Cost plus percentage of cost contracts are a common form of contract used in industries like construction, engineering, and manufacturing where the full scope or costs of a project may be uncertain. In this type of contract, the buyer agrees to pay the seller for all actual costs incurred, plus an extra percentage as profit. This helps provide flexibility in situations where the final project expenses are hard to predict accurately ahead of time.
In this comprehensive guide, we’ll explore what exactly cost plus percentage of cost contracts are, how they work, their pros and cons, and examples of when they may be suitable to use.
What Is a Cost Plus Percentage of Cost Contract?
A cost plus percentage of cost contract, sometimes referred to as a cost-reimbursement contract, is an agreement where the buyer pays the seller for the actual costs of performing the contract work, plus an additional predefined percentage over the seller’s costs as profit. The profit element is typically a fixed rate percentage, such as 15%, that applies to all incurred costs.
Unlike fixed price contracts where the total price is set cost plus percentage contracts provide flexibility on the final price tying it directly to the actual costs experienced by the seller. The seller must maintain detailed records and provide transparency into expenses so the buyer can verify costs.
Key Elements of Cost Plus Percentage Contracts
Cost plus percentage contracts include certain key elements
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Reimbursement of actual costs – The seller gets reimbursed for all direct and indirect costs related to the contract work. This includes labor, materials, overhead, administration, equipment usage, etc.
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Profit percentage – The contract specifies the profit percentage the seller will earn, usually a fixed rate applied to all costs. A common rate is 10-20%.
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Record keeping – The seller must maintain comprehensive records of all costs and provide details to the buyer. This allows the buyer to verify and approve costs.
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Change orders – If the scope changes, the resulting cost adjustments must be documented through change orders approved by both parties.
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Cost limitations – Caps or limitations may be placed on which cost categories can be claimed or profit earned.
How Do Cost Plus Percentage of Cost Contracts Work?
Cost plus percentage contracts follow a typical workflow:
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The seller provides an initial cost estimate for the full project.
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The contract is signed, specifying the profit percentage the seller will earn.
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As work progresses, the seller incurs actual costs while keeping detailed records.
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Upon completion, the seller presents all project costs to the buyer along with supporting documents.
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The profit is calculated by applying the agreed percentage rate to the total verified costs.
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The seller submits an invoice for the total costs plus profit percentage.
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After reviewing the records, the buyer makes payment on the invoice.
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Any disputes over claimed costs may be resolved as defined in the contract.
When Are Cost Plus Percentage Contracts Used?
Cost plus percentage contracts are best suited for complex, uncertain projects where the final specifications or costs are unpredictable. Some examples include:
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Construction projects – Where plans frequently change during building.
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Product development – When requirements evolve over long development cycles.
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Government contracting – For multistage programs with fluid objectives.
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R&D contracts – Where the outcome and costs of experimental work is unknown.
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IT projects – Subject to changing technologies and business needs.
Pros and Cons of Cost Plus Percentage Contracts
Cost plus percentage contracts offer advantages but also pose some disadvantages to consider:
Potential Advantages
- Flexibility to accommodate changes in scope or specifications
- Low risk for the seller since all costs are covered
- Buyer has visibility into project costs
- Seller can focus on quality not lowest cost
- Collaboration between buyer and seller on changes
Potential Disadvantages
- Overall costs may be higher than a fixed price
- Administrative overhead of extensive record keeping
- Conflict of interest if seller inflates costs to increase profit
- Buyer has less control over costs
- Complex negotiations required
Cost Plus Percentage vs Fixed Price Contracts
Cost plus percentage contracts differ significantly from fixed price contracts:
| Factor | Cost Plus Percentage | Fixed Price |
|---|---|---|
| Price | Not fixed, adjusted for actual costs | Fixed price agreed upfront |
| Risk | Buyer carries most risk | Seller carries risk |
| Cost visibility | Buyer has high visibility | Low visibility for buyer |
| Changes | Easy to accommodate | Difficult without renegotiation |
| Profit | Seller profit tied to costs | Seller profit fixed |
| Incentives | May encourage seller to limit costs | May incentivize seller to cut corners |
Examples of Cost Plus Percentage Contracts
Here are some examples of how cost plus percentage contracts are applied:
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A construction company is hired to build a large customized home. The final design is likely to change, so a cost plus percentage contract is used. Their costs for labor, materials, and subcontractors will all be reimbursed plus a 15% profit on top.
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A software company is contracted to develop a complex booking system for a client. The needs are expected to evolve over the long development cycle. A cost plus percentage contract allows flexibility, with all programming costs covered plus 20% profit.
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An engineering firm is retained for a multi-year R&D project to develop new solar panel technologies. The innovations required are unpredictable. A cost plus percentage contract provides for reimbursement of engineering costs as they are incurred plus 12% profit.
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The defense department awards a cost plus percentage contract to a technology company to deliver an integrated communications system. The 5-year project will undergo many changes in requirements as it is developed.
Tips for Managing Cost Plus Percentage Contracts
Here are some useful tips for effectively managing cost plus percentage contracts:
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Establish clear guidelines for what costs are allowable and how they must be tracked.
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Define an invoicing cadence such as monthly to regularly review costs.
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Use change orders diligently for any scope changes to avoid disputes.
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Watch out for excessive costs and question anything that seems inappropriate.
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Conduct periodic audits of incurred costs for compliance.
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Set a not to exceed limit in the contract to cap costs if desired.
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Maintain open communication and collaboration with the seller throughout.
Key Takeaways About Cost Plus Percentage Contracts
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They provide flexibility on final price tied to actual costs experienced.
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Seller gets reimbursed for all costs plus predefined profit percentage.
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Useful on complex projects with uncertain specifications and costs.
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Require extensive record keeping and transparency into expenses.
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Allow accommodation of changes through change orders.
Cost plus percentage contracts can be an effective tool when the scope or cost of a project is unpredictable. By understanding how they work and their pros and cons, you can determine if this form of contract is suitable for your needs. With clear communication, diligent administration, and mutually aligned incentives, cost plus percentage arrangements can help manage risk and flexibility across a wide range of projects and partnerships.
Advantages and Disadvantages of Using Cost-Plus Contracts
The pros and cons of using these types of contracts include the following:
- They eliminate some risk for the contractor.
- They allow the focus to shift from the overall cost to the quality of work being done.
- They cover all the expenses related to the project, so there are no surprises.
- They may leave the final cost up in the air since they cant be predetermined.
- They may lead to a longer timeline for the project.
- Might lead to disputes when trying to recover construction-related expenses
- Requires additional resources to reproduce and justify all related costs
What Is a Cost-Plus Contract?
A cost-plus contract is an agreement to reimburse a company for expenses incurred plus a specific amount of profit, usually stated as a percentage of the contract’s full price. These type of contracts are primarily used in construction where the buyer assumes some of the risk but also provides a degree of flexibility to the contractor. In such a case, the party drawing up the contract anticipates that the contractor will make good on their promises to deliver, and agrees to pay extra so that the contractor can make additional profit upon completion.
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.
- In a cost-plus contract, one party agrees to reimburse the contracting party for expenses plus a specified profit proportional to the full value of the contract.
- Cost-plus contracts are often used in construction when the budget is restricted or when there is a high probability that actual costs might be less than anticipated.
- Contractors must provide proof of all related expenses, including direct and indirect costs.
