Construction projects require a formal agreement between the owner and the contractor to define responsibilities, scope, and payment. The specific type of contract chosen greatly influences the financial outcome and risk profile for both parties. The Cost Plus model is frequently employed, but it is often misunderstood. This article clarifies the operational mechanics and business implications of this arrangement.
Defining the Cost Plus Construction Contract
The Cost Plus agreement shifts the payment basis away from a single predetermined price. Under this model, the owner commits to reimbursing the contractor for all verified costs incurred during construction. These expenditures must be legitimate and directly related to the project, such as procuring materials or paying for labor hours.
Beyond these reimbursed expenses, the contractor receives an additional, agreed-upon fee designed to cover overhead and profit margin. The final price is the sum of the actual project costs and the pre-negotiated fee, ensuring the contractor is compensated for real-world spending.
The Structure of Cost Plus Contracts
The total financial obligation is composed of reimbursable costs and the contractor’s fee.
Reimbursable Costs
Reimbursable costs represent the direct, documented expenses of construction. These include wages paid to workers, the purchase price of materials (lumber, steel, concrete), and rental costs for heavy machinery. The contractor typically pays these expenditures first and then submits them to the owner for verification and repayment.
Contractor’s Fee Structure
The contractor’s fee accounts for non-project-specific overhead and the company’s profit. Overhead includes costs like corporate office rent, administrative staff salaries, and general insurance not directly attributable to the job. The fee can be structured in two main ways: as a fixed fee or as a percentage of the total reimbursable costs.
A fixed fee provides a stable profit incentive that does not increase if project costs escalate. Conversely, a percentage fee arrangement means the contractor’s profit grows directly with the project’s expenditures. The contract must strictly define allowable costs, distinguishing project-related expenses from non-allowable costs, such as personal travel.
Guaranteed Maximum Price (GMP)
A major structural modification designed to address owner risk is the Guaranteed Maximum Price (GMP) variation. Under a GMP contract, the parties agree on a maximum total price the owner will pay, including estimated costs and the contractor’s fee. If actual costs exceed this guaranteed amount, the contractor covers the difference, capping the owner’s financial exposure. If actual costs are under the GMP, the savings are often shared between the owner and the contractor according to a pre-agreed formula, providing an incentive for efficiency.
Advantages of Using Cost Plus Contracts
This contracting method offers a high degree of financial transparency. Because the contractor is reimbursed for actual expenditures, they operate under an “open book” policy, providing detailed documentation and receipts for all costs incurred. This transparency allows the owner to track spending in real-time and verify that funds are used appropriately for the project scope.
The arrangement also introduces flexibility for the project’s design and execution. Since final costs are not fixed, the owner can request design changes or material upgrades during construction without the burdensome renegotiation process common in fixed-price agreements. This responsiveness allows the project to evolve as new information or owner preferences emerge.
The Cost Plus structure facilitates a faster start to construction, often termed “fast-tracking.” Detailed engineering and design plans do not need to be 100% complete before work begins. Initial site work and foundation laying can commence while later design elements are finalized, significantly reducing the overall project timeline.
Disadvantages and Risks of Cost Plus Contracts
The primary financial drawback for the owner is the inherent risk of cost overruns, which they largely bear in a standard Cost Plus arrangement. If the contractor’s expenditures for labor or materials increase due to unforeseen circumstances, the owner is obligated to pay the higher final price. This lack of initial price certainty complicates budget planning and financial approvals.
The contract also places an increased administrative burden on the owner or their representative. To ensure only legitimate expenses are paid, the owner must implement rigorous auditing procedures to review every invoice, receipt, and payroll record submitted by the contractor. This continuous verification process requires dedicated time and resources throughout the construction period.
Conflicting interests can strain the owner-contractor relationship. Since a percentage-based fee structure rewards the contractor with higher profit as costs increase, there is a disincentive for the contractor to pursue the most economical options. Disputes often arise when the owner questions the necessity or efficiency of certain expenditures.
When to Use a Cost Plus Contract
Cost Plus contracts are best utilized in specific scenarios:
- When the scope of work is complex or not fully defined at the outset.
- When new technology or experimental design makes accurate cost estimation nearly impossible.
- When rapid mobilization is required, such as in fast-track construction scenarios.
- When a high degree of mutual trust and a long-standing relationship exists between the owner and the contractor.
The flexibility of this structure allows project requirements to be finalized as work progresses and technical challenges become clearer. If the owner needs to start construction immediately to meet a tight deadline, preliminary elements can begin before the full design is complete. Trust between parties mitigates concerns about efficiency and the need for excessive cost auditing.
Key Differences from Fixed-Price Contracts
The fundamental distinction between a Cost Plus agreement and a Fixed-Price (or Lump Sum) contract lies in the allocation of financial risk. In a Fixed-Price contract, the contractor agrees to a single, predetermined amount and absorbs the financial risk of cost increases. Conversely, the Cost Plus structure places the risk of rising costs squarely on the owner, who pays for the actual expenditures.
The incentive for efficiency differs significantly between the two models. Under a Fixed-Price contract, the contractor is motivated to complete the work efficiently because cost savings directly increase their profit margin. In a standard Cost Plus agreement, the contractor’s incentive is less tied to cost reduction, especially under a percentage fee model where higher spending results in higher profit.
Transparency in billing is a major point of contrast. Fixed-Price contracts offer low financial transparency once the price is set, as the owner typically does not see the contractor’s underlying cost breakdown. The Cost Plus model demands complete transparency through the “open book” policy, requiring documentation for every dollar spent.
The impact on change orders also separates the two structures. In a Fixed-Price contract, any scope change requires a formal change order, often leading to time-consuming negotiations over price and schedule. The Cost Plus model handles changes more fluidly, as the owner simply pays for the actual costs associated with the revised scope, streamlining modifications.