Cost-Plus Contract

Cost-Plus mean something over and above the cost involved in completing the contract which is under consideration; the former word "Cost" will include all types of cost, i.e., direct, indirect, overhead, etc., incurred while performing the activity and the latter word "Plus" refer to profit which will include a specific percentage of income over and above the total cost of the contract as agreed by the contracting parties.

There are three major components of a Cost-plus contract:

1. Direct Cost:- Direct Cost includes the cost incurred by the contractor specific to a contract, viz. labor cost, material cost, equipment hiring charges, and professional consultancy charges for the contract.
2. Overhead Cost:- Overhead Cost includes the allocable cost to the contract, viz., office rent, traveling expenses, insurance, office supplies, etc.
3. Profit:- Usually, this is a fixed percentage amount calculated on the project's cost.

The contract can vary only in the payment of profit or fee component to the contractor.

1. Cost + Fixed Percentage Fee:- In this, the contractor will receive the income by using a pre-decided percentage on the cost of the contract.
2. Cost + Fixed Fee Contract:- Under this contract, the amount to be paid to the contractor is fixed and independent from the cost of the contract.
3. Cost + Fixed percent / Fee and Incentive:- Certain contracts may have an additional incentive covenant, which states that in case of early completion of the completion of levels as mentioned in the agreement, the contractor is eligible to receive the incentive as mentioned in terms of the agreement.

Let us understand the cost-plus contract with a small example.

Suppose Infra Constructions receive a contract for the construction of a building, and the following terms were agreed upon,

The entire cost of the project will be reimbursed to Infra Constructions (estimated cost of the project being $ 25 million)

The profits will be 20% of the entire cost of a project subject to a max of $ 5 million.

If the project is completed within 12 months, an incentive fee of $ 0.5 million will be paid.

Infra Construction completed the project in 11 months and is eligible for the incentive fee of $ 0.5 million.

The total cost incurred was $ 20 million, including direct labor cost, material cost, and overhead allocated to the projects. Required documents like Bills, labor hours on a project, and labor costs were provided to the contractee. Therefore the total income for contractor will be = $ 20 million * 20% = $ 4 million +$ 0.5 million = $ 4.5 million.

The cost-plus agreement will be successful only if certain systems are in place before the execution of the contract,

1. There is a proper system to check the expense incurred during the construction of the contract.
2. A proper communication channel is established between the contractor and the contractee to keep up a knowledge of the progress of the contract.
3. All the terms and conditions are all properly mentioned in the contract to avoid disputes in the future.
4. A contractor has sufficient funds to execute the contract as the contract cost will not be immediately paid to the contractor; he will have to pay for the expense first. Therefore, adequate financing arrangements should be there with the contractor.
5. A team should be there to ensure that proper accounting, budgeting, audit, and other records are maintained for the contract under consideration.

Some of the advantages of a Cost-Plus Contract are as follows:

• The contractor is paid a fixed percentage of fees, so in the case of cost overrun it will not be a burden on the contractor, i.e., the risk is transferred to the contractee.
• The quality of the project will not be compromised as there are no budget constraints to the contractor, which leads to a better quality of the project.
• The contractee will have complete knowledge about the expenses incurred on the project as the contractor must provide details of all the expenses while reimbursing the cost from the contractee.
• The project's final cost may be less than the estimated cost, which will benefit the contractor.
• In case of a decrease in material and labor costs, the benefits are transferred to the contractee as he is paying for the cost.

Some of the disadvantages of Cost-Plus Contract are as follows:

• In cases of cost overrun, the contractor requires to show a lot of additional evidence to justify the increase in the cost of the project.
• Disputes may arise between the contractor and contractee while reimbursement of expenses.
• To avoid disagreement while settlement of the contract cost, more expense in incurring in accounting, making monthly reports, etc.
• A project might go longer than expected.
• Uncertainty for the contractee as the project's final cost cannot always be easily determined.
• The contractor will not be eligible for the incentive if the project isn’t completed within a specific time range, or penalties may be levied on the contractor for delay in completion.

Cost-plus contracts are majorly found in the construction industry where the contractor is reimbursed the number of expenditures made for the contract and fixed percentage fees of the contract cost as the profit made on the contract.

This article has been a guide to what a cost-plus contract is. Here we discuss Components, types, and examples of Cost-Plus Contracts along with advantages and disadvantages. You can learn more about financing from the following articles –

• Cost-Based Pricing Formula
• Quasi-Contract Examples
• Direct Labor
• Incurred Cost Types