Definition — what a cost-plus contract is
A cost-plus contract (also called a cost-reimbursement contract) is an agreement in which the project owner agrees to repay the contractor for allowable project expenses and to pay an additional amount that represents the contractor’s profit. That extra payment is usually expressed as a fixed fee or a percentage applied to the contract’s price.
When they are used
Cost-plus contracts are common when the total scope or costs cannot be estimated reliably before work begins — for example, complex construction, research and development (R&D) projects, or government technology programs. Owners who prioritize contractor capability or speed over a low initial bid may prefer them; contractors like them because they reduce the risk of unpaid outlays and can guarantee a margin.
How payment normally works
– The owner reimburses direct costs (materials, labor, subcontractors) and allowable indirect costs (overhead such as insurance or site security).
– The contractor must support charges with invoices, receipts and time records.
– On top of reimbursed costs, the contractor receives the agreed profit element (a fixed fee, a percentage, or an incentive).
– Some contracts use a percentage-of-completion billing schedule so the contractor can invoice periodically as work milestones are reached.
Common contract features and limits
– Many cost-plus contracts exclude reimbursement for contractor error or negligence.
– Contracts often cap reimbursable costs or set a maximum total price to protect the owner.
– Incentive fees may reward early completion, cost savings, or quality metrics.
– Owners usually retain rights to inspect work and verify milestones before payments.
Who uses them
– Construction owners and contractors (for projects with uncertain scope).
– Companies outsourcing R&D, such as large pharmaceutical firms contracting small biotech labs.
– Governments (national defense and other agencies) frequently use them to select the most qualified contractor rather than the lowest bidder.
Advantages (what they accomplish)
– Reduce the contractor’s financial risk for unexpected or hard-to-estimate work.
– Shift focus toward quality and technical performance rather than just a low bid.
– Allow projects to start sooner because contractors are assured of reimbursement.
– Provide flexibility for evolving scope.
Disadvantages and risks
– Final project cost can be uncertain and often higher than a fixed-price bid.
– Owners rely on contractor records; inadequate documentation or misclassified expenses can produce disputes.
– Contractors may need extra administrative resources to track and justify all costs.
– Owners face some risk that contractors could inflate or misallocate expenses unless controls are robust.
Accounting and billing — percentage-of-completion (short)
If the contract and accounting standards allow, the contractor may recognize revenue and bill the owner as work progresses by applying contract-specified percentages (for example, bill 20% of the contract value when 20% of materials are purchased and a foundation is in place). The contractor also records their portion of profit corresponding to the billed percentage.
Error and negligence
Most cost-plus contracts exclude payment for costs caused by the contractor’s negligence or errors. Contracts often specify which expenses are disallowed and may limit reimbursement to prevent moral hazard.
Checklist — what to verify before signing
– Is there a maximum reimburs
ursable cost or a guaranteed maximum price (GMP)? A GMP caps the owner’s exposure; without one the owner bears unlimited cost risk.
– How are reimbursable costs defined? Confirm which direct costs (labor, materials, subcontractors) and indirect costs (overhead, general & administrative — G&A) are allowed, and which are expressly disallowed (e.g., penalties, certain bonuses, entertainment).
– Is there a contract ceiling or cost-sharing formula? If a target cost is used, how are overruns shared between owner and contractor (the incentive rate)?
– What is the fee structure? Identify whether the contract is cost-plus-fixed-fee (CPFF), cost-plus-incentive-fee (CPIF), cost-plus-award-fee (CPAF), or another variant, and get the exact fee calculation formula in writing.
– What audit and documentation rights does the owner have? Specify bookkeeping standards, frequency of reporting, access for audits, and approval steps for major subcontracts.
– Are invoicing and progress-billing rules clear? Define the schedule (e.g., monthly), supporting documentation required, retention/holdback amounts, and payment terms.
– How are change orders handled? Require written change orders with cost-authority limits and a clear method for pricing changes.
– Do insurance, bonding, and warranty requirements protect the owner? Require performance bonds, adequate liability and builder’s risk insurance, and warranty periods tied to milestones.
– What are the termination provisions? Define termination-for-convenience and termination-for-cause mechanics, settlement formulas, and protection for work in progress.
– Which costs are subject to prior approval? List any high-value items (long-lead materials, capital equipment, subcontractor awards) that require owner pre-approval.
– How are disputes resolved? Specify escalation steps, mediation/arbitration venues, and governing law.
– What accounting method will the contractor use for revenue recognition? If progress billing or percentage-of-completion accounting is intended, document the criteria and supporting metrics.
Practical owner controls checklist (minimum safeguards)
– Require a cost ceiling or a target cost with a clear incentive scheme.
– Reserve audit and inspection rights in the contract and schedule periodic audits.
– Require detailed monthly cost reports with variance explanations and backup invoices.
– Hold back a retention percentage until key milestones or final acceptance.
– Pre-approve large subcontract awards and long‑lead purchases.
– Use performance-based milestones and tie portions of fee to objective performance metrics.
– Specify disallowed costs and require certification that invoices exclude them.
– Include strong termination and cure provisions to limit open-ended exposure.
Common contract variants — concise definitions
– Cost-Plus-Fixed-Fee (CPFF): Owner pays actual allowable costs plus a fixed fee. The fee does not change with cost over-
runs; the contractor’s fixed fee remains the same whether costs underrun or overrun.
Cost-Plus-Incentive-Fee (CPIF): Owner pays allowable costs and an incentive fee that increases or decreases based on performance against a target cost (and sometimes technical or schedule targets). The fee adjustment is set by a share ratio that allocates cost savings and overruns between owner and contractor, and often includes a fee ceiling.
Cost-Plus-Award-Fee (CPAF): Owner pays allowable costs plus an award fee that is discretionary and based on subjective evaluation of criteria such as quality, responsiveness, innovation, or customer satisfaction. Award fees are not formulaic; they’re determined by a board or designated officials against pre‑published criteria.
Cost-Plus-Percentage-of-Cost: A fee calculated as a percentage of the costs. This variant is rare or prohibited for many public-sector contracts because it creates a perverse incentive to increase costs.
Guaranteed Maximum Price (GMP) — hybrid: A cost‑reimbursable arrangement may include a guaranteed maximum price that caps owner exposure. Costs above the GMP may be absorbed by the contractor unless explicitly allowed in the contract.
Advantages and disadvantages — concise
Advantages (for owners)
– Flexibility to accommodate scope change and unforeseen conditions.
– Useful when defining a firm price is impractical (novel technologies, early design stage).
– Easier to attract contractors when risk is high and uncertainty large.
Advantages (for contractors)
– Reimbursement of allowable costs reduces downside risk.
– Predictable recovery of direct costs; administrative fee covers some overhead.
Disadvantages (for owners)
– Potentially weak cost control if incentives are poorly designed.
– Higher administrative burden: audits, cost monitoring, and approvals.
– Risk of paying for inefficiencies without strict contract controls.
Disadvantages (for contractors)
– Administrative reporting burden and open-book exposure.
– Cost controls and disallowed costs reduce recoverable amounts.
– Fee may be fixed or limited, constraining profit if costs escalate.
When to use cost‑plus contracts
– Early-stage development, R&D, prototypes, or technologies with high uncertainty.
– Projects where scope is expected to change frequently or is hard to define.
– Situations where owner needs technical collaboration and transparency.
When to avoid
– Mature, repeatable work where costs and scope can be estimated reliably.
– Low-risk projects where fixed-price procurement yields stronger cost discipline.
Negotiation and drafting checklist — items to insist on
1. Define “allowable costs” clearly and reference applicable cost principles (e.g., FAR/GAAP/CAS).
2. Establish a target cost, target fee, and share ratios for CPIF. Specify floors/ceilings for fee.
3. Require detailed invoicing: monthly cost reports, backup invoices, time sheets, and subcontract details.
4. Reserve audit and inspection rights (frequency and scope) and specify who bears audit costs.
5. Pre‑approve large subcontracts, capital equipment, and long‑lead items.
6. List disallowed costs (e.g., entertainment, unrelated corporate expenses, penalties).
7. Include termination for convenience and default clauses with clear cure periods.
8. Add holdbacks or retention tied to milestones or final acceptance.
9. Specify performance metrics and link some fee to objective measures where possible.
10. Require use of an Earned Value Management System (EVMS) on large contracts if applicable.
Monitoring and control — step-by-step
1. Establish baseline: approve the initial cost breakdown and budget.
2. Monthly reporting: receive cost reports with variance explanations and supporting documents.
3. Reconcile incurred costs to invoices and bank records each billing cycle.
4. Trigger audits on variance thresholds or at pre-set intervals.
5. Review subcontract awards against pre-approval thresholds.
6. Implement change-order review for scope changes and adjust target cost and fee if agreed.
7. Hold periodic performance reviews tied to award/incentive fees.
Worked numeric examples
Example A — Cost‑Plus‑Fixed‑Fee (CPFF)
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