Cost-plus contract

What is a cost-plus contract?

A cost-plus contract is an agreement that specifies the client will pay the contractor for construction expenses detailed in the contract, plus an additional percentage to provide the contractor with a profit. Many contracts specify that reimbursement may not exceed a specific dollar limit. The contract reimburses the contractor for direct costs and indirect costs, but all expenses must be documented and provided to the client.

Deeper definition

Cost-plus contracts are created to protect clients from cost overruns. They are commonly used in situations where the costs are difficult to define ahead of time, such as research and development activities.

When the U.S. government contracts with military defense contractors to develop new technologies for U.S. defense, they typically use cost-plus contracts. Government agencies prefer cost-plus contracts because they enable them to pick the most qualified contractors rather than the contractors that provide the lowest bids.

Award-fee cost-plus contracts hold the contractor accountable for the end product’s quality. Incentive-fee contracts provide larger profits for the contractors when they meet or exceed certain performance targets, such as cost savings. Fixed-fee contracts specify the contractor’s fees ahead of time, without offering an incentive for performance or cost savings.

While cost-plus contracts are designed to avoid cost overruns, critics argue that cost-plus fixed-fee contracts don’t provide contractors with incentives to reduce costs further.

Cost-plus contract example

A construction company is contracted to build a $30 million commercial building. The cost-plus fixed fee contract states that the building cannot exceed $34 million. Per the contract, the construction company’s profit is 15 percent of the contract’s full price ($4.5 million).

The contract specifies the construction company must submit receipts for supplies, services and any other overhead to the client. The contractor may bill the client for direct and indirect expenses.

To ensure the work meets the client’s standards, the contract specifies the client may inspect and verify the work.

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