Cost plus contract

What Is a Cost Plus Contract?

A cost plus contract is a type of agreement within contract types where a buyer agrees to reimburse a contractor for all allowable, incurred costs associated with a project, plus an additional fee for profit. This fee can be a fixed amount, a percentage of the total costs, or an incentive-based payment. Cost plus contracts are often employed when the scope of work is not precisely defined at the outset, or when there is significant uncertainty regarding the true costs, such as in complex research and development projects. The primary aim is to ensure the contractor is compensated for their actual expenses while also receiving a fair profit margin, which helps mitigate the contractor's financial risk management in unpredictable endeavors. This contract structure is a common tool in procurement and project management, especially where the emphasis is on quality and timely completion over strict cost certainty.

History and Origin

The origins of the cost plus contract can be traced back to the early 20th century, notably gaining prominence during periods of national urgency and large-scale industrial mobilization. One of the earliest documented uses of "cost-plus-a-fixed-sum" contracts in building construction was by industrial engineering pioneer Frank B. Gilbreth in 1907. However, the widespread adoption and formalization of cost plus contracts by the U.S. government occurred during World War I. At this time, the government needed to rapidly encourage wartime production by American businesses for essential war materials, despite unpredictable market conditions and difficulties in accurately estimating costs⁶. These contracts allowed manufacturers to be reimbursed for their expenses and receive a guaranteed profit, which helped to streamline procurement and foster cooperation between the government and businesses during a critical period⁵. This method became a staple in government contracting for complex, high-uncertainty projects like defense and space initiatives.

Key Takeaways

A cost plus contract reimburses a contractor for all legitimate project expenses, in addition to a negotiated fee for profit.
This contract type is typically used for projects with undefined or evolving scopes, where costs are difficult to estimate accurately upfront.
It shifts a significant portion of the financial risk from the contractor to the client, providing the contractor with greater financial security.
While offering flexibility, cost plus contracts require rigorous audit and cost control mechanisms to prevent inflated expenses.
Various types exist, including cost-plus-fixed-fee (CPFF), cost-plus-incentive-fee (CPIF), and cost-plus-award-fee (CPAF), each with different fee structures.

Formula and Calculation

The basic formula for a cost plus contract calculates the total payment to the contractor by summing all incurred allowable costs and the agreed-upon fee.

Total Contract Price = Allowable Costs + Fee

Where:

Allowable Costs: These include all direct and indirect expenses, such as variable costs (e.g., labor, materials) and overhead costs (e.g., administrative expenses, facilities). The specific definition of "allowable" is typically detailed in the contract terms.
Fee: This is the additional amount paid to the contractor as profit or as an incentive for performance. It can be a fixed sum, a percentage of costs, or based on performance metrics.

For example, if a project incurs $500,000 in allowable costs and the agreed-upon fee is $50,000, the total contract price would be:

Total Contract Price = $500,000 (Allowable Costs) + $50,000 (Fee) = $550,000

Interpreting the Cost plus Contract

Interpreting a cost plus contract involves understanding its implications for both the client (buyer) and the contractor. For clients, this contract structure implies a willingness to accept higher budget uncertainty in exchange for greater flexibility and potentially higher quality outcomes, especially when dealing with complex projects where initial specifications may evolve. The client must be prepared for vigilant contract management and diligent oversight of the contractor's expenses.

From the contractor's perspective, a cost plus contract reduces financial exposure, as legitimate costs are reimbursed. This encourages contractors to focus on delivering the project's requirements without the pressure to cut corners to stay within a predetermined, potentially insufficient, price. However, it also means that the contractor's profit is tied directly to the contract's terms, which are typically established during the negotiation phase. Careful documentation of all expenses is paramount for the contractor to ensure proper reimbursement.

Hypothetical Example

Consider "Alpha Solutions," a software development firm, contracted by "InnovateCorp" to develop a novel AI-driven analytics platform. Due to the experimental nature of the technology, the exact features and development pathway are not entirely clear at the outset, making a cost plus contract an appropriate choice.

Agreement: InnovateCorp and Alpha Solutions agree to a cost-plus-fixed-fee contract, where Alpha Solutions will be reimbursed for all direct and fixed costs of development, plus a fixed fee of $150,000.
Initial Estimate: Alpha Solutions provides an initial estimate of $800,000 for labor, software licenses, and necessary hardware.
Development Phase: During development, unforeseen complexities arise, requiring additional specialized hardware and an extended period for testing. The team also discovers a more efficient algorithmic approach that requires re-engineering a core module.
Cost Incurrence: Over the course of the project, Alpha Solutions meticulously tracks all expenses. The total allowable costs incurred amount to $920,000, including the initial estimate plus the unforeseen hardware, additional labor hours, and testing resources.
Final Payment: InnovateCorp reimburses Alpha Solutions for the $920,000 in allowable costs and pays the fixed fee of $150,000.
Total Cost: The total cost to InnovateCorp for the project is $1,070,000 ($920,000 costs + $150,000 fee).

This example illustrates how the cost plus contract allows for flexibility when the project's scope creep or technical challenges necessitate deviations from initial estimates, ensuring the contractor is fairly compensated for the actual work performed.

Practical Applications

Cost plus contracts find significant application in scenarios where project uncertainty is high, and defining a precise fixed price is impractical or risky. Key areas include:

Government and Defense: Federal agencies frequently utilize cost-reimbursement contracts, including various forms of cost-plus, for highly complex government contracting, research and development (R&D), and large-scale infrastructure projects. This is particularly common in defense and aerospace, where the development of new weapon systems or space technology involves extensive unknowns. The Federal Acquisition Regulation (FAR) outlines specific guidelines for the use of these contract types within U.S. federal procurement.
Construction: For unique or highly customized construction projects, such as bespoke homes or intricate renovations where material costs or design elements might change during the process, cost plus contracts can provide the necessary flexibility.
Research and Development (R&D): Companies undertaking groundbreaking R&D efforts, particularly in technology or pharmaceuticals, often use cost plus contracts with external partners to share the inherent risks of innovation. The focus here is on achieving technical milestones rather than adhering to a rigid cost ceiling.
Emergency Situations: In cases of disaster relief or urgent repairs, where the full extent of damage or work required cannot be assessed upfront, cost plus contracts enable rapid mobilization of resources without extensive initial negotiation over a fixed price.
Complex IT Projects: Large-scale software development or system integration projects with evolving requirements and long delivery timelines may also leverage cost plus arrangements, particularly those involving extensive supply chain dependencies or new technologies.

The nature of reimbursable expenses under these contracts, especially for federal contracts, is governed by stringent regulations. For instance, the U.S. Code specifies allowable costs under defense contracts, requiring meticulous accounting and documentation.

Limitations and Criticisms

Despite their utility in certain contexts, cost plus contracts face several limitations and criticisms:

Lack of Cost Control Incentive: A primary criticism is that cost plus contracts can remove the contractor's incentive to control costs. Since expenses are reimbursed, contractors may have less motivation to seek efficiencies, leading to potential cost overruns⁴. The more costs incurred, the higher the "plus" portion of the payment, especially in cost-plus-percentage-of-cost arrangements, which are largely prohibited in federal contracting for this reason³.
Budget Uncertainty for Clients: For the client, the final project cost can be highly unpredictable, making budget planning challenging. This uncertainty can lead to financial strain if expenses far exceed initial estimates.
Increased Oversight Requirements: To mitigate the risk of excessive costs, clients must implement rigorous audit and oversight mechanisms, including detailed expense tracking and regular reviews. This adds to the administrative burden for the client.
Potential for Abuse: Without sufficient oversight, there is a risk that contractors might inflate costs or prolong project timelines, a phenomenon sometimes referred to as scope creep, knowing their expenses will be covered.
Government Scrutiny: The use of cost plus contracts, particularly in government contracting, has drawn significant scrutiny over the years due to instances of large cost overruns. For example, NASA Administrator Bill Nelson has publicly criticized cost-plus contracts, referring to them as a "plague" on the agency due to their association with delays and steep cost increases in major development programs like the Space Launch System². Similarly, the National Association of State Procurement Officials (NASPO) ValuePoint has highlighted the long-standing prohibition of cost-plus-a-percentage-of-cost (CPPC) contracts in federal procurement due to the perverse incentive for contractors to increase costs to increase profits¹.

Cost plus contract vs. Fixed-price contract

The fundamental difference between a cost plus contract and a fixed-price contract lies in how financial risk is allocated and how the final price is determined.

A cost plus contract offers flexibility and transfers most of the financial risk to the client. The contractor is reimbursed for all approved project costs, plus a predetermined fee. This structure is ideal for projects with uncertain scopes, where the final cost is difficult to estimate upfront, such as research and development or highly innovative endeavors. The client assumes the risk of potential cost overruns but gains flexibility to adapt the project as needed.

Conversely, a fixed-price contract, also known as a lump-sum contract, establishes a single, predetermined price for the entire project upfront. The contractor agrees to complete the work for this set amount, absorbing any cost overruns and benefiting from any cost savings. This shifts most of the financial risk to the contractor, incentivizing them to manage costs efficiently. Fixed-price contracts are suitable for projects with clearly defined scopes and predictable expenses, providing the client with budget certainty from the outset. Confusion often arises because both aim to define payment terms, but they approach the critical element of cost predictability and risk bearing from opposite standpoints.

FAQs

What are the main types of cost plus contracts?

The main types include Cost-Plus-Fixed-Fee (CPFF), where the fee is a set amount; Cost-Plus-Incentive-Fee (CPIF), where the fee is adjusted based on performance against agreed-upon metrics (e.g., meeting deadlines or staying under a target cost); and Cost-Plus-Award-Fee (CPAF), where a portion of the fee is earned based on subjective evaluation of performance. These variations introduce different levels of incentive for the contractor to control costs or achieve specific outcomes.

When is a cost plus contract typically used?

A cost plus contract is typically used when the scope of work is not clearly defined, when there's high uncertainty about the actual costs involved, or when the project involves significant research, development, or innovation. This allows for flexibility and ensures the contractor isn't unduly penalized for unforeseen challenges. It's common in project management for complex or experimental undertakings.

What are "allowable costs" in a cost plus contract?

Allowable costs are the expenses that the client agrees to reimburse the contractor for. These typically include direct costs (like labor and materials) and indirect costs (like overhead costs and administrative expenses). The specific criteria for what constitutes an allowable cost are detailed within the contract itself and are often subject to strict documentation and audit requirements, particularly in government agreements.

Do cost plus contracts always lead to higher costs?

Not necessarily. While they can lead to higher final costs due to reduced contractor incentive for cost control, they are often chosen for projects where initial cost estimates are unreliable due to inherent uncertainties. In such cases, a fixed-price contract might be either prohibitively expensive (as contractors would build in high contingency) or lead to disputes and lower quality if the contractor cuts corners to stay within a low bid. The goal of a cost plus contract is to ensure project completion and quality, even if the final cost is less predictable.