Cost-Plus-Percentage Contract

An agreement on a construction project where the contractor earns a specified percentage profit over the actual costs incurred. This contract type is considered suboptimal due to reduced incentives for cost control. An alternative approach is the cost-plus-fixed-fee contract.
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Cost-Plus-Percentage Contract

Definition

A cost-plus-percentage contract is a type of agreement used predominantly in construction projects whereby the contractor is reimbursed for all actual costs incurred and, in addition, receives a pre-determined percentage of these costs as profit. This arrangement means that the higher the cost of the project, the greater the contractor’s profit, thus potentially reducing any incentive to minimize expenses.

Key Characteristics

  • Reimbursement of Actual Costs: Contractor is reimbursed for all direct costs (materials, labor, equipment, etc.) and indirect costs (overheads, administrative expenses, etc.).
  • Percentage Profit: The profit is determined as a fixed percentage of the project’s total actual cost.
  • Risk and Incentive: Contractor’s risk is minimized, but there is little incentive to control or reduce project expenses.

Examples

  1. Commercial Building Construction: A contractor building a commercial office complex is reimbursed for all construction-related expenses plus a 10% profit margin on the total costs.
  2. Government Projects: Public sector projects can sometimes use such contracts, despite their potential for cost overruns if not carefully monitored.
  3. Research and Development Projects: Specialized R&D projects where the costs can be highly variable and difficult to estimate upfront.

Frequently Asked Questions (FAQ)

Q: What makes cost-plus-percentage contracts less favorable? A: They discourage the contractor from managing costs efficiently because higher project costs result in higher profits, leading to potential cost overruns.

Q: What is an alternative to cost-plus-percentage contracts? A: A cost-plus-fixed-fee contract is a better alternative where the contractor receives a fixed fee in addition to the reimbursement of actual costs, aligning incentives for cost control.

  • Cost-Plus-Fixed-Fee Contract: An agreement where the contractor is reimbursed for all actual costs plus a fixed fee which does not vary with the project cost, encouraging cost control.
  • Lump-Sum Contract: A contract where the contractor agrees to complete the project for a fixed total price, thereby assuming the risk of cost overruns.
  • Time and Materials Contract: The contractor is paid for the time spent and materials used, suitable for projects where the scope is not well-defined.
  • Guaranteed Maximum Price Contract: The contractor is reimbursed for costs up to a maximum price, providing protection against cost overruns.

Online References

Suggested Books

  1. “Construction Contracts: Law and Management” by John Murdoch and Will Hughes - Provides in-depth coverage of various construction contracts and their legal implications.
  2. “Construction Project Management: A Practical Guide to Field Construction Management” by S. Keoki Sears, Glenn A. Sears, and Richard H. Clough - A guide to managing construction projects effectively.
  3. “Handbook of Construction Contracting: Plans, Speculations, Building” by Jack P. Jones - Offers practical advice on decision-making and contract management in construction.

Fundamentals of Cost-Plus-Percentage Contract: Contract Management Basics Quiz

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