Key Takeaways

  • A cost plus percentage of cost contract reimburses a contractor for actual project costs plus a fixed percentage markup as profit.
  • These contracts are common when project costs are uncertain or likely to change during the work.
  • Benefits include flexibility in project scope and material choices, but they can create budget unpredictability for buyers.
  • Markup percentages vary based on market conditions, job type, and location, and can be higher for complex or regulated projects.
  • Costs typically include labor, materials, subcontractor fees, equipment use, and other direct and indirect expenses.
  • U.S. federal law restricts the use of these contracts in certain government projects due to the risk of inflated costs.
  • Clear documentation, expense verification, and agreed-upon limits are essential to avoid disputes and cost overruns.

Cost-plus percentage of cost is a method contractors often use to price services. This type of contract specifies that the buyer must pay all the project costs incurred by the seller, plus an additional amount for profit.

Products such as purses and services such as car detailing have fixed prices. Other services and projects, such as home remodels, have variable costs that are hard to predict. These depend on the cost of materials. Any changes or additions made while the work is being done might increase that expense. The cost plus percentage contract ensures contractors are reimbursed for the actual expenses they incur, rather than allowing for a fixed price that covers everything.

The cost-plus contract is also referred to as the cost-reimbursement contract. It includes a percentage cost on top of the seller's costs for their overhead. That way, the seller can make a profit from the transaction.

When Are Cost-Plus Contracts Used?

Cost-plus contracts are appropriate to use when it's difficult to determine the cost of items or estimate a project's cost in advance. These contracts place some of the risks of overhead expenses on the buyer rather than the seller.  

Contractors often use cost-plus contracts when doing custom work or a type of work that is subject to frequent changes. In such cases, it is difficult to determine how much the contractor needs to spend on supplies ahead of time.

Some contractors use a cost-plus time contract, instead. This also varies and is based on how much time a job takes.

Restrictions in Government Contracts

Under U.S. federal law, cost plus percentage of cost contracts are generally prohibited in government procurement because they provide little incentive to control costs and can lead to inflated spending. For example, 10 U.S. Code § 3322 restricts the Department of Defense and other federal agencies from using such contracts except in limited, statutorily defined circumstances. In these rare cases, strict oversight and justification are required to ensure costs are reasonable. Contractors working on federally funded projects should be aware of these limitations before proposing this pricing method.

Benefits and Disadvantages

One drawback to cost-plus percentage contracts is they don't provide sellers with an incentive to keep costs low. However, clients usually ask for a list of expenses so they can verify the amount they are paying. This means the seller must keep careful track of everything spent and only bill for reasonable costs.

Cost-plus percentage contracts benefit the seller when the job he or she is doing requires buying a lot of materials. If the cost of supplies is minimal, there's no point in using this type of contract.

The disadvantage to the seller is that when a job requires extra time due to difficulties or unexpected occurrences, they won't be paid for the extra time because their material costs remain the same.

The time issue is a benefit to the buyer, however. Buyers don't need to worry about how long the project is taking because they will pay the same amount even if it takes longer than expected to complete.

If more material is needed, however, the cost will be higher; this is a disadvantage for the buyer. It becomes more difficult to budget for a project like this since the price might change as the project goes along.

Managing Risk in Cost Plus Percentage Contracts

While these contracts offer flexibility, they also carry risks that need active management:

  • Detailed Recordkeeping: Maintain clear documentation of all direct and indirect costs to build trust and support invoicing.
  • Expense Verification: Allow buyers to audit receipts and time logs to prevent disputes.
  • Defined Scope Controls: Even in flexible projects, include scope boundaries to prevent unnecessary cost growth.
  • Performance Incentives: Consider adding performance-based bonuses or cost-sharing clauses to encourage efficiency.

Proactive management helps offset the lack of inherent cost-control incentives in this contract type.

How Much Is the Markup Percentage?

There is no standard amount of markup percentage cost. This can vary depending on:

  • Market conditions
  • Job type
  • Location

Areas such as California or New England that have complicated building regulations typically have higher markup percentages than the Midwest for construction jobs. And remodeling markup is usually higher than new construction. Markup might also be higher when contractors are in high demand.

Factors That Influence Markup Negotiations

Several factors can influence the agreed-upon markup percentage in a cost plus percentage of cost contract:

  • Complexity of Work: Specialized or technically demanding projects often justify higher markups.
  • Risk Level: Projects with unpredictable material prices or labor availability may command higher rates.
  • Regulatory Compliance: Projects subject to strict safety or environmental regulations may increase contractor overhead.
  • Market Demand: A shortage of qualified contractors can drive markup percentages higher.

Negotiating a fair markup should balance contractor profitability with buyer budget constraints.

What Costs Are Included?

For a cost-plus percentage contract to work well, the contractor must provide all costs of materials purchased upon giving you the invoice. When providing the initial estimate, the contractor should list all costs that will be included in the bill. These typically include:

  • Costs of employees, including taxes, workers' compensation, and other benefits.
  • Subcontractor expenses.
  • Materials used in the project.
  • Bits, blades, and other consumable equipment.
  • Dumpster rental.
  • Vehicle expenses, such as rentals or fuel.
  • Insurance costs.
  • On-site supervision and security.

Indirect Costs and Overhead Considerations

In addition to direct costs like labor and materials, contractors often include indirect costs in their reimbursement. These may cover:

  • Office administrative expenses
  • Project management salaries
  • Equipment depreciation
  • Accounting and legal fees
  • Safety and compliance programs

Including indirect costs should be clearly defined in the contract to avoid disputes over what is reimbursable.

Warnings About Cost Plus Percentage Contracts

Often, cost-plus contracts are used by contractors who are not skilled at making estimates or don't want to bother creating detailed bids. To avoid exorbitant costs and disputes:

  • Make sure the plans are as complete as possible.
  • Get a fixed bid for as many parts of the project as you can.
  • Try to include a “not to exceed” limit in the contract.

Frequently Asked Questions

  1. Why are cost plus percentage of cost contracts banned in most U.S. government projects?
    They are banned to prevent excessive spending and cost inflation, as the contractor’s profit increases with higher costs.
  2. Can a cost plus percentage of cost contract include indirect expenses?
    Yes, but these must be clearly outlined in the contract to avoid disputes over reimbursement.
  3. How is the markup percentage determined?
    It depends on factors like project complexity, risk, location, and market demand.
  4. What is the main advantage of this contract type for contractors?
    It ensures reimbursement for actual expenses plus a guaranteed profit margin, even if costs rise.
  5. How can buyers manage costs under this contract model?
    By requiring expense verification, setting “not to exceed” limits, and defining the project scope clearly.

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