If you are looking for a type of contract that reimburses you directly for all (yes ALL) costs associated with the assigned project – plus a fee which takes into account your overhead and profit – then look no further. A cost-plus contract may at times be at a higher cost than other contracts, due to owners wanting to get the project moving quickly. This is usually due to unclear scope and the request from you as a contractor to provide an estimate without knowing the full scope of work.
This contract reimburses you for all costs plus your standard markup
Easier to negotiate as you will have less risk due to direct reimbursement of project costs
Guaranteed fee (type is defined below) for performing the work vs. a reduced fee in a contract type like lump sum when project costs exceed expectations
Do not account for contractor’s mistakes or negligence
In this Article
What is a Cost-Plus Contract?
A cost-plus contract requires the owner to reimburse direct (also called project) costs and then pay an additional fee which 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 is not 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. Granted, not all scopes are well defined, hence why cost-plus contracts are attractive to contractors.
Here’s a breakdown of how the two categories of costs work in a cost-plus contract:
- Direct costs include: labor, materials, subcontractor profit, expenses, allowances and change orders. Any cost must be presented to and then reimbursed by the owner. This type of contract will protect you, if you show the appropriate reasoning for the costs, as the owner is required to reimburse you for project costs.
- Your markup can either be charged as a percentage of the total project cost OR as a fixed overhead and profit on top of the project costs. Other types of fee arrangements include incentive fees and award fees. There is no formula that will tell you exactly when to use a percentage or a fixed fee, but it is best to first understand the scope of work and the profit margin you are looking to achieve for performing the work.
It is in your best interest to provide an accurate estimate at the onset of the project as if 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 will hopefully lead to more work in the future.
👉🏻 Need a refresher on the other contract types? Check out our guide to the 8 types of construction contracts.
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 it 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 save costs (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
- 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.
- 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 are concerned about the overall project timeline versus 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 expenses, 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 speciality 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, it guarantees a certain percentage (or fixed) of profit. It’s your responsibility throughout the project to monitor line item costs based off the estimation originally provided to the owner, as this could backfire. 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 toughand often leads to taking the money from your profit.
Most of these contracts also include a cap on either total expenses 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%.
Cost-plus contracts have a lot of positives for contractors, 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 is feeling like the actual costs are nearing (or exceeding) the original estimate. Project documentation is essential to show the original scope of work and the reason for the changes so the owner doesn’t think you are pulling a fast one over their head.
Jarone started his construction career working for a commercial general contractor in Los Angeles, before transitioning to being an Owner’s Representative for the past eight years. Jarone has led multiple projects and has been integral in cross-departmental communication and implementation of processes with design, leasing, planning and facilities/operations teams. From preconstruction, which included dealing with landlord work letters, General Contractor interviews, bidding and scope buyout, to construction and managing the General Contractor and other vendors, to eventually punch and close out, Jarone has consistently delivered projects on time and within budget.