The Quick Guide to Cost-Plus Contracts for Construction

The construction industry places a lot of risk on the shoulders of contractors, and the unexpected can quickly eat into your profit margin. If you’re looking for a type of contract that reimburses you for all costs associated with the project – plus a fee to cover your overhead and profit – then look no further.

Key Takeaways

• This contract reimburses you for the cost of the work plus your standard markup.
• It reduces the amount of risk to you.
• You collect a guaranteed amount for performing the work vs. a reduced fee in a contract type like lump sum/fixed price contracts when project costs exceed expectations.
• It does not account for a contractor’s mistakes or negligence.

How Cost-Plus Contracts Work

A cost-plus contract requires the owner to reimburse direct costs and then pay an additional fee that covers your markup. While that may seem like a win-win for your side of the deal, it’s important to understand that a cost-plus contract isn’t a blank check (spend as much as you want and we’ll pay you back). Most of the time, these contracts require a good-faith estimate of the scope of work and cost of the project. Granted, not all scopes are well defined, hence why cost-plus contracts are attractive to contractors. Your ability to communicate additional costs that go beyond your initial estimate and the reasoning for them will be critical for maintaining trust with the owner.

Here’s a breakdown of how the two categories of costs work in a cost-plus contract:

Project Costs

• Direct costs include: labor costs, material costs, subcontractor profit, expenses, allowances, and change orders. Any cost must be presented for cost reimbursement to owner. This type of contract will protect you from the danger of cost overruns, as long as you can show appropriate reasoning and documentation to the owner.

Contractor Markup

• Your markup can either be charged as a percentage of the total project cost OR as a fixed fee for overhead costs and profit on top of the project costs. Other types of fee arrangements include incentive fees and award fees. There isn’t a formula that will tell you exactly when to use a percentage or a fixed fee, but it’s best to first understand the scope of work and the profit margin you want to achieve for performing the work.

The key to success with these types of contracts is to provide an accurate estimate at the onset of the project so you come close to (or better yet, below) the original estimate once you close the books on the project. This builds trust with the owner and set you up for more work in the future.

Types of Contractor Fees

When determining the fee structure to use for your markup, you have a few options.

• Percentage of cost – This can vary from project to project based on scope and costs, but this type of fee ensures an equal markup percentage of the total project cost.
• Fixed fee – This is a flat fee where you as the contractor say “I need to make $x for performing the scope of work.”
• Incentive fee – Set by the owner and agreed upon by you as the contractor, if you meet targets like finishing the project ahead of schedule or if the owner sees some cost savings (from value engineering or other methods), you will receive certain financial incentives based on a predetermined fee.
• Award fee – On top of the predetermined fee, the award fee is given if you exceed the owners expectations based on the original contract.

Pros + Cons of Cost-Plus Construction Contracts

Advantages of a Cost Plus Contract

• Since your fee is predetermined, you take on less risk as your profit is calculated separately from the scope of work.
• Cost-plus contracts sometimes use incentivized fees, which means more money in your pocket and a happy owner. These incentives are often based on you working faster or below budget.
• Cash flow is not a burden as costs are directly reimbursed. It is important to negotiate payment terms at the onset of the contract signing so you don’t encounter cash flow issues down the road.
• Typically leads to more trust between you and your owner as it is a bit more open-book.

Disadvantages of a Cost Plus Contract

• You must fully understand the definition of project costs in the contract as some costs may not be considered reimbursable. If denied, this will eat into your markup.
• Cost tracking and documentation is crucial as you will need to provide sufficient documentation to the owner for each pay application.
• There is the potential for change order disputes due to deviations from the original scope.

Uses for a Cost-Plus Contract

Generally, owners will engage a contractor in this type of contract when they’re more concerned about the overall project timeline than nitpicking the budget. Understanding the project documents are not fully complete, they want quick negotiations and a general estimation to understand the costs before they kick off the project. This makes it impossible for you to predict the final cost of the project, so make sure to provide a detailed scope of work so the owner is clear on which expenses are included.

While this contract type is most common between contractors and the project owner, you can also use this type of contract with specialty contractors. But be sure (when reporting the final projected sum of the project to the owner) to include some allowances in your accounting to account for inconclusive project scope and detail.

How a Cost-Plus Contract Affects Profitability

First and foremost, cost-plus contracts guarantee a certain percentage (or fixed dollar amount) of profit. It’s your responsibility throughout the project to monitor line item for cost overruns based off the estimation originally provided to the owner. For example, if you provide a cost of X for millwork but it actually comes out to X + 2, the negotiation between you and the owner gets tough and often leads to taking the money from your profit.

Most of these contracts also include a cap on either total expenditures or your fee which in turn can impact your profit. For example, if you estimate the cost to be $1M plus a fixed fee of 10%, the owner might put a cap on total expenses at $2M and not allow for further profit above said number. The contract can also have a de-escalated fee where at $1M it is 10%, $1-2M is 8% and $2M+ at 5%.

Final Thoughts

Cost-plus contracts have a lot of positives for construction companies, but you have to be diligent about providing an accurate estimate and documenting all costs. This will help you avoid some of the most common issues with this type of contract, like disputes over change orders if the project owner feels like the actual costs are nearing (or exceeding) the original estimate. Project documentation is essential to show the original scope of work for the construction project and the reason for the changes so the owner doesn’t think you are pulling a fast one on them.