Cost-Plus Contract

Definition

A cost-plus contract (also called a cost-reimbursement contract) is an agreement in which a project owner reimburses a contractor for allowable project costs and pays an additional amount for the contractor’s profit, typically expressed as a fixed fee or a percentage of costs.

How it works

• The contractor documents and submits invoices/receipts for direct costs (materials, labor, subcontractors) and allowable indirect costs (overhead, insurance, security).
• The owner reimburses those costs and pays an agreed-upon profit component (fixed fee, percentage, or incentive).
• Contracts may exclude reimbursement for contractor error or negligence, and owners often include limits or audit rights to control abuses.
• Common uses: construction projects with uncertain scope or budgets, R&D outsourcing, and government procurement (where choosing a qualified contractor may be preferred over the lowest bid).

Types of cost-plus contracts

• Cost-plus fixed-fee: Reimburses costs plus a predetermined fixed fee.
• Cost-plus incentive fee: Reimburses costs and pays an additional fee if performance targets are met or exceeded.
• Cost-plus award fee: Reimburses costs and awards a discretionary fee for superior performance.
• Cost-plus percentage-of-cost: Reimburses costs plus a fee that is a percentage of the actual costs (this can incentivize higher spending and is generally less favored).

Advantages

• Reduces financial risk for contractors—encourages them to accept projects with unknown scope.
• Allows focus on quality and project outcomes over strict low-bid pricing.
• Enables projects to start more quickly when detailed estimates are not available.
• Covers actual expenses, reducing surprises for contractors.

Disadvantages

• Final cost can be uncertain if all expenses aren’t predetermined.
• Typically results in higher total cost than a well-scoped fixed-price contract.
• Requires extensive recordkeeping and oversight to verify expenses.
• Potential for disputes over reimbursable items and cost allocation.

Example

A firm contracts ABC Construction to build a $20 million office building. The contract:
– Limits total allowable costs to $22 million.
– Sets contractor profit at 15% of the contract price (15% of $20M = $3M).
– Includes an incentive for completing within nine months.

If ABC has completed verified work representing 20% of the project, it may bill 20% of the contract price:
– Invoice for 20% of $20M = $4,000,000.
– Recognize 20% of the total profit = 20% of $3M = $600,000.

Direct costs (materials, labor, subcontractors) and allowable overhead (e.g., insurance, safety) are billed with supporting receipts; overhead billing rates (for example, $50 per labor-hour) should be specified in the contract.

Special considerations

• Percentage-of-completion billing and clear milestones help coordinate cash flow and accounting.
• Owners should include audit rights, reimbursement limits, and definitions of allowable costs to limit exposure.
• Governments often use cost-plus contracts to procure complex or high-tech work where selecting qualified contractors is critical.

Risks

• For owners: potential manipulation of expenses and uncertain final price.
• For contractors: responsibility to track costs carefully; unreimbursed errors or negligence.
• For both: disputes over what costs are allowable and how they are allocated.

When to use

• Project scope or scope pricing cannot be reliably estimated up front.
• Owner values contractor flexibility and quality over obtaining the lowest bid.
• Contractor requires reduced risk to accept the work.
• Projects where progress-based incentives or performance targets are appropriate.

Conclusion

Cost-plus contracts offer flexibility and reduced contractor risk when project scope is uncertain, but they require strong recordkeeping, clear definitions of allowable costs, and owner oversight to control total cost and prevent disputes. Negotiate fee structure, reimbursement limits, milestones, and audit rights before proceeding.