What is a cost-plus contract? What it is, how to create one, and when to use it

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  1. Introduction
  2. How does a cost-plus contract work?
    1. Sample scenario
  3. What are the advantages of cost-plus contracts for businesses?
    1. Sample scenario
  4. What are the disadvantages of cost-plus contracts?
  5. How do you structure a cost-plus contract?
  6. When should businesses use cost-plus contracts?
    1. When the project’s scope is uncertain
    2. When quality is a top priority
    3. When the client wants transparency
    4. When speed is important
    5. When there’s trust between client and contractor

A cost-plus contract is an agreement in which a contractor is reimbursed for all allowable expenses incurred during the project plus an additional amount for profit. This type of contract is commonly used in situations where the scope of work is uncertain or likely to change, which makes it difficult to estimate costs up front.

Below, we’ll explain how cost-plus contracts work, their advantages and disadvantages for businesses, and how to structure them.

What’s in this article?

  • How does a cost-plus contract work?
  • What are the advantages of cost-plus contracts for businesses?
  • What are the disadvantages of cost-plus contracts?
  • How do you structure a cost-plus contract?
  • When should businesses use cost-plus contracts?

How does a cost-plus contract work?

With a cost-plus contract, the contractor and client first agree on what counts as costs and how profit will be calculated.

  • Costs: Costs might include only direct costs, such as labour and materials, or they might include additional indirect costs, such as overhead expenses.

  • Profit: The “plus” part might be calculated as a flat fee, a percentage of the costs, or an incentive for hitting certain goals.

Once the work starts, the contractor tracks all the expenses in detail, using receipts, invoices, and payroll records. The contractor periodically submits a bill to the client for reimbursement that covers the actual costs plus the agreed profit.

Since the contractor is being reimbursed, they can be more flexible with these contracts. If the project changes – for instance, if unexpected materials are needed or the scope grows – that doesn’t slow down the project. The client covers those extra costs as long as they’re reasonable and adequately documented.

When the project is completed, there’s usually a final review. The client reviews all the contractor’s records to ensure everything matches what was agreed on, and they settle any remaining payments.

Sample scenario

Imagine you’re building a custom home and the contractor agrees to a cost-plus-fixed-fee contract. You estimate the total cost will be $500,000, and the contractor’s fixed fee is $50,000. During construction, the price of timber unexpectedly increases, and the total cost rises to $550,000. In this scenario:

  • The contractor gets reimbursed for the actual cost of $550,000

  • Their profit (the fixed fee) stays the same at $50,000

  • The client covers the unexpected increase

Cost-plus contracts are useful for projects in which upfront costs are hard to predict, such as construction and research. This type of contract provides flexibility and transparency while still requiring oversight, so costs don’t spiral out of control.

What are the advantages of cost-plus contracts for businesses?

Cost-plus contracts offer solid advantages for businesses. Here’s why they can be a great choice:

  • Flexibility: Cost-plus contracts let businesses adapt to changes. If something comes up unexpectedly – such as fluctuating material costs or additional work – it’s not a hurdle because the contractor gets reimbursed for actual expenses.

  • Reduced financial risk: These agreements reduce financial risk for businesses on the contracting side. Since the contractor is reimbursed for actual expenses, they don’t have to worry about losing money due to underestimated costs or unforeseen challenges.

  • Better outcomes: Because contractors are reimbursed for actual costs, they’re not tempted to cut corners to save money. They can focus on quality rather than squeezing expenses into a fixed budget. This often results in better outcomes for the client, which can strengthen the business relationship.

  • Shorter negotiations: When the total cost is difficult to estimate upfront, a cost-plus contract helps avoid lengthy negotiations over a fixed price. This can speed up the process, which is important in fast-moving industries or urgent situations.

  • Transparency: With cost-plus contracts, all expenses are documented and shared with the client. This openness can strengthen business relationships and pave the way for long-term partnerships.

  • Incentive opportunities: Some cost-plus contracts include performance bonuses or other incentives. These give contractors another reason to work quickly and effectively, benefiting everyone.

Sample scenario

Imagine that a construction company takes on a project to build a new office building. The client wants a modern design but hasn’t finalised all the details. Instead of guessing a lump-sum price, they agree to a cost-plus contract. The contractor benefits because they don’t take on the risk of unpredictable costs, and the client gets a high-quality build with the flexibility to tweak the design as they go.

Cost-plus contracts are a good choice for businesses that handle complex, developing projects. They lower financial risk for contractors, provide room to adapt, and help ensure quality outcomes.

What are the disadvantages of cost-plus contracts?

Although cost-plus contracts can be a great choice for businesses, they have their challenges. Here are some of the disadvantages businesses should consider:

  • Risk of cost overruns: Because the client agrees to reimburse all costs, there’s a risk that the project will go over budget. If the contractor isn’t managing expenses well, the client will end up paying the bill. That can make costs rise beyond initial expectations.

  • Oversight requirements: Cost-plus contracts demand thorough documentation and transparency. Contractors must track every expense carefully and clients often need to review these records to ensure costs are reasonable. This administrative burden can slow things down and add extra overhead.

  • Uncertainty in final costs: Unlike fixed-price contracts, cost-plus agreements don’t provide a clear, up-front picture of the total cost. For clients, this lack of certainty can make it harder to plan budgets or secure financing for the project.

  • Potential for disputes: Because the definition of “allowable costs” can vary, disagreements can arise over what should or shouldn’t be reimbursed. A failure to set expectations from the start can lead to strained relationships.

  • Higher administrative costs: The need for tracking, documentation, and auditing means additional time and expenses. Clients and contractors often need extra resources, such as accountants and project managers, to manage these details, which can lower the project’s efficiency.

How do you structure a cost-plus contract?

Here’s how to structure a cost-plus contract:

  • Outline the project’s scope. What’s the goal? What needs to be done?

  • To avoid confusion, define what counts as reimbursable costs and what won’t be reimbursed (e.g. personal expenses, fines). Covered costs typically fall into two buckets:

    • Direct costs, such as labour, materials, and equipment.
    • Indirect costs, such as office supplies, admin support, and utilities.
  • Define the “plus”. This might be a fixed fee (set amount, no matter how much the project ends up costing), a percentage of costs (a profit margin tied to the actual expenses), or an incentive fee (a bonus if the contractor meets specific goals, such as finishing early or staying under budget). These fees vary, but percentage markups generally range from 5%–25%.

  • Establish how often expense reports should be submitted (e.g. monthly, at certain milestones). Expense documentation might include:

    • Receipts and invoices
    • Time sheets for labour
    • Itemised reports for materials
  • Decide how often the contractor will be reimbursed. Include the amount of time the client has to make a payment after receiving an invoice and any conditions for the final payment.

  • If the client is concerned about costs, consider adding a cost ceiling (the maximum amount they’ll reimburse) or including an estimated range.

  • Create a process for handling changes, such as adding new work and adjusting costs. Typically, this involves written change orders that both parties agree on before moving forward.

  • Include a clause that explains how disputes will be handled, whether through mediation, arbitration, or another method.

  • Add any standard legal terms, such as confidentiality, governing law (what state’s laws apply), and a termination clause that explains how the contract can be ended early and what happens with costs if it is.

When should businesses use cost-plus contracts?

Businesses should use cost-plus contracts when the project’s scope or costs are difficult to estimate upfront or when flexibility and transparency are important. However, businesses should avoid cost-plus contracts when budgets are tight, the project’s scope is straightforward and unlikely to change, or the contractor lacks a good system for tracking and reporting costs.

Here are some situations in which cost-plus contracts make sense.

When the project’s scope is uncertain

A cost-plus contract can be helpful when the full details or requirements of a project aren’t locked in. It lets you adapt as things change without locking yourself into a rigid budget or timeline. This is common in industries such as construction, where surprises can appear for custom builds or renovations, and research and development, where the amount of trial and error can be difficult to predict.

When quality is a top priority

When contractors are reimbursed for all costs, they’re less likely to cut corners to stay within a fixed budget. This makes cost-plus contracts a good fit for projects where high-quality or specialised work is non-negotiable.

When the client wants transparency

Cost-plus contracts require detailed cost tracking, which means clients can see exactly where their money is going. A cost-plus agreement makes sense if the client values this level of transparency – or if it’s legally required (as with many government contracts).

When speed is important

If the work needs to get started quickly and you can’t afford lengthy negotiations over a fixed price, cost-plus contracts can help move things along. By agreeing to cover costs plus a profit margin, you bypass the need to specify an exact budget before starting.

When there’s trust between client and contractor

Cost-plus contracts work best when there’s a strong relationship. Because clients bear the risk of cost overruns, they need to feel confident that the contractor will manage costs responsibly and provide accurate documentation.

The content in this article is for general information and education purposes only and should not be construed as legal or tax advice. Stripe does not warrant or guarantee the accuracy, completeness, adequacy, or currency of the information in the article. You should seek the advice of a competent lawyer or accountant licensed to practise in your jurisdiction for advice on your particular situation.

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