A cost-plus contract provides reimbursement for all of the costs associated with a construction project, plus a fee to account for the contractor’s overhead and profit.
In the world of construction, flexibility and uncertainty are often the norm. When project owners have a tight timeline, or when the scope of work is unclear, it can be challenging to estimate the total cost accurately. In such cases, a cost-plus contract may be the solution. This type of contract allows project owners to get a project moving quickly, but it's essential to understand the pros and cons before deciding if it's the right fit.
How Cost-Plus Contracts Work
A cost-plus contract is a construction agreement that includes reimbursement for project costs and a markup that covers the contractor's overhead and profit. The name itself sums up the contract's content: project costs plus contractor markup. While this contract is most common between a project owner and a general contractor, it can also be used with general contractors and specialty contractors.
The contract specifies what costs are considered project costs, often referred to as direct costs. These costs typically include labor, materials, and the markup from subcontractors. The contract also defines how the contractor's fee is calculated. Cost-plus contracts are often easier to negotiate because they reduce the risk for contractors. Unlike lump sum contracts, where contractors face reduced profits if project costs exceed expectations, cost-plus contracts guarantee that the contractor will have costs reimbursed and still receive their fee.
However, it's important to note that a cost-plus contract is not a blank check from the project owner to the general contractor. The contract usually includes a clause that requires the contractor to provide a good faith estimate of the total project cost. Additionally, the contractor provides a schedule of values indicating the estimated cost of each aspect of the project, which later serves as a basis for subcontractors' progress payments.
Ultimately, it is in the best interest of the general contractor to provide a reasonable estimate for the project. A realistic estimate builds trust with the project owner and increases the likelihood of future collaborations. Furthermore, cost-plus contracts do not cover costs associated with a contractor's mistakes or negligence, although they may cover situations related to estimating errors.
Advantages of Cost-Plus Contracts
Cost-plus contracts offer several advantages for both project owners and contractors:
- Project owners benefit from cost-plus contracts when they prioritize timelines and quick negotiations. These contracts are easier to arrange with general contractors.
- General contractors prefer cost-plus contracts due to reduced risk. They provide a near guarantee that the contractor will be profitable on the project while having all direct costs reimbursed.
Disadvantages of Cost-Plus Contracts
However, cost-plus contracts also present some disadvantages:
- A basic cost-plus contract leaves the owner unsure of the final construction cost, which may lead to an over-budget project.
- Cost-plus contracts work best when both parties have already built trust over time. Using this contract type with unknown entities could result in disputes over scope or cost throughout the project.
- General contractors must provide sufficient documentation of costs and completion percentage to get reimbursed. This requires a more sophisticated cost management system compared to other contract types.
- Change orders on cost-plus projects can potentially lead to disputes if rising costs put pressure on the project owner.
Cost-Plus Contract Example
To illustrate how a cost-plus contract works, consider this hypothetical scenario:
A property development company approaches Greene Construction, a trusted general contractor, to convert a decommissioned airplane hangar into an upscale retail space. The existing partnership between the two entities makes a cost-plus arrangement less risky for the project owner.
The signed cost-plus contract stipulates that Greene Construction will be reimbursed for all project costs, along with a fee of 10 percent of the total project costs to cover their indirect costs, overhead, and profit. As the project progresses, specialty contractors submit pay applications to Greene Construction, who request draws from the project owner based on the completion percentage outlined in the schedule of values. Change orders may occur throughout the project, but they require approval from both parties to be reimbursable.
Upon substantial completion of the project, the project owner prepares to make final payments to Greene Construction. The original cost-plus contract states that all remaining project costs and contractor fees will be paid out within 30 days of signing the Certificate of Substantial Completion. At this stage, Greene Builders addresses items on the punch list and pays retainage to its subcontractors.
By utilizing a cost-plus agreement, Greene Construction secures a significant fee with relatively low risk, while the property development company completes construction within a favorable timeline with reduced negotiation burdens.
Cost-Plus Contract Template
Many owners and contractors rely on the A103, a sample cost-plus contract produced by the American Institute of Architects (AIA). This template provides the basic structure of a cost-plus construction agreement, including fields that specify reimbursable costs and how the contractor’s fee will be calculated. Standard sections about payments, dispute resolution, liquidated damages, contract termination, and more are also included. However, it's important to customize the contract to fit the specific needs of each project or business.
Other Contract Types Compared
While cost-plus contracts are useful, they are not the only option available. Depending on the project's details and the owner's approach, different types of contracts may be a better fit. For example:
- Lump Sum Contracts: These contracts specify a fixed price for the entire project, making budgeting easier for project owners.
- Time and Materials Contracts: These contracts allow project costs to be based on the actual time and materials used, offering flexibility and transparency.
- Unit Price Contracts: These contracts establish prices for specific units of work, making them ideal for projects with repetitive elements.
Each contract type has its own advantages and disadvantages, and it's crucial to select the right one to balance financial risk and maximize profit margins.
Importance of Contract Formation
Contract formation is a critical step for both project owners and contractors to mitigate financial risk in a construction project. Careful review of clauses related to reimbursable items, change orders, dispute resolution, payment applications, and more can help prevent conflicts and ensure a smoother and more profitable project.
Choosing the right contract type is a vital financial management strategy for owners and contractors alike. Owners need projects that provide a sufficient rate of return to pay back lenders and generate profit. Contractors, on the other hand, bear financial risk early in a project. By using a well-defined contract, both general contractors and specialty contractors can work towards ensuring project profitability, despite complexity and uncertainty.
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