Contracts may not be your business, but your business depends on contracts. Getting all parties on the same page can protect your company and its bottom line, but not every type of contract is right for every business.
One contract type gaining in popularity — especially in construction — is a cost-plus format. In fact, today, cost-plus contracts are used in everything from highway construction projects to aerospace rocket development. Here’s why they could be right for your business, too.
What Is a Cost-Plus Contract?
A cost-plus contract is one in which the contractor is paid for all of a project’s expenses plus an additional fee for the job. The additional fee is intended to be the contractor’s profit. Also known as cost-reimbursement contracts, these arrangements contrast with fixed-price contracts, in which the contractor is paid a single set fee for a project, regardless of total expenses.
Cost-plus contracts shift some of the risk from contractors to customers, who may have to pay more to cover increased expenses.
Cost Plus vs Fixed Price
As the name implies, a fixed-price contract sets a lump sum cost for a project, regardless of whether expenses and materials go up or down. In a fixed-price deal, the contractor must carefully calculate how much to charge to ensure a jump in material costs doesn’t wipe out profits.
Buyers may prefer a fixed-price arrangement over cost plus because the former provides certainty on what they will be charged for a project. Contractors should ensure they carefully track and itemize materials and overhead.
- Cost-plus reduces a contractor’s risk by separating profit from a project’s direct and indirect expenses. But customers lack certainty on the final bill.
- Contract variations may factor in incentives for work completed ahead of schedule or exceeding original specifications, or stipulate fee increases if project costs increase.
- Cost-plus contracts require careful accounting and tracking, and customers may insist on a cost-cap clause.
Cost-Plus Contracts Explained
Cost-plus contracts, where a contractor bills for a project’s direct and indirect expenses plus an additional fee, allow for considerable flexibility and ensure a profit. However, they’re not blank checks. The contractor must produce a detailed estimate of expected costs upfront, and the buyer must agree to a set of recognized expense increases that may be incurred.
Typical price fluctuations covered in such contracts include the cost of commodities, such as lumber and copper, that may experience spikes in demand. Expenses may also include overhead, like research and development costs necessary to meet contractual goals.
However, estimating errors, mistakes and costs incurred due to negligence are not covered in most cost-plus contracts. In some cases, the customer may request a cap on total chargeable expenses. Finally, when a cost-plus contract is expected to last for many months or years, it usually provides for interim payments to reimburse the contractor’s expenses along the way.
What Is Included in a Cost-Plus Contract?
No matter the specifics of a project, a cost-plus contract typically breaks down costs into three categories.
These are the more obvious costs that relate to the specific job in the contract. Known as the cost of goods sold (COGS) in other contexts, examples of direct costs include labor for the project, raw materials required to complete the project, equipment purchased or rented for the job and fees for outside specialists like engineers or consultants.
Indirect costs/overhead costs
Also known as overhead costs, indirect costs are the myriad expense categories associated with running a business. Such costs include administrative expenses, like office leases, insurance fees, licensing, transportation expenses and utilities. A percentage of the contractor’s overall overhead is usually included in a cost-plus contract, with the amount depending on the size and timespan of the project.
The amount your company will earn for completing the project. This can be a fixed fee or vary depending on overall costs or particular incentives — for example, a bonus for finishing on time or early.
Cost-Plus Contract Variations
Cost-plus contracts come in a variety of formulations, depending on the type of business and the products or services to be delivered.
Cost-plus fixed fee (CPFF): This is the most basic type of cost-plus contract. In this version, the buyer simply pays a flat fee on top of the actual costs incurred to meet the contractual obligations.
Cost-plus incentive fee (CPIF): As the name implies, these contracts include a higher fee whenever the contractor meets or exceeds performance targets stipulated in the contract. Those targets typically involve completion dates but may also reward other results, most notably additional cost savings.
Cost-plus a percentage of cost (CPPC): In these contracts, the contractor’s fee is a percentage of the overall costs incurred. So as costs escalate, so does the contractor’s fee. While such an arrangement may protect the contractor in case of, say, rising labor or research costs incurred to meet a deadline, most large companies and government agencies are averse to such contracts because there is little incentive for the contractor to keep costs from rising.
Cost-plus award fee (CPAF): These contracts pay an additional fee based on work performance. In delivering a product, for example, additional fees may be earned if the item is more durable, energy efficient or faster than the original specifications set forth.
Cost-plus fixed rate: Rarely used, and only by contractors who really know their costs and labor rates, this type of cost-plus contract establishes labor rates up front. Neither party gets much flexibility.
Cost-Plus Contract Example
While cost-plus contracts are used in industries ranging from biotech to military defense, the construction business offers the most prevalent examples of how such contracts work.
In a typical case, a company we’ll call Apex Construction agrees to build an office complex that has an estimated cost of $15 million. As part of the cost-plus contract, Apex agrees that the total cost will not exceed $17 million.
In other words, the total anticipated costs are capped at $17 million to protect the buyer.
Apex Construction also agrees to receive a fee of $2.25 million, no matter what the final costs amount to. The fee in this example is roughly 15% of the cost of the project, although fees that equal 20% are not uncommon. This particular project will cost the buyer at least $17.25 million — the total cost estimate plus the fee to the contractor. Apex and the client also agree to an incentive fee of an additional $1 million if the building is completed 30 or more days early and the total cost does not exceed $15 million.
To satisfy elements of the contact, Apex tracks all resources used and, at set intervals, turns in receipts and documentation for its expenses. Apex must meet interim targets that can be confirmed by a client or a consultant inspection. So that Apex can continue to fund its business operations during the period of construction, it submits bills at agreed-on junctures, when 25%, 50% and 75% of the building is complete. Those midterm bills include not only billable expenditures but also a percentage of the expected profit.
When to Use a Cost-Plus Contract
Cost-plus contracts are particularly useful when it’s not possible to predict the final expenses of a long-term project or when there isn’t enough information to create a detailed estimate of expenses because the final designs have not been completed.
A cost-plus contract also allows a buyer to quickly initiate a project without exposing the contractor to excessive risk.
Pros and Cons of a Cost-Plus Contract
The yin-yang of cost-plus contracts is transparency. Buyer and seller both know — and agree to — all the costs and the profit involved. That shifts many of the risks inherent in any such deal and, depending on the contract’s specifics, may limit benefits.
Additional pros and cons also spread risk and reward.
Cost-plus contract benefits
Upsides of cost-plus contracts include:
- Less risk to contractors of having to absorb unanticipated costs due to price inflation.
- The best materials can be used to meet project goals.
- Emphasizes quality of work and meeting performance goals rather than cost-cutting.
- Tends to balance the responsibility to manage costs equally between the contractor and the buyer.
Cost-plus contract disadvantages
However, these contracts do have cons, including:
- The final cost of the project is not fixed.
- Without regular monitoring, costs can quickly escalate for the buyer.
- Requires more sophisticated management and tracking of all related resources and expenses.
Protecting Your Business
Cost-plus contracts have obvious advantages for industries like construction where direct costs comprise a large part of the work, but where such costs are out of the contractor’s control and may be subject to rapid fluctuations in supply and demand. However, to ensure that a cost-plus contract truly protects their business, contractors must keep careful records and have a good accounting system in place. Otherwise, they may not be able to recover all expenses.
Record-keeping needs to be done in real time to reduce administrative costs, allow for constant tracking of costs, minimize lost documentation or forgotten items and control the usage of materials and commodities — and to be able to deliver a timely, comprehensive report to the client to meet contractual obligations.
History of Cost-Plus Contracts
The concept of a "cost-plus-a-fixed sum" contract was first published by Frank B. Gilbreth in a 1907 article in Industrial Magazine. Gilbreth said he used such contracts in his construction business. Gilbreth is best known today as an efficiency expert and the father in “Cheaper by the Dozen,” the 1948 semi-autobiographical novel he and his wife co-authored that has been made into several movies.
Cost-plus contracts came into more widespread use in the U.S. market during the First and Second World Wars. These agreements were employed to encourage rapid production to meet military demands. However, cost-plus contracts also boosted new technology companies, such as Hewlett-Packard, which were able to bill charges for research and development to the Department of Defense and thus create products that may not have been viable otherwise.
Trends in Cost-Plus Contracts
Cost-plus fixed fee contracts continued to dominate the defense sector through the late 1990s. By the early 2000s, however, cost-plus award fee contracts became the favored instrument in defense contracts.
Cost-plus contracts as a whole were used extensively in research-heavy businesses, followed by service-oriented and then product-oriented businesses. In the early 2000s, however, cost-plus contracts began to be used by more companies in the services arena. This also reflects their current popularity in the construction and building sector.
Managing Cost-Plus Contracts With NetSuite
To ensure the success of a cost-plus contract, contractors must be able to account for the whole project, from initiation to completion, without incurring additional overhead. It’s essential to be able to do this not only for the business itself but also to be able to show and justify costs to buyers and clients.
To make the task as easy as possible, cloud-based automated financial management systems such as NetSuite’s can track resources, inventory, billing and other parts of a job without additional administration. Automating expense tracking and record keeping also helps keep costs in line. Access from the cloud becomes important when employees need to update resource tracking and accounting for expenses from the front seat of a truck, or a subcontractor needs to report completion of work immediately from a job site.
NetSuite’s unified Accounts Receivable (AR) billing platform supports a variety of contract types and pricing models, including cost-plus contracts.
Ultimately, cost-plus contracts can work for a wide variety of projects, particularly in construction. In uncertain business environments, these contracts can offer not only transparency to the buyer but also better protections for the contractor. But to obtain those protections, businesses must be diligent in monitoring costs. Deploying the right tools is the first step.
Cost-Plus Contract FAQs
A: In a cost-plus contract, the buyer and seller agree on a set of expenses that will be reimbursed for a project, as well as a —usually fixed — fee on top of those costs. The fee represents the contractor’s profit.
A: Advantages offered by cost-plus contracts include protection against price inflation for the contractor and the ability to cover unanticipated outside consulting and engineering fees. These contracts also share the responsibility of cost management between contractor and buyer.
A: One disadvantage of a cost-plus contract is that the customer lacks certainty on the final cost. Contractors with systems to do sophisticated management and tracking of all overhead and expenses can ease concerns by providing complete, timely documentation.
A: As an example, a cost-plus contract may establish that the total estimated cost of a building project is $10 million plus a fixed fee of $1.5 million, roughly 15% of the total cost, as the contractor’s profit. So the total expense to the buyer would be approximately $11.5 million —the cost plus the fee. The contracts may include a cap on total expenses, such as not exceeding $12 million, and incentive fees for meeting early completion dates.