What is a Cost Plus Contract?
Cost plus contracts, sometimes known as cost-reimbursable contracts or cost-plus incentives contracts, are agreements where the contractor is reimbursed for all of their construction-related expenses, plus a percentage or fixed fee of profit that provides an incentive whenever the allowable costs are lower than the agreed-upon budget.
As compared to lump sum contracts, cost-plus contracts give contractors a lot of flexibility to address issues that come up without having to worry about exceeding the scope of work approved by the owner. Instead of a potentially expensive change order (forcing contractors to charge more) and extensive negotiations, all a contractor has to do when they notice something that wasn’t anticipated in the budget is to bring it to the owner’s attention and discuss possible solutions. However, while cost-plus contracts may seem like a safety net, contractors also assume a lot of risk. If something happens to increase costs beyond what was anticipated, cost-plus contractors are rarely allowed to ask for more money to cover those costs.
For contractors, cost-plus contracts are one of the furthest things from a "one size fits all" contract. The terms and conditions of a cost-plus contract are highly variable and depend on a basis of trust between the contractor and the owner . Generally, owners do not want to work with a contractor they do not completely trust on a cost-plus contract. There is a tremendous amount of risk on the part of the owner, requiring them to accept a level of trust on the part of the contractor. It is inherently assumed that the contractor will not take advantage of the owner with unnecessary costs. Therefore, contractors need to take time to get to know the owner before agreeing to a cost-plus contract. Understanding the owner’s needs and concerns is essential so a positive, trusting working relationship can be established.
While cost-plus contracts were designed to be flexible, allowing for changes as time moves on, the flexibility is really in the hands of the owner. In order for a cost-plus contract to be successful, the owner has to take the proper amount of monitoring and oversight on the project. If a contractor has too much independence, cost-plus contracts can lead to extra expenses that may not have been necessary. However, if the owner micromanages the contractor, the project likely will run behind schedule.
There are several different cost-plus contracts, including cost-plus fixed fee (CPFF) contracts, cost-plus award fee contracts, cost-plus incentive contracts, and cost-plus percentage of costs contracts. Each one is unique and specifies a different profit structure as well as the level of risk accepted by both parties.
Benefits of Cost Plus Contracts
One of the primary advantages a cost plus contract provides is the flexibility in the costs. If a contractor finds out that the plumbing or electrical estimate it provided was inaccurate, the flexibility of the cost-plus contract allows the cost to be adjusted after the actual cost has been revealed. The owner only pays for the actual cost of the work completed, and thus prevents overpaying. A cost-plus contractor also allows for quick change orders and eliminates the potential for delay claims that might delay the project change.
The principles of a cost plus contract benefit both parties, the owner and the contractor. It also provides the ability to make changes to the contract or scope of the work without needing to create a brand new contract or order.
A cost-plus contract is transparent and affords the parties an opportunity to know exactly what the costs are going to be. Because a cost-plus contract contains the actual expenditures, a court will look to a cost-plus contract if a dispute arises regarding the costs on the contract.
Drawbacks and Dangers of Cost Plus Contracts
Cost plus contracts carry certain disadvantages, starting with the fact that contractors are permitted to increase their fees as they see fit. As a result, there is a risk that their maximum costs of providing a service will be high. When you hire a contractor under a cost plus contract, you’re not hiring them by the job, but rather for the total cost of materials, labor, overhead and management – plus a fee for their services.
However, whereas lump sum contracts typically have all the fees included, cost plus contracts require additional monitoring and oversight. This can lead to disputes over their contract fees and vendors. We’ve all heard horror stories about contract disputes resulting in upper management spending months or years in court; such an outcome isn’t unheard of.
Finally, because a cost plus contract blinds a business owner to costs as they accrue, it may have lower incentives for contractors to save money. Why worry about efficiently using resources such as overtime hours or expensive materials when you can simply charge more?
Must-Haves for a Cost Plus Contract Template
To ensure clarity and mutual understanding, a cost plus contract template must include various critical components. These sections not only lay the groundwork for pricing and payments, but also help to avoid disagreements above what should and shouldn’t be included in the budget. The essential elements for an effective cost plus contract template are:
Pricing Structure
An effective contract must spell out how the pricing will be determined for each line item. It’s essential that parties agree on exactly what is to be included. The agreement must answer questions such as: Are indirect costs to be included? Is there a total cap on costs?
Payment Terms
It’s also important to agree on when and how payment will be made. These should include:
What kinds of information is the contractor required to provide to the client?
It may be a good idea to stipulate that the contractor provide an accounting of all spent funds for each phase or stage of the project. This can help to identify potential problems early on. While a cost plus contract template should be flexible, it still needs to be clear.
Because these contracts can be complex, it’s important that both the contractor and the owner understand exactly what’s covered. Keep in mind that when it comes to cost plus contracts, a true "fixed" price doesn’t exist. For this reason, costs tend to be high; this is offset by the fact that the client bears the risks of cost overruns.
Making Your own Cost Plus Contract Template
Creating a cost plus contract template involves a step-by-step approach to ensure that the final document is comprehensive and complies with legal requirements. Here, we illustrate the process of how to create a customized cost plus contract, which contractors can use as a foundation for their own agreements.
First, you’ll want to gather all necessary information. This includes contact details for both parties, a detailed description of the project, and a breakdown of the applicable cost and fee structure. Next, use the information you have and input it into a contract template. There are many different templates available, both online and in legal resources. Choose one that best fits your needs, and be sure to review all the terms and conditions that are listed.
In the contract, identify the parameters of the costs that the client will be responsible for, such as labor, materials, equipment, and overhead. Additionally, include information about the profit or fee to be paid to the contractor. It’s also important to note the timing of payments, as well as any provisions for changes in the project scope, limits on liabilities, and termination of the contract .
Next, you’ll want to establish the degree of documentation that the contractor is required to keep. For instance, the builder may be required to provide invoices and receipts for all costs of the project, while they may also be required to produce timesheets and travel logs. Be sure to specify clearly in the contract how documentation should be submitted, such as a weekly or monthly basis.
After that comes the review process. It’s essential that you carefully review the terms of the contract. Run through all of the details to ensure that you have a comprehensive understanding of your rights and responsibilities under the agreement. After you have reviewed the contract, make sure to proofread it for spelling, grammar, and punctuation errors, and be sure to sign and date the contract when complete.
Finally, it’s always a good idea to have a legal professional review your contract to ensure that it complies with all governing rules and regulations. They can also make recommendations on how to further customize the contract to best suit your business interests.
Samples of Cost Plus Contract Templates
Cost plus contracts are advantageous in many situations, and as such have been implemented in a variety of industries. Below we have included a selection of examples to provide a clearer idea of the typical contract structure.
Construction
As is the case with most other industries, construction has a variety of cost savings advantages. Among these is that the final cost at the end of the project is more accurate, rather than based on a pre-project estimate. As an example of the advantages of cost plus contracts, consider the following:
A mall is being constructed at a budget of $3 million dollars. In developing the original budget, the architects and engineers determined a material estimate of $1.5 million. However, by the end of the project, the costs of materials had increased to $2.2 million. Because the majority of these materials would be reimbursed, the added expense in this case would be accepted as a reasonable cost.
A similar example could be seen in upgrading machinery in an industrial plant. To provide a reasonable upgrade, it would be expected that a capital investment be made in advance, and the costs then reimbursed.
In both of these examples, cost plus contracts provide a solution for a fair compensation of the risks associated with cost increases. Unfortunately, with any risk there is also the necessary accompanying uncertainty. In situations where the costs saving benefits of a cost plus contract do not outweigh the potential disadvantages, the option to request a fixed fee request should be taken into consideration.
In both of these examples, the increased costs of the materials was not the fault of the contractor. Of course, there are many examples where expenses are being incurred because of negligence or poor planning by the contractor. In such cases, the project may have been completed faster, more efficiently, or without the need to reorder materials upon realizing that the original order was incomplete.
Residential Services
One of the most common residential applications of cost plus contracts is in the field of home remodeling. Consumers are often confused by the basic process, especially when already undertaken a home improvement project previous to this one.
In the case of a home remodel, the buyer has two choices. The first is to hire a contractor to complete the project for a fixed price, meaning that the total cost has been established before work begins. The second choice is to enter into a contract that provides that the buyer will pay for the cost of the project, plus an amount in dollars (or a percentage of the cost) as a profit margin for the buyer.
Cost plus contracts are sometimes written with an "upside", meaning additional profits will be collected by the contractor if the finished project ends up being under budget. Although this is not only an accepted practice, it is encouraged by buyers as a way to significantly reduce costs in the end.
Based on the experiences of an actual homeowner, the following example illustrates the parameters of the cost-plus contract, and the method through which the potential profit will be calculated.
The buyer hires a contractor to remodel their kitchen. Both sides agree upon an estimated cost of $4,500, and a 15 percent profit margin. Based on how the contract has been written, the buyer will pay the contractor an additional $675 if the cost of the project matches the estimate. If the cost of the project is $45,00, the buyer will pay the contractor an additional $675. However, if the cost of the project is closer to $2,500, the buyer may only pay the contractor an additional $375. Therefore, the final profit paid to the contractor can fall anywhere between $375 and $675.
Legal Implications of Cost Plus Contracts
Many states have enacted laws that prohibit or regulate the use of cost plus contracts. Be sure to check your state’s statutes, as well as local ordinances and regulations, to be sure you are allowed to use a cost plus contract for that particular project.
For example, both the federal government and the state of California have laws that govern when a cost plus contract can be used and what protections must be in place. Notably, the federal "Truth in Negotiations" law requires contracting officers to require cost or pricing data from contractors for cost plus contracts that exceed $2 million. In California, cost plus contracts for public works projects may only be used under approved circumstances, such as emergency construction where no bidding is practicable.
When using cost plus contracts , it is crucial that you avoid liability for violations of laws, such as the federal False Claims Act (FCA). The FCA includes cost related violations that include knowingly presenting a false claim with "costs not authorized by the contract." Under the post-2009 FCA, slash & burn tactics like those employed by the Qui Tam suits are less effective (although still disastrous for the contractor) in that if only part of the claim is false, the fraudulent (and potentially inflated) costs may be deducted from the overall claim, but other costs remain. Thus, it is best to have a clear understanding with your client about how costs will be incurred, governed and reimbursed.
If the cost plus contract is for a government project, be sure to review the applicable Federal Acquisition Regulation clauses governing modifications, claims, and disputes.