Cost-Plus Contracts: Definition, Benefits And Challenges
Updated 11 October 2022
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When a professional or private client wants to engage a contractor to build or restore a building, they use a contract to set expectations and establish a budget for the project. The type of contract the client and contractor choose might affect how the contractor receives their payment and how the client handles unexpected costs. If you work in construction or project management, learning about different types of contracts for these types of projects can help you in your work.
In this article, we define cost-plus contracts, describe what these agreements contain, share some of their benefits and challenges and explain when you might use this type of contract.
What Is A Cost-Plus Contract?
A cost-plus contract is a type of agreement between a contractor and a client where the client promises to reimburse the contractor for certain expenses, along with the contractor's fee for completing the job. These agreements are common in the construction and renovation industries. Often, the contractor and client agree to stay within a general budget for the project, but the amount might change as the contractor completes the project. You can contrast this type of arrangement with a fixed-cost contract, where the contractor's materials, labour and other expenses are a part of the overall fee.
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Elements Of These Arrangements
This agreement usually cover three main types of costs:
Direct costs: These expenses include the purchases a contractor might make to complete the project, like building materials, subcontractor wages and fees for any consultants assigned to the project.
Indirect costs: Also called overhead costs, these are business costs the contractor might incur as they are completing the project, like fuel mileage.
Profit: The contractor's fee is the profit that the contractor makes for their work and expertise and might be a flat fee or a fixed percentage based on the direct and indirect costs.
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Types Of Cost-Plus Contracts
Here are some common types of this arrangement:
Fixed fee: In this model, the contractor receives reimbursement for all direct and indirect costs, plus a predetermined fee for completing the project.
Award fee: Contractors who use this model receive reimbursement for costs and get an award fee if they complete their project within budget and on time. If they are late or go over budget, they may receive a reduced amount.
Per cent-of-cost: In this model, contractors might gain additional pay if the project takes longer or is more expensive than expected, as long as the contractor can justify the extra time and cost. They usually earn their agreed-upon fee, plus an additional percentage of the cost.
Incentive fee: Under this type of agreement, a contractor can earn extra money if they follow the contract exactly. This incentive might also reward contractors who complete their work early.
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Benefits Of Using These Contracts
Here are some advantages to these agreements:
This model allows contractors to complete a project successfully, even if circumstances make it impossible for them to follow their original job estimate. While contractors try to be as accurate as possible when providing an estimate to a client, external factors can change their available labour and materials. Weather events and other emergencies can also delay work on a project and cause the contractor to fall behind schedule. Because this model allows more flexibility, it protects contractors from the risk of losing their pay due to factors outside of their control.
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More budget flexibility
Because this model allows clients and contractors to discuss individual charges, clients might not receive unexpected invoices for charges. Some models encourage contractors to stay within budget by offering awards or incentive payments. It also allows the client to adjust the budget over time, especially with longer projects.
For example, a school director might hire a contractor to build a new science wing with an endowment the school received from a donor. If the school receives a second large donation while the contractor is building the new science wing, the school director might decide to add to the contractor's project, which means more money for the contractor. Likewise, a client might ask the contractor to reduce the size of a project if their company decides to divert funding to another department.
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Allows contractors to use their expertise
Having a more flexible budget can allow an experienced contractor to make recommendations about services and materials to help their clients. Depending on the type of job it is, a contractor's clients might not have detailed knowledge about the most cost-efficient or long-lasting building materials. The contractor can suggest a course of action that they think might be effective for the building and allow the clients to decide whether to incur any extra costs.
For example, a contractor working on a new medical facility might recommend the clients use a different flooring material than planned because it is more durable. The project manager can discuss the option with the contractor and then make a decision about the extra cost. To recover some of the spent money, the contractor might suggest cost-saving paint options for the walls.
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Challenges Of Using These Contracts
Here are some potential disadvantages of using this type of arrangement:
Longer project lengths
The added flexibility of these contracts might mean that a contractor asks their client before making any purchase. As it might take time to discuss the different options for building materials and techniques, these projects might take a longer time to complete. Projects with multiple clients might take even longer to complete. For example, a contractor building a new hospital wing might send their recommendations to the project manager, who takes the recommendations to discuss with the hospital's administrative board before approving certain options.
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This model relies on the contractor purchasing materials and employing subcontractors with their funds before completing the project and billing the client. Contractors who use this method might have cash reserves from previous projects or use credit to make initial purchases. If a contractor does not have available reserves or credit, they may need a different type of contract.
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More administrative labour
Because this type of contract bills the client for reimbursement from separate transactions, the contractor and client might have additional administrative tasks to complete to ensure the project stays on budget. For example, a contractor might submit several forms for reimbursement or a single form that lists every purchase amount and date. The client's administration team might take several days to check the reimbursement request to ensure that the requests match purchase approvals on the relevant dates before submitting a reimbursement payment.
When To Use These Contracts?
Here are some situations where a contractor might use this type of agreement:
Project managers and contractors might use these documents in situations where the project manager has a restricted budget for a construction or renovation project. Because the contractors and project managers agree on each purchase, this model gives the project manager more control over the costs that contribute to the overall budget. For example, the contractor might show the project manager three flooring options for a renovation of a corporate building, with three separate prices. The project manager can choose the flooring material that fits their budget and preferences, and the contractor can install it.
When a contractor begins a job, the first step is to examine the project manager's plans and provide an estimate of the cost and length of the project. Sometimes, the project manager does not provide enough information for a comprehensive estimate because they need the contractor's expertise to help them finalise the project plan. This situation might benefit from a contract with more flexible budgeting, since the contractor might make suggestions that change the project's scope.
For example, a project manager for a government agency might hire a contractor who specialises in preserving historical buildings to renovate a city library. The contractor might recommend certain processes to protect the library's structure and materials, which may change the cost of the project. A flexible contract allows the contractor to discuss multiple options with the project manager before purchasing building materials or hiring subcontractors.
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This type of contract can be ideal for construction projects that have a long timeline or that contain several stages. Without a firm deadline, the contractor and client can work together to ensure the project's materials and techniques match the client's needs exactly. If the project manager is able to wait longer for the project to be completed, they can benefit from the added input and cost savings that this contract offers.
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