cost plus contract

The Ins and Outs of Cost Plus Contracts

A cost plus contract, also known as a cost reimbursement contract, is a common type of agreement used in construction and government contracting. As the name suggests, this type of contract guarantees that the contractor will be reimbursed for all allowable costs related to the project, plus an additional predetermined fee to cover overhead and profit.
While cost plus contracts offer some advantages, they also come with downsides that need to be considered carefully before entering into such an agreement. This article provides an in-depth look at how cost plus contracts work, their pros and cons, and best practices for making them successful.

How Do Cost Plus Contracts Work?

The basic framework of a cost plus contract is straightforward:

• The contractor agrees to take on all costs related to labor, materials, equipment, subcontractors, and other direct expenses needed to complete the project
• The customer (usually a government agency or private company) agrees to reimburse the contractor for all allowable costs
• On top of the reimbursement, the customer also pays an additional predetermined amount as a fee to the contractor, which is intended to cover overhead and profit

This type of agreement shifts much of the financial risk from the contractor to the customer. Since all costs are covered, the contractor has less incentive to control costs and maximize efficiency. The contractor’s profit is locked in regardless of actual costs, unless costs exceed a negotiated ceiling price.
The predetermined fee paid to the contractor is typically calculated as a percentage of estimated costs. Common fee percentages range from 5-15%, depending on the size, complexity, and risk level of the project.

Pros of Cost Plus Contracts

There are several potential advantages to using a cost plus contract:

Flexibility for Changing Requirements

Cost plus contracts allow greater flexibility to change project specifications, timelines, and deliverables while work is underway. With a firm fixed price agreement, such changes would require renegotiating the entire contract. But with reimbursable costs, changes can be made without resetting all terms.

Full Visibility into Spending

All project expenditures are fully visible to the customer under a cost plus contract. This transparency allows for better cost monitoring and control if desired. Fixed price contracts lack this level of openness.

Appropriate for High-Risk Work

When projects have a high degree of uncertainty or risk, cost plus agreements shift much of that risk onto the customer. This makes sense for complex initiatives like research & development where unknowns make it difficult to accurately estimate a fixed total cost.

Incentive for Quality

Since profit is locked in, cost plus contractors focus less on cutting corners to reduce expenses. Their incentive is directed more towards quality workmanship that will please the customer and secure additional business.

Cons of Cost Plus Contracts

Despite the advantages, cost plus contracts also come with downsides to consider:

Limited Cost Control Incentives

Because the customer shoulders much of the financial risk, the contractor lacks strong profit incentives to control costs. Without a focus on efficiency, projects can end up costing significantly more than a fixed price contract.

Vulnerability to Inflated Costs

The reduced emphasis on cost control also makes cost plus contracts potentially vulnerable to inflated expenses. Contractors may feel greater freedom to run up costs that they pass along to customers.

Higher Administrative Burden

The detailed cost documentation and open book accounting required under cost plus contracts creates additional administrative work for both contractors and customers. There’s much less paperwork with fixed price agreements.

Difficulty Setting Reasonable Fees

It can be tricky initially defining a reasonable fee percentage that gives contractors adequate profit while also being fair to customers. Poorly calibrated fees lead to lopsided contracts.

Best Practices for Cost Plus Contracts

If you move forward with a cost plus agreement, the following tips can help manage the cons while maximizing the pros:

Conduct Thorough Due Diligence on the Contractor

Carefully vet candidate firms on their track record controlling costs and delivering quality work on schedule. Focus extra attention checking client references.

Build a Foundation of Trust

Cost plus contracts function best when the customer and contractor have a strong relationship built on trust and transparency. Invest time upfront establishing shared goals and accountability.

Define Allowable Costs Clearly

Provide clear guidelines on what constitutes reasonable and allowable expenses. Set limits on certain cost categories like labor, travel, entertainment, etc.

Implement Cost Monitoring Controls

Put cost oversight mechanisms in place like requiring preapprovals for major purchases or added subcontractors. Conduct periodic cost reviews.

Incentivize Savings

Offer to split a portion of any cost savings with the contractor as an incentive for efficiency. This also guards against inflated expenses.

Set Time & Materials Ceilings

For extra protection, establish not-to-exceed limits on total reimbursable expenses over the life of the contract.
Overall, cost plus contracts can provide needed flexibility on projects with unclear specifications or high uncertainty. They shift risk onto customers, while incentivizing quality work from contractors. However, the model can falter without diligent cost control and oversight. By following best practices and basing agreements on trust and transparency, customers and contractors can harness the power of cost plus collaborations successfully.