Cost plus contracts

What Is Cost Plus Contracts?

Cost plus contracts are a type of agreement where a contractor is reimbursed for all allowable expenses incurred during a project, in addition to receiving a predetermined fee or profit. As a fundamental aspect of contract types in procurement and project management, this structure shifts a significant portion of the financial risk management from the contractor to the client. This arrangement is typically used when the scope of work is uncertain, complex, or subject to significant changes, making it difficult to estimate total costs accurately at the outset.

History and Origin

The origins of cost plus contracts can be traced back to the early 20th century, notably gaining prominence during periods of significant national need and industrial expansion. Frank B. Gilbreth, an early pioneer in industrial engineering, described a "cost-plus-a-fixed sum" method for his building contracting business as early as 1907. However, it was the urgent demands of wartime production that truly propelled cost plus contracts into widespread use. During World War I, the U.S. government adopted these agreements to encourage businesses to rapidly produce essential war materials, recognizing the difficulty firms faced in estimating costs amidst unpredictable market conditions for labor and materials. This approach continued through World War II, when it was frequently employed for complex defense and space research initiatives where private contractors were unwilling to bear the full risk of potentially much higher-than-anticipated costs.⁸

Key Takeaways

Cost plus contracts reimburse contractors for all approved expenses plus a predefined profit or fee.
They are commonly used for projects with uncertain scopes, high complexity, or when rapid commencement is critical.
This contract type shifts much of the financial risk from the contractor to the client.
Effective cost accounting and rigorous auditing are crucial to manage and verify expenses.
While offering flexibility, cost plus contracts can reduce the contractor's incentive to control costs, potentially leading to higher overall project expenses.

Formula and Calculation

The basic formula for a cost plus contract is straightforward:

\text{Total Contract Price} = \text{Allowable Costs} + \text{Fee}

Where:

Allowable Costs: These are the direct costs (e.g., labor, materials, equipment) and indirect costs (e.g., administrative, overhead costs) that are explicitly permitted for reimbursement by the contract terms. These costs must be reasonable, allocable, and incurred during the performance of the contract.
Fee: This is the contractor's profit margin. It can be structured in various ways, such as a fixed fee, a percentage of actual costs (though this is often restricted or prohibited in government contracting due to disincentives for cost control), or an incentive-based fee tied to performance metrics.

For example, if a project incurs $500,000 in allowable costs and the contractor's fee is a fixed $50,000, the total contract price would be $550,000.

Interpreting Cost Plus Contracts

Interpreting a cost plus contract involves understanding the balance between flexibility and accountability. For clients, it means accepting a potentially variable final project cost in exchange for the ability to commence complex projects without a fully defined scope, ensuring quality, or expediting delivery. The interpretation hinges on the "allowable costs" clause, which defines what expenses the client is obligated to reimburse. Clear definitions and stringent negotiation are essential to prevent disputes over what constitutes a legitimate expense. Regular reconciliation of actual costs against initial estimates is vital for both parties to monitor financial progress and manage expectations.

Hypothetical Example

Imagine "TechSolutions Inc." is hired by "FutureCorp" to develop a novel AI-powered software platform. The exact requirements and technical challenges are highly uncertain at the outset, making a fixed price unfeasible. They agree on a cost plus contract.

Contract Terms:

Allowable Costs: All documented labor hours (developers, project managers), software licenses, cloud computing resources, and office supplies directly attributable to the project.
Fee: 15% of the total allowable costs.

Project Execution:

Month 1: TechSolutions incurs $100,000 in labor, $10,000 in software licenses, and $5,000 in cloud resources.
Month 2: They incur $120,000 in labor, $12,000 in software, and $6,000 in cloud.
Month 3: Due to unforeseen technical hurdles, they incur $150,000 in labor, $15,000 in software, and $7,000 in cloud. They also needed to issue a change orders for additional specialized hardware, costing $20,000.

Calculation:

Total Allowable Costs = ($100,000 + $10,000 + $5,000) + ($120,000 + $12,000 + $6,000) + ($150,000 + $15,000 + $7,000 + $20,000) = $115,000 + $138,000 + $192,000 = $445,000
Fee = 15% of $445,000 = $66,750
Total Contract Price = $445,000 + $66,750 = $511,750

In this scenario, FutureCorp pays the actual costs incurred by TechSolutions, plus the agreed-upon 15% fee, even though the final cost exceeded initial rough estimates.

Practical Applications

Cost plus contracts are prevalent in sectors where project uncertainty is high or technological advancement is rapid. They are widely used in:

Government contracts and Defense: For large-scale defense projects, aerospace initiatives, and research and development (R&D) where the precise scope or technological path is unclear at the outset. The Federal Acquisition Regulation (FAR) provides extensive guidance on their use.⁷,⁶
Construction: Particularly for complex, large-scale projects like custom homes, specialized infrastructure, or renovations where existing conditions are unknown, and significant change orders are anticipated.
Research and Development (R&D): In scientific or technological endeavors where the outcome is experimental, and costs cannot be accurately projected.
Emergency Response: When rapid action is required after disasters, and immediate resource deployment takes precedence over detailed cost estimation.

These contracts allow clients to secure necessary services or products quickly without extensive upfront planning, while providing contractors with assurances of reimbursement for their efforts.

Limitations and Criticisms

While offering flexibility, cost plus contracts face several limitations and criticisms:

Lack of Cost Control Incentive: A primary concern is that contractors may have little incentive to control costs, as their expenses are reimbursed, and their fee might be a percentage of those costs. This can lead to inefficiencies or inflated charges.⁵
Uncertainty for Clients: For the client, the final project cost remains uncertain until completion, making budgeting and financial planning challenging.⁴
Increased Administrative Burden: These contracts necessitate meticulous record-keeping, detailed documentation of all direct costs and indirect costs, and robust auditing by the client to verify expenses. This can lead to a significant administrative workload.³
Potential for Disputes: Disagreements can arise over what constitutes an "allowable cost" or the reasonableness of certain expenses, potentially leading to project delays or legal disputes.²
Risk of Overruns: If not carefully managed, particularly for those with a percentage-based fee, the absence of a strong financial incentive for the contractor to economize can lead to significant cost overruns.

Cost Plus Contracts vs. Fixed-Price Contracts

Cost plus contracts stand in contrast to fixed-price contracts, which represent the opposite end of the risk spectrum.

Feature	Cost Plus Contracts	Fixed-Price Contracts
Risk Allocation	Primarily on the client (owner)	Primarily on the contractor
Price Certainty	Low; final cost unknown at outset	High; total cost determined upfront
Scope Suitability	Best for uncertain, complex, or evolving projects	Best for well-defined projects with clear scope
Cost Control Incentive	Lower incentive for contractor to economize	High incentive for contractor to control costs
Administrative Burden	Higher for client (verification of costs)	Lower for client (less oversight needed post-agreement)

Confusion often arises because both aim to deliver a project, but their underlying risk tolerance and project suitability differ significantly. Cost plus contracts prioritize flexibility and quality when scope is fluid, while fixed-price contracts prioritize budget certainty when scope is clear.

FAQs

What are the main types of cost plus contracts?

The main types include Cost-Plus-Fixed-Fee (CPFF), where the contractor receives a fixed fee regardless of final costs; Cost-Plus-Incentive-Fee (CPIF), which includes a bonus for meeting or exceeding performance targets or cost savings; and Cost-Plus-Award-Fee (CPAF), where the fee is determined by a subjective evaluation of performance. Some contracts might use Cost-Plus-Percentage-of-Cost (CPPC), but this is generally disfavored, especially in government contracts, due to the lack of incentive for cost control.¹

When is a cost plus contract most appropriate?

Cost plus contracts are most appropriate when the scope of work cannot be accurately defined at the project's start, when there is high technical or performance uncertainty, or when project speed and quality are more critical than strict budget adherence. This often applies to research and development, innovative projects, or emergency situations.

How do clients protect themselves in a cost plus contract?

Clients protect themselves by clearly defining "allowable costs," establishing caps on total costs (Guaranteed Maximum Price or GMP), conducting thorough due diligence on the contractor, implementing strong auditing and reporting requirements, and maintaining open communication and joint project management oversight to monitor expenses and progress.