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Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.
Updated September 05, 2024
A cost-plus contract is an agreement made between a project owner and a contractor to reimburse the contractor for expenses incurred and to add a specific, additional payment for their profit. This profit is usually stated as a percentage of the contract’s full price.
These types of contracts are primarily used in construction for projects where the owner reduces some of the contractor's risk related to expenses, thereby providing the contractor with a degree of flexibility.
In such cases, the owner agrees to pay the contractor extra based on the contractor's agreement (and obligation) to deliver according to the contract's terms.
Cost-plus contracts can be contrasted with fixed-cost contracts, in which two parties agree up front to a specific cost, regardless of the actual expenses incurred by the contractor. Cost-plus contracts may also be known as cost-reimbursement contracts.
Cost-plus contracts are generally used if the party drawing up the contract has budgetary restrictions or if the overall scope of the work can't be properly estimated in advance.
For example, this party could be either the project owner, who wants to encourage a timely project launch or the contractor, who lacks necessary information for a thorough estimate.
In construction, cost-plus contracts are drawn up so contractors can be reimbursed for direct costs and indirect or overhead costs. All expenses must be supported by invoices and receipts that identify the contractor's spending.
The contract also provides the contractor with the opportunity to make a specific profit—hence, the term "plus" in cost-plus contracts.
Cost-plus contracts normally don't cover contractor error or negligence. Therefore, some contracts may limit the amount of reimbursement, so that not every expense is covered.
This contractual limitation benefits the owner if the contractor makes an error during the course of the project or is negligent with regard to any part of the construction.
Cost-plus contracts are also used in research and development (R&D) activities, where a larger company may outsource R&D activities to a smaller firm, such as when a large pharmaceutical company contracts to the lab of a small biotech company.
The U.S. government also uses cost-plus contracts with military defense companies that develop new technologies for national defense.
Governments generally prefer cost-plus contracts because they can choose the most qualified contractors instead of the lowest bidder.
Cost-plus contracts can be separated into four categories. Each allows for the reimbursement of costs as well as an additional amount for profit:
Assume ABC Construction Corp. has a contract to build a $20 million office building, and the agreement states that costs cannot exceed $22 million.
ABC’s profit is agreed at 15% of the contract’s full price, or $3 million. Additionally, ABC Construction is eligible for an incentive fee if the project is completed within nine months.
ABC must submit dated receipts for all expenses, and the client will inspect the job site for quality to verify that specific components, such as the plumbing, electrical, and fixtures, are completed to specification.
The contract allows ABC to incur direct costs for materials, labor, and costs incurred to hire subcontractors. ABC can also bill indirect, or overhead, costs, which include insurance, security, and safety. The contract states that overhead costs are billed at $50 per labor-hour.
The above project uses the percentage of completion process to account for profit and to submit bills to the client, and the contract provides specific percentages for billing.
Assume, for example, that ABC can bill for 20% of the full contract price once 20% of the materials are purchased, and the client verifies the concrete foundation is in place.
At that point, ABC sends an invoice for 20% of the $20 million contract, or $4 million, and posts 20% of the firm’s profit, or $600,000, to the financial statements (.20 x $3 million).
For the owner, one risk can be the manipulation of expenses by the contractor. For the contractor, cost overruns that they don't keep track of can be another. Miscommunications with the owner can result in unexpected costs.
They can. For instance, a cost-plus contract can instill confidence in the contractor that they'll be paid and therefore, they'll be more willing to start a project even if not every detail has been finalized. That's a plus for owners who need to get a project going fast.
They can be attractive to some contractors because not only do they reduce the risk of not getting paid, they also guarantee profitability.
A cost-plus contract is a contract whereby the owner of a project agrees to pay the expenses incurred by a contractor during the project and agrees to pay pay a specific amount that represents profit for the contractor. That amount is usually a percentage of the full price of the contract.
Cost-plus contracts have their pros and cons so be sure to consider all aspects of a contract, including the risks, before entering into one.
Article SourcesInternational commercial terms (Incoterms) clarify the rules and terms that buyers and sellers use in international and domestic trade contracts.
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