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.

👉🏻 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 “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.