What is a Cost Plus Construction Contract? Uncovering the Secrets of Flexible Building Budgets

Uncertainty, variability, and price changes are legitimate concerns in the construction industry. When prices go up, supply chains get disrupted, a shortage of key workers, and unexpected site problems pop up, it becomes hard to predict the final project costs.

For this, project owners and contractors prefer using cost plus construction contracts when executing a project whose scope is uncertain, dynamic, or subject to change. Think of a project to renovate historical buildings with hidden structures or outdated materials. Or, upgrading a sewer system whose underground conditions are unknown. 

Then, how do cost plus construction contracts work? 

Our quick guide offers an overview of a cost plus construction contract, highlighting its advantages and disadvantages. Also, we share valuable tips on how both the owner and contractor can safeguard themselves from the potential challenges of such contracts. Then, we list best practices for overseeing a cost plus construction agreement to guarantee positive project outcomes. 

Let’s dive in!

What are Cost Plus Contracts?

Cost plus contracts, also known as cost-reimbursement contracts, are legal construction agreements whereby the project owner commits to reimbursing the actual costs associated with the project plus a predetermined fee or profit. Such contracts apply to projects whose final cost is difficult or impossible to determine at the onset. 

A cost plus contract example occurs when constructing a custom home whose final costs are unknown. Here, the client reimburses the contractor for the costs incurred plus an additional sum for performing the services outlined in the scope of work. Accordingly, the contractor has to maintain records and provide a breakdown of the total cost to justify the agreed reimbursement. 

Components of Cost Plus Contracts

Cost plus contracts follow the basic idea that the final project cost is uncertain from the onset. Here, the contractor cannot estimate the direct and indirect costs, profit, or contractor’s fee as detailed below: -

Direct Costs

A cost plus construction contract refunds the contractor for actual wages, salaries, and benefits of direct workers. Likewise, the owner pays for material costs, direct supplies, equipment, and additional components vital to executing the project. Plus, it caters to subcontractor fees hired for specialized tasks like installing electrical fixtures, maintaining climate control systems, and complex decorative finishes.

Indirect Costs

Typical overhead costs covered by a cost plus contract include general and administrative expenses for the construction business, insurance coverage for workers, rental, and maintenance of vital equipment, and project management expenses.

Profit Margin or Contractor’s Fee

The profit margin in a cost plus construction contract covers the contractor's income. It can be a flat fee, a percentage of actual costs, or a custom amount agreed between the contractor and the project owner before the construction project begins.

The contractor must keep accurate records and control costs. Further, they must be transparent by regularly updating the project owner about these costs. It ensures the owner pays fair compensation for the completed work. 

Types of Cost Plus Contracts

Generally speaking, five different categories of cost-plus contracts vary depending on the agreed-upon additional fee. Check them out below: -

Cost Plus Award Fee (CPAF)

The Cost Plus Award Fee (CPAF) contract provides for a contractor’s fixed price in addition to the reimbursable costs. The award fee relates to how the client assesses the contractor’s ability to meet the predetermined performance criteria. 

CPAF contracts are ideal for construction projects with demanding deadlines and objectives like attaining cost or energy efficiency, strict safety standards, and exceptional craftsmanship. 

For example, a contractor may use CPAF to bid for a transportation hub project with stringent timelines and safety standard targets.

Cost Plus Fixed Fee (CPFF)

As the name suggests, the Cost Plus Fixed Fee contract (CPFF) reimburses the contractor for the actual costs plus a fixed price. This fixed fee remains constant regardless of any unanticipated costs. 

CPFF contracts are suitable when the project owner prefers a straightforward approach in reimbursing the cost of the project and ensuring the contractor receives a specified remuneration, especially for projects with uncertain scope or design. 

For instance, contractors involved in a post-disaster reconstruction project opt for CPFF contracts to ensure they receive payment despite the unpredictable nature of their work. It is a secure option for project owners who want to ensure they pay for the total cost of the reconstruction.

Cost Plus Incentive Fee (CPIF)

Cost Plus Incentive Fee (CPIF) is similar to CPAF. Indeed, both construction contracts cover the final cost and a negotiated fee or profit. However, whereas the award fee in a CPAF construction project relies on the client’s assessment of the contractor’s performance, CPIF has an incentive fee for meeting or exceeding mutually agreed targets. Hence, preset performance targets are vital in CPIF. 

As an illustration, a CPAF contract could reimburse a contractor for renovating HVAC systems to create an energy-efficient home that meets the Leadership in Energy and Environmental Design (LEED) certification standards.

By connecting the stimulus pay to a target agreed upon by both parties, CPAF fosters collaboration between the contractor and the project owner.

Cost Plus Percent of Cost (CPPC)

Cost Plus Percent of Cost (CPPC), also referred to as Cost Plus Percentage Fee (CPPF), reflects the contractor’s profit as a percentage of the actual project costs. 

For instance, a CPPC construction bid may allocate 10% of the allowable project costs as the contracts pay. 

CPPC can be detrimental to a project owner who works with inefficient or fraudulent contractors who inflate project costs like office supplies and other overhead expenses. No wonder Federal government agencies prohibit contractors from using this type of cost plus contract when bidding for government construction projects, citing high incidences of fraud. 

Then, is CPPC ever favorable to the project owner? 

Yes.

Project owners should engage reputable contractors known to execute complex projects using these contract types. They rely on mutual trust to complete the project professionally and accurately, with minimal cost overruns. 

Cost Plus Fixed Rate

Cost Plus Fixed Rate or Cost Plus Fixed Percentage (CPFP) is a contract type that reimburses the contractor a fixed percentage of the estimated cost as profit. It is a variation of the CPFF, pegging the contractor’s profit on the actual project costs while cushioning the project owner against excessive cost overruns. 

To illustrate this, a construction project using CPFF can assign $40,000 as a contractor's fixed fee. If this project has $400,000 as actual project costs, a CPFP with 5% as the fixed rate will pay the contractor $20,000. 

Like the cost plus percent-of-cost (CPPC), CPFP requires working with reputable contractors who keep tabs on their project costs.

Apart from these five categories of cost plus contracts, a contractor may opt for a contract type that combines the benefits of a cost plus contract with a guaranteed maximum price contract (GMP). Hence, the Cost Plus Guaranteed Maximum Price (CPGMP) pays the actual project costs and a predetermined fee whose total should not exceed a set price. Project owners using CPGMP undergo less risk despite the undefined scope of work.

Advantages of Cost Plus Contracts

Cost plus contracts are an excellent alternative to fixed price contracts. They present numerous benefits to both the project owner and contractor, as detailed below: -

Flexibility in Project Management and Adjustments

A cost plus contract allows changing the project scope, budget, and timeline to adapt to unforeseen challenges and uncertainties. For example, there is no need for extensive contract renegotiation or dispute resolution process over contractor's overhead when adding a new floor to a commercial complex, utilizing the latest technological advancements for building a groundbreaking specialized laboratory for scientific research, or allocating more resources to troubleshoot a plant construction project. 

Coverage of All Related Expenses and Risks for the Contractor

A cost plus contract covers all allowable project costs while providing a markup or contractor’s fee. Hence, this cost plus arrangement cushions the contractor from losses due to an uncertain or evolving project scope.

Second, the contract allocates risks like cost overruns, inefficiencies, project delays, and poor subcontractor performance to the contractor to cushion the project owner from excessive losses, if any.

Suitability for Projects with Undefined Scopes

Contractors that use a cost plus contract facilitate future modification of cost estimates and contract prices to accommodate new project scopes and specifications. This flexibility is advantageous when executing future projects with an undefined scope or unclear estimated construction budget. Such projects include constructing smart cities and cultural centers, restoring historical buildings, urban redevelopment, and hospital wing renovations. 

Encouragement for High-Quality Work and Materials

Under a cost plus contract, a contractor focuses more on delivering work of the utmost quality instead of worrying about rigid budget constraints. They can choose premium materials and advanced construction techniques that guarantee superior outcomes. Hence, the contractor can adopt best practices and technologies to deliver the best possible results. It is a win-win approach since the project owner is assured of positive project outcomes, and the contractors build their reputation in the industry.  

Disadvantages and Risks

Whereas a cost plus contract is cost-oriented, the structure of the construction industry and the nature of the bidding process are often market-oriented. In turn, a cost plus agreement poses the following setbacks and risks:

Potential for Higher Overall Project Costs

The uncertainty surrounding the project scope and timeline can lead to inflating the contractor’s expenses in a cost plus agreement. Indeed, without an incentive for saving costs, there is a high risk of estimating errors and overcharging the fixed cost to the contractor. 

Lack of Incentive for Cost Savings and Control By the Contractor

Contractors that use a cost plus agreement like the Cost-Plus Percent-of-Cost (CPPC) lack the motivation for managing projects that minimize costs. In turn, they are less inclined to adopt cost-saving strategies as these could mean the contractor receives lesser pay. 

Uncertainty in Final Project Costs for the Owner

Project owners struggle to control costs due to uncertainties in cost plus contracts. Without accurate cost estimates from the start, they project is prone to cost overruns or delays due to shortage of vital resources. 

Risk of Disputes Over Construction-Related Expenses

Uncertainties associated with a cost plus contract can result in disputes over what qualifies as an allowable project cost. For example, a cost plus contract using ambiguous terms to define reimbursable expenses is an avenue for client-contractor misunderstandings. Without proper record keeping practice or a concrete dispute resolution plan, such disagreements can tarnish the contractor’s reputation and potentially lead to legal damages, fines, and penalties. 

Challenges in Project Timeline and Budget Management

An unclear project timeline makes it almost impossible to allocate funds to a cost plus contract efficiently. In turn, the project owner struggles to create financial projections for future projects and has a lower negotiation power during the contract formation.

Protecting Yourself in a Cost-Plus Contract

A 2018 study on the effects of inaccurate cost estimation on construction project stakeholders indicates that contractors risk jeopardizing their reputation and credibility and losing profit. And project owners can incur losses due to the misallocation of scarce resources. For this, the stakeholders need to have effective strategies to mitigate risks as follows: -

Importance of Detailed Documentation and Accurate Record Keeping

Proper documentation and adequate record keeping ensure the contractor can substantiate all reimbursements claimed at project completion.

Setting Clear Terms and Conditions in the Contract

Projects with uncertain scopes and timelines should have clear terms and conditions to set the boundaries as a basis for cost estimation and control. The boundaries eliminate risk of misinterpretation, disputes due to changes in project requirements, and inadequate documentation.

Communication and Transparency Between Parties

Contractors should schedule regular meetings to update the project owner about the project. Also, they should invest in accounting software for accurate record keeping and real-time updates of the cost estimates to keep all parties on the same page throughout the project execution.

Establishing Caps or Limits on Costs

Setting limits on allowable costs minimizes contractor's risk like cost overruns, wastages, and fraudulent practices. For example, a project owner can define the threshold for change order limits and hourly rates ensures the contractors receive reimbursement for a reasonable compensation structure.

A Cost Plus vs. Fixed Price Contract

A fixed price contract or lump sum agreement reimburses the contractor for a fixed price for the entire project determined during the bidding process. In contrast, a cost plus contract compensates the contractor based on the true costs and a profit margin.

Second, a project owner assumes the most risk in a cost plus contract. On the other hand, the contractor bears unexpected costs in a lump sum agreement.

Third, a cost plus contract allows for greater flexibility in response to the project uncertainties. While altering a fixed price contract may call for fresh negotiations between the contractor and project owner.

Next, a contractor using a lump sum agreement is motivated to save on costs and maximize profit from the fixed price. However, these professionals are less keen in controlling costs associated with a cost plus contract. In some instances, they may inflate the costs to earn a higher percentage of the cost as profit.

Finally, a cost plus contract is appropriate for complex projects with uncertain scopes and timelines. A lump sum agreement works best for straightforward, predictable projects requiring minimal record keeping.

Best Practices for Managing Cost-Plus Contracts

Contractors who opt for a cost plus contract should adhere to best industry practices in managing the projects. Such an approach guarantees effective project management, better cost management, optimum risk mitigation, transparency and accountability between the contractor and the project owner, legal compliance, and continuous improvement. 

Here are four best practices contractors and project owners can adopt when using cost plus contracts:

Effective Management of Cost Plus Contracts

• Define the project scope, setting adequate provisions for the anticipated uncertainties.
• Outline the standard operation procedures (SOPs) for change of order processes.
• Document and report all allowable costs for trust and transparency.
• Conduct regular project audits and reviews to update the project scope and make necessary adjustments for emerging challenges.
• Add incentives to a cost plus construction contract to reward cost savings and early project completion.

Ongoing Communication and Collaboration

• Define the preferred communication protocols and channels to keep all stakeholders up-to-date with the project milestones.
• Invest in cloud-based document management systems like Aconex Oracle (Aconex Oracle Construction and Engineering Cloud) to centralize project management and collaborate with teams on a real-time basis.
• Designate project liaisons who will serve as the primary point of contact between the contractor and the project owner, subcontractors, environmental agencies, government regulators, and local communities.
• Hold regular meetings to discuss and align project milestones with client expectations and address any concerns from stakeholders.

Monitoring and Controlling Project Costs

• Utilize the regular project meetings to review the total costs.
• Invest tools to track, budget, forecast, report, analyze costs, and manage change order processes.
• Benchmark the allowable costs against industry averages from such sources as RSMeans Data, Engineering News-Record (ENR), Dodge Construction Network, and U.S. Bureau of Labor Statistics (BLS).

Utilizing Technology and Software for Tracking and Reporting

• Invest in a project portfolio management tool like Oracle Primavera for real-time cost tracking, task scheduling the tasks, and performance analysis.
• Utilize integrated solutions like Sage 300 Construction and Real Estate to streamline complex projects, access custom reporting tools, and track and manage costs across all project phases.
• Use bidding software like B2W Estimate for a head start in the construction bidding process.

Conclusion

Cost plus construction contracts are incremental, flexible, transparent, and allow risk-sharing between the contractor and the project owner. They emphasize on the effect of market conditions on cost estimates and markup values. Hence, project owners and contractors should adopt strategies that guarantee best practices to minimize associated risks and the ascertain project success.