Understanding Cost-Plus Contracts in Construction: Pros and Cons

Choosing the right type of contract is important for the success of every construction project. One popular type of agreement is the cost-plus contract. Understanding the pros and cons of cost-plus contracts in construction can help both contractors and clients make informed decisions. This article will explore the pros and cons of cost plus, fundamentals of them and practical tips for managing them effectively.

What Are Cost-Plus Contracts in Construction?

A cost-plus contract is an agreement where the client agrees to pay the contractor for all construction-related expenses plus an additional fee for profit. These expenses can include materials, labor, and any other costs incurred during the project. The extra fee can be a fixed percentage of the total costs or a predetermined lump sum.

Here's a simplified breakdown:

Total Project Cost = Direct Costs + Contractor Fee

This approach stands in contrast to a fixed-price contract, where the contractor takes on the entire financial risk for completing the project within a set budget.

Read more: 5 Major Types of Construction Contracts

Types of Cost Plus Construction Contract

There are several variations of cost-plus contracts

• Cost-Plus Fixed Percentage Contract: The contractor is paid for all costs plus a fixed percentage of these costs as profit.

• Cost-Plus Fixed Fee Contract: The contractor is paid for all costs plus a fixed fee regardless of the total project cost.

• Cost-Plus with Guaranteed Maximum Price (GMP): The contractor is reimbursed for costs but up to a maximum price limit. Any cost exceeding the GMP is the contractor's responsibility.

Pros of Cost-Plus Contracts

Cost-plus contracts offer several benefits, particularly for projects where the scope and expenses are difficult to predict accurately.

• Flexibility: Cost-plus contracts shine in their adaptability. As project needs evolve, changes can be incorporated more readily with minimal financial repercussions for the owner. This is particularly advantageous for projects with an undefined project scope or those involving innovative features with variable costs.

• Transparency: Both the contractor and the owner maintain a clear view of project expenditures. The contractor provides regular documentation of all direct costs, ensuring transparency and fostering trust. This detailed reporting is especially beneficial for complex projects where keeping track of expenses is crucial.

• Reduced Risk for Contractors: Cost-plus contracts minimize the contractor's financial risk. Since they are reimbursed for actual costs, unexpected price fluctuations in materials or labor won't erode their profit margin.

• Stronger Collaboration: The shared financial responsibility in a cost-plus contract incentivizes open communication and collaboration between the owner and the contractor.

Cons of Cost-Plus Construction Contracts

While cost-plus contracts offer notable advantages, they also come with certain drawbacks.

• Potential for Cost Overruns: Since the owner shoulders the burden of all direct costs, there's a greater risk of the project exceeding the initial budget. This necessitates meticulous cost control measures and a proactive approach to managing change orders.

• Reduced Incentive for Efficiency: With guaranteed reimbursement for costs, contractors might have a lessened drive to optimize material costs and labor efficiency. Cost control becomes a shared responsibility between the owner and the contractor.

• Increased Bookkeeping: Both the owner and the contractor need robust bookkeeping practices to track and document all direct costs meticulously. This ensures transparency and facilitates smooth project reconciliation.

• Potential for Disputes: Disagreements over the legitimacy of certain direct costs can arise. A clearly defined contract with detailed cost categories and approval processes for change orders can help mitigate such disputes.

Who Should Consider a Cost-Plus Construction Contract?

Cost-plus construction contracts are a good fit for projects with the following characteristics:

• Uncertain Scope: When the project's final design is still evolving, a cost-plus contract provides the flexibility to accommodate changes without significant financial effect.

• Fast-Paced Projects: For projects with tight timelines, a cost-plus contract allows for quicker decision-making and streamlined change order processes.

• Complex Projects: Highly intricate projects with unforeseen challenges might benefit from the adaptability of this contract.

How to Make Cost-Plus Contracts Work for You

If you decide to move forward with a cost-plus construction contract, here are some practical tips to ensure a successful project:

• Define a Clear Project Scope: While a cost-plus contract allows for flexibility, a well-defined initial project scope provides a baseline for cost estimation and management.

• Establish Cost Control Measures: Implement a system for monitoring and approving all direct costs. Utilize cost-estimating software and conduct regular project budget reviews.

• Maintain Open Communication: Foster a collaborative environment where both parties openly discuss project developments, potential changes, and cost implications.

• Clearly Define Change Orders: A cost-plus contract should have a clear and detailed process for handling change orders. This includes defining who can initiate a change order, the approval process, and how cost impacts will be determined.

• Consider Incentive Clauses: Explore incorporating incentive clauses into the contract. These can reward the contractor for completing the project under budget or within a specific timeframe.

• Use of GMP: Consider using a cost-plus with guaranteed maximum price (GMP) contract. This type of contract caps the maximum cost, protecting the client from excessive spending while still offering the flexibility of a cost-plus contract.

Conclusion

Cost-plus contracts offer a flexible and transparent way to manage construction projects making them an attractive option for many clients and contractors. However, they require effective construction cost control and robust bookkeeping to mitigate potential drawbacks. By understanding the advantages of cost plus fee construction contract and their risks, you can make an informed decision that best suits your project's needs. If you need help managing the complexities of cost-plus contracts, our team at Construction Cost Accounting specializes in construction bookkeeping services tailored to your needs. We ensure accurate cost tracking, efficient reporting, and effective cost control, enabling you to focus on project execution while we handle the financial intricacies. Contact us today for a free consultation!