What is the 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.
Components of a Cost-Plus Contract
There are three major components of Cost-plus contract:
- 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.
- Overhead Cost:- Overhead Cost includes the allocable cost to the contract viz. office rent, traveling expense, insurance, office supplies, etc.
- Profit:- Usually this is a fix percentage amount calculated on the cost of the project.
Types of Cost-Plus Contract
The contract can vary only in the aspect of payment of profit or fee component to the contractor.
- Cost + Fixed Percentage Fee:- In this, the contractor will receive the income in using a pre-decided percentage on the cost of the contract.
- 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.
- Cost + Fixed percent / Fee and Incentive:- Certain contract 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 the terms of the agreement
Example of Cost-Plus Contract
Let us understand the cost-plus contract with a small example.
Suppose Infra Constructions receive a contract for construction of a building and 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 then an incentive fee will be paid for $ 0.5 million.
Infra Construction completed the project in 11 months and hence eligible for the incentive fee of $ 0.5 million.
The total cost incurred was $ 20 million which includes Direct labor cost, material cost and overhead allocated to the projects. Required documents like Bills, labor hours on a project, labor cost were provided to the contractee. Therefore the total income for contractor will be = $ 20 million * 20% = $ 4 million +$ 0.5 million = $ 4.5 million.
When to Use a Cost-Plus Contract?
The cost-plus agreement will be successful only if certain systems are in place prior to the execution of the contract,
- There is a proper system to have a check on the expense incurred during the construction of the contract
- A proper communication channel is established between the contractor and the contractee to have up to date knowledge of the progress of the contract
- All the terms and condition all properly mentioned in the contract to avoid disputes in future
- 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 at first. Therefore, adequate financing arrangements should be there with the contractor
- A team should be there to make sure that proper accounting, budgeting, audit, and other records are maintained for the contract under consideration.
Advantages of Cost-Plus Contract
Some of the advantages of 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 is no budget constrains to the contractor which leads to a better quality of the project.
- The contractee will have entire knowledge about the expenses incurred on the project as the contractor is required to provide details of all the expenses while reimbursing the cost from the contractee.
- The final cost of the project may be less than the estimated cost which will benefit the contractee
- In case of a decrease in the cost of material and labor the benefits will be transferred to the contractee as he is required to pay only for the cost incurred.
Some of the disadvantages of Cost-Plus Contract are as follows:
- In cases of cost overrun a lot of additional evidence are required to be given to justify the increase in the cost of the project
- Disputes may arise between the contractor and contractee while reimbursement of expense
- 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 final cost of the project 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 of the project.
Cost-plus contracts are majorly found in the construction industry where the contractor is reimbursed the number of expenditures made by him for the contract and a fix percentage fees of the contract cost as the profit made on the contract.
This has been a guide to what is Cost-Plus Contract. Here we discuss Components, types, and examples of Cost-Plus Contract along with advantages and disadvantages. You can learn more about financing from the following articles –