideal when the project scope cannot be precisely defined. This flexibility allows the project to adapt to changes without renegotiating the contract terms.

High-Quality Requirements: When high-quality materials or specialised labour are essential, cost-plus contracts enable premium resources without the contractor worrying about cost overruns.

Client-Contractor Trust: These contracts work well in scenarios with high trust between the client and contractor. The transparency required in cost-plus contracts fosters a collaborative environment.

Time-Sensitive Projects: For projects that need to start quickly, cost-plus contracts allow work to begin before the entire scope is finalised, expediting the project timeline.

Research and Development: In R&D projects, where outcomes and processes are uncertain, cost-plus contracts provide the flexibility to explore various approaches without financial constraints.

Cost-plus contract template

A cost-plus contract template outlines the reimbursement process for a contractor’s expenses plus a specified profit margin. It typically includes sections for defining direct costs, indirect costs, and the contractor’s fee. This template ensures clarity in financial arrangements and helps manage flexible project scopes effectively.

 

Other contract types compared.

Cost-plus contracts are valuable in various situations, but they’re not the only type of construction contract available. A fixed price contract sets a predetermined cost for a project regardless of fluctuations in expenses and materials, providing certainty for buyers and requiring careful cost calculations by the contractor. Fixed price contracts involve predetermined pricing based on estimated costs, while cost-plus contracts allow for flexibility in covering actual expenses. Other contracts may be more suitable depending on the construction project’s specifics and the owner’s approach.

Types of Construction Contracts:

Lump Sum Contracts:

Description: These contracts specify a fixed service fee at the project’s onset.

Advantages: They provide a predictable budget for project owners and can simplify the payment process.

Best Used When: The project scope is well-defined, and changes are unlikely to occur.

Guaranteed Maximum Price (GMP) Contracts:

Description: These contracts set an upper limit on the project owner’s costs. If costs exceed this limit, the construction manager at risk (CMAR) absorbs the additional expenses.

Advantages: GMP contracts reduce financial risk for the project owner.

Best Used When: The project owner wants to limit financial exposure while allowing some flexibility in scope.

Time and Materials (T&M) Contracts:

Description: These contracts establish a fee for labour and material costs, including the contractor’s overhead and profit.

Advantages: They offer flexibility in accommodating project changes and unforeseen circumstances.

Best Used When: The project scope is uncertain, and estimating costs upfront is challenging.

Unit Price Contracts:

Description: These contracts bill for repeatable work units, such as framing residential homes with a set pattern.

Advantages: They provide clarity and structure for projects with repetitive tasks.

Best Used When: The project involves repeated units of work that can be easily quantified.

 

Managing Cost-Plus Contracts With Powerplay

Construction management Software like Powerplay can be invaluable for managing cost-plus contracts effectively. It offers comprehensive features like detailed cost tracking, real-time budget monitoring, and robust financial management tools. These features help contractors and project owners monitor expenses, manage changes efficiently, and ensure that the total project cost stays within budget while maintaining high-quality standards​.

So, for better and seamless management of all your construction projects, request a free demo or download Powerplay now to manage your construction project more efficiently and your administrative costs more effectively.