Episode 138 - Cost Plus Contract

This week we will be talking about Cost Plus Contracts. This episode content meets PC5 - Building Procurement of the Part 3 Criteria.

Resources from today's episode:

Websites:

• https://downtobid.com/blog/cost-plus-construction-contract
• https://www.procore.com/library/cost-plus-contracts

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Transcript

Episode 138:

Hello and Welcome to the Part3 with me podcast. 

The show that helps part 3 students jump-start into their careers as qualified architects and also provides refresher episodes for practising architects. I am your host Maria Skoutari and this week we will be talking about the Cost Plus Contract. Todays episode meets PC5 of the Part 3 Criteria.

Make sure to stay until the end for a case study example. 

What is a Cost Plus Contract in Construction:

A cost-plus contract, also known as cost-reimbursement contracts, provide reimbursement for all of the costs associated with a construction project, plus a fee to account for the contractor’s overhead and profit. 

Clients tend to select this type of contract when they want to get a project moving quickly or when  the scope of work is unclear which makes it difficult to estimate the total cost. 

Essentially, under the cost plus contract, the client agrees to pay the actual costs incurred by the contractor plus the additional fee for their overheads and profits. Something clients need to bear in mind is that cost plus contracts may ultimately lead to a higher cost of the overall works than it would be with other fixed cost contract types, placing a higher financial risk to the client. 

It is a faster route to completion and provides greater quality control from the client side as they tend to have more involvement and control over project decisions and changes, but at the expense of cost uncertainty. This type of contract bears less risk to the contractor and is easier for them to negotiate because of this. 

Cost plus contracts are generally most suitable when:

• The project scope is uncertain or likely to change
• Fast-tracking is required, with construction starting before design is complete
• The project involves new or experimental techniques
• Emergency work is needed with little time for detailed planning

So the Components of the Cost Plus Contract includes:

That they require open-book accounting with the contractor providing detailed documentation of all expenses and they must be transparent with the client by providing them with regular updates regarding the costs. This includes direct costs, indirect costs and Contractors Profit Margin.

Direct Costs relate to all costs directly associated with construction activities such as labour, materials, and the subcontractor costs. It essentially refunds the contractor for actual wages, salaries, and benefits of direct workers, as well as material costs, direct supplies, equipment, and additional components vital to executing the project. 

Now in terms of Indirect Costs, these include overhead costs such as general and administrative expenses of the business and insurance.

And lastly you have the contractors profit margin, which covers the contractors income.This can either be a flat rate, a percentage of actual costs or a custom amount agreed between the contractor and clients before the works commence. 

When using cost plus contracts, several legal and contractual factors should be considered:

• Contract Drafting: Careful attention must be paid to drafting the contract to clearly define reimbursable costs, fee structures, and any limitations or incentives.
• Dispute Resolution: Include clear procedures for resolving disagreements over costs or contract interpretation.
• Termination Clauses: Define the circumstances under which either party can terminate the contract and the associated financial implications.
• Insurance and Liability: Clearly outline insurance requirements and liability allocation between the client and contractor.
• Compliance with Regulations: Ensure the contract adheres to relevant UK construction laws and regulations, including those related to health and safety, environmental protection, and building standards.

There are five different types of Cost Plus Contracts:

Cost Plus Award Fee (CPAF):

The Cost Plus Award Fee (CPAF) contract which provides for a contractor’s fixed price in addition to the reimbursable costs. The award fee relates to how the client assesses the contractor’s ability to meet the predetermined performance criteria. Cost Plus Award Fee contracts are ideal for construction projects with demanding deadlines and objectives like attaining cost or energy efficiency, strict safety standards, and exceptional craftsmanship.  For example, a contractor may use a Cost Plus Award Fee contract to bid for a transportation hub project with tight timelines and safety standard targets. A penalty fee may apply if the contracting team cant complete the project on time and within budget.

Cost Plus Fixed Fee (CPFF)

The Cost Plus Fixed Fee contract (CPFF) reimburses the contractor for the actual costs plus a fixed price. This fixed fee remains constant regardless of any unanticipated costs. 

Cost Plus Fixed Fee contracts are suitable when the client prefers a straightforward approach in reimbursing the cost of the project and ensuring the contractor receives a specified remuneration, especially for projects with uncertain scope or design. 

Cost Plus Incentive Fee (CPIF)

Cost Plus Incentive Fee (CPIF) is similar to Cost Plus Award Fee contract. In that both construction contracts cover the final cost and a negotiated fee or profit. However, whereas the award fee in a Cost Plus Award Fee construction project relies on the client’s assessment of the contractor’s performance, the Cost Plus Incentive Fee has an incentive fee for meeting or exceeding mutually agreed targets. Meaning, preset performance targets are vital in Cost Plus Incentive Fee contracts and if the contractor abides by the rules and provisions specified in the contract, they can earn a significant incentive fee. However if they fail they may incur a penalty fee.

Cost Plus Percent of Cost (CPPC)

Cost Plus Percent of Cost (CPPC), also referred to as Cost Plus Percentage Fee (CPPF), reflects the contractor’s profit as a percentage of the actual project costs. Meaning the contractor can recover any expenses that exceed the budgeted direct and indirect costs, provided they can justify the fees as necessary for the successful completion of the project.

Clients should ensure they engage reputable contractors known to execute complex projects using these contract types, as they rely on mutual trust to complete the project professionally and accurately, with minimal cost overruns. 

Cost Plus Fixed Rate

Cost Plus Fixed Rate or Cost Plus Fixed Percentage (CPFP) is a contract type that reimburses the contractor a fixed percentage of the estimated cost as profit. Meaning, past costs incurred are assessed and used to predetermine the contractors labour rates. 

It is a variation of the Cost Plus Fixed Fee contract, pinning the contractor’s profit on the actual project costs while cushioning the client against excessive cost overruns. 

Like the cost plus percent-of-cost (CPPC), the Cost Plus Fixed Percentage contract requires working with reputable contractors who keep tabs on their project costs.

So what are the advantages and disadvantages in using cost plus contracts:

Starting with the advantages: 

They are great alternative contracts to fixed price contracts. On the client side, they provide:

• Easier and more straight forward negotiations meaning the project can commence on site earlier 
• They have an options of various hybrid contracts to choose from, guaranteeing maximum price caps ensuring the clients budget doesn’t go over
• Suitability for projects with undefined scope. Meaning there is allowance for future modification of cost estimates and contract prices to accommodate new project scopes and specifications. This flexibility is advantageous when executing future projects with an undefined scope or unclear estimated construction budget.
• It provides clearer transparency as the contractor is required to provide regular cost updates
• Encouragement for high quality work and materials. Under cost plus contracts, the contractor focusses more on delivering work of the highest quality instead of worrying on budget constraints as they can choose premium materials and advanced construction techniques that guarantee superior outcomes.

On the contractor side, they provide:

• Coverage of all related expenses and risks for the contractor providing a less risky approach to the contractor from losses due to an uncertain or evolving project scope. Additionally, the contract allocates risks like cost overruns, inefficiencies, project delays, and poor subcontractor performance to the contractor safeguarding the client from excessive losses.
• It can include incentives to encourage better workmanship or lower costs
• A guaranteed profit for the contractor
• Improved cashflow because the way the costs are reimbursed, cash flow burden is often less with cost plus contracts
• Trust, due to the transparent nature of the contract leading to future opportunities for partnership

Cost Plus contracts also provide flexibility in Project Management and allow for adjustments, meaning allowance for changes to the project scope, budget and timeline to adapt to unforeseen challenges and uncertainties. 

Now in terms of the disadvantages: 

On the client side, there is:

• The fear of the unknown as the initial cost provided is simply an estimate and not a fixed price. The uncertainty surrounding the project scope and timeline can lead to inflating the contractor’s expenses in a cost plus contract. Without an incentive for saving costs, there is a high risk of estimating errors and overcharging the fixed cost. As well as, the process of determining and agreeing on a budget and obtain approval for certain expenses can be long and complicated extending the timeline.
• It requires a trusted partnership to satisfy the client that the project budget will not overrun
• An unclear timeline makes it impossible for the client to allocate funds efficiently
• Potential for disputes as the client is ultimately responsible for every costs, meaning they will need to audit charges to ensure they are reimbursable according to the contract

On the contractor side, it:

• Requires careful review of the reimbursable items to ensure costs don’t cut into their fee
• Requires consistent cost tracking 
• Some change orders may lead to disputes, because most costs are covered, change orders that deviate from the original scope could be disputed.

How do Cost Plus contracts compare to Fixed Price Contracts:

A fixed price contract or lump sum agreement reimburses the contractor for a fixed price for the entire project determined during the bidding process. Whereas, a cost plus contract compensates the contractor based on the true costs and a profit margin.

Additionally, the client assumes most of the risk under a cost plus contract. Under a fixed price contract, the contractor bears unexpected costs and financial risk.

A cost plus contract also allows for greater flexibility in response to the project uncertainties. While altering a fixed price contract may call for fresh negotiations between the contractor and client.

Under fixed price contracts, the contractor is motivated to save on costs and maximise profit from the fixed price. Whereas under a cost plus contract, they are less keen in controlling costs and in some instances they may inflate the costs to earn a higher percentage of the cost as profit. 

Finally, a cost plus contract is appropriate for complex projects with uncertain scopes and timelines. A fixed price contract works best for straightforward, predictable projects requiring minimal record keeping.

Therefore, when using a Cost Plus Contract, its good practice:

• To keep detailed and accurate records and documents to ensure the contractor can substantiate all reimbursements to be claimed at project completion. 
• As well as setting clear terms and conditions in the contract in order to eliminate any risks of misinterpretation, disputes and inadequate documentation.
• For contractors to schedule regular meetings to update the client about the project progress and costs and maintaining ongoing communication and collaboration. 
• To establish caps or limits on costs minimising the contractors risk on cost overruns, wastages and fraudulent practices. 

To sum up what I discussed today:

• A cost-plus construction contract, also known as reimbursement contract, stipulates that contractors are reimbursed for project costs and receive a certain amount of profit from the project.
• There are five different types of cost plus contracts. Cost plus award fee, cost plus fixed fee, cost plus incentive fee, cost plus percentage cost and cost plus fixed rate
• The key benefits in using a cost plus contract include reduced risk for the contractor, higher quality workmanship and materials, increased flexibility and transparency in communication and collaboration
• The key drawbacks in using a cost plus contract include undefined timelines, potential for cost overruns, and higher dispute risk. 
• The key items to be established when using a cost plus contract include, Defining the scope of work, establishing an agreed upon cost basis, defining the maximum price or budget, setting a fee/incentive structure, establish a change order process, include insurance and indemnification requirements, determine the payment schedule, establish the dispute resolution procedure and lastly, review and approve.