Cost-Plus Contract - Explained
What is a Cost-Plus Contract?
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What is a Cost-Plus Contract?
A cost-plus contract is a contract where a project owner agrees to cover the cost of all the project expenses from the beginning to the end. The expenses are labor and materials, including margin profits and overheads. The contractors labor charges are agreed upon before the project kicks off. The contract is common among construction companies. Another term for a cost-plus contract is a cost-reimbursement contract.
How Does a Cost-Plus Contract Work?
Generally, in a cost-plus contract, a construction company usually obtains all the materials and services it requires throughout the stages of construction, and the contractor forwards the costs to the owner of the project. The part of plus is basically the fixed fee that parties discuss and agrees on in advance, to cover margins for overhead and profits. So, this type of contract is a representation of a win-win deal on the part of the contractor because the owner of the project covers all the costs and risks. However, it is also important to note that most cost-plus contracts contain a maximum cost that contractors should not surpass. They are in the form of open books, where the owner of the project is free to see how the expenses look like. This type of contract differs from a fixed-price contract. With a fixed-price contract, the owner of the project pays the contractor the agreed amount only. It does not consider any other extra incurred expenses. The main function of a cost-plus contract is to ensure that contractors do not experience cost overruns, especially in situations where defining costs ahead of time is difficult. A good example is a cost for development activities and research.
Why use Cost-Plus Contracts?
The United States government usually use cost-plus contracts when they want to contract the military defense contractors to work on new technologies for United States defense. They prefer this type of contract because it enables them to choose contractors with the best qualifications rather than ending up with contractors with the lowest bids but with poor qualifications. The award-fee cost-plus contract is also preferred because it ensures project quality. It holds contractors accountable for the quality of work they produce. On the other hand, a cost-plus contract, such as incentive-fee contract, provides contractors with larger profits, especially those who exceed given performance targets. Generally, although cost-plus contracts are developed to prevent things such as overruns, there has been criticism that some types of cost-plus contracts such as cost-plus fixed fees contracts do not prevent overruns.
Types of Cost-Plus Contract
There are four types of cost-plus contracts, and all of them pay every allocable, allowable, and reasonable cost that contractors incur. Also paid is any other profits or fee, although this one varies depending on the type of contract. The four types of cost-plus contracts include the following:
- Cost-plus fixed-fee: Here, the contractor is only paid a predetermined fee as per the parties' as initially stipulated in the contract.
- Cost-plus incentive fee: This includes a larger fee awarded mostly to contractors who exceed performance targets, including project savings.
- Cost-plus award fee: Here, the work performance determines the fees the contractor gets. For some contracts, payment objective performance determines the contractor's fees.
- Cost-plus percentage of cost: This is a fee that comes up when the cost of the contractor goes up. Note that this type of contract does not provide the contractor with an incentive to control the project costs. So, in most cases, contractors incur extra expenses that force them to increase their charges.
When to Use Cost-Plus Contract
A cost-plus contract can be of use when there is a need for flexibility to make some changes in the course of project implementation. So, for those individuals or companies that operate on a tight budget, a lump-sum price can be a better option for them. The reason is that you cannot avoid the ultimate cost of a project with cost-plus pricing. Also, cost-plus contracts can be useful in situations where parties find it difficult to assess the projects overall cost but operating on a flexible budget. In this case, it is wise to use a cost-plus contract as long as there is mutual trust between the owners of the project and the contractor. Also, this type of contract can work well if the parties come up with a meticulous record-keeping, including a well-defined and executed contract. A good example where a cost-plus contract may be useful is when there is a project that needs implementation, but enough details are not there to help do detailed work cost estimates.
Advantages of Using a Cost-Plus Contract
A cost-plus contract has the following benefits:
- It is budget-friendly, especially for contractors. For instance, they can easily decide which materials to use without worrying about their costs. The reason is that there is no time when the costs incurred on the project will be charged on the contractors paycheck. With a cost-plus contract, the owners of the project cover all project costs, including any other additional costs that may come up.
- Since putting together estimates for some projects may prove to be difficult, a cost-plus contract can help in reimbursing costs as project implementation progresses. Contractors are not worried about flawed estimate ruining project implementation as cost-plus contracts always accommodate extra costs they may incur to complete the project.
- With a cost-plus contract, it is easy to cap or limit the number of money contractors spend on a project. This can help the owner of the project or property to work with a tight budget.
Disadvantages of Using a Cost-plus Contract
There are various disadvantages that arise when an individual or property owner fails to cap the cost-plus contract. Some of these disadvantages are as follows:
- A contractor always has to justify the project's expenses. For this reason, the contractor must work hard to keep track and expenses. So, those contractors who are disorganized are likely to encounter a lot of problems.
- There is a problem when it comes to indirect cost accountability. Contractors incur costs related to administrative and rent. To be sincere, these are not expenses contractors will be okay with. So, contractors need to be keen and ensure that they also cater for indirect costs.
- Since the cost-plus contract operates through reimbursement, it means that contractors have to use their money to pay for whatever expenses they incur. So, since those in the construction industry have a cash flow problem most of the time, cost-plus contracts can cause hitches in project implementation if they don't take appropriate measures.
- Profits for those using this kind of contract are pre-determined. Contractors enter a contract aware of how much profit they will get. The contract has all the details, including the contractor's fees. So, it is impossible for contractors to make extra profits by cutting expenses as the money will already be reflected and reimbursable. Cutting costs will instead bring down their profits.
- Cost-plus contracts are likely to create room for conflict of interest when it comes to contractors leading to inflated prices for the property owners. Note that the cost-plus works in a way that when the project has many costs, it creates additional expenses.
It is because the contractor will definitely increase his charges, which the owner of the project must pay. So, unless the cap is put on spending as an incentive, project owners should be ready to spend more on their projects.
How to Protect your Business
Generally, a cost-plus contract enables contractors to recover costs related to the project they are handling. However, if there is no good record keeping to help them keep track of those costs, there is a likelihood that they wont be able to recover them. The following tips can help contractors to avoid such problem:
- Contractors should learn how to negotiate critical items that are likely to cause disputes
- Contractors should ensure that they control the use of material during project implementation. In most cases, a cost-plus contract leads to material misuse, an act that may force a contractor to acquire unexpected additional material.
- Contractors should avoid exploiting the project owner. They need to be honest in their dealings but also ensure that they do not experience cost exploitation
- Finally, contractors should learn how to control both soft and hard costs
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