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This article has been written by Muskaan Bangani pursuing the Certificate Course in Introduction to Legal Drafting: Contracts, Petitions, Opinions & Articles from LawSikho. This article has been edited by Zigishu Singh (Associate, Lawsikho) and Smriti Katiyar (Associate, Lawsikho).

Introduction

A cost-plus contract may also be known as a cost-reimbursement contract, it is an agreement between two parties in which one of the parties repays the company for the expenses incurred along with a percentage of profit which is usually the contract’s total price. These contracts are commonly used in construction, where the customer accepts some risk while simultaneously allowing the contractor considerable flexibility. In some cases, the budget is limited or there is a good chance that real expenses will be lower than what the parties anticipated. The contractor is required to show proof of all connected expenses.  The contractor is permitted to collect a specified amount in excess of the amount reimbursed in order to make a profit—hence the “plus” in cost-plus contracts. Because certain contracts limit the amount of payback, not all expenses are reimbursed. This is especially true if the contractor makes any inaccuracy or error during the course of the contract or is found to be not performing his duties in due diligence in any part of the construction. Cost-plus contracts are preferred by governments because they allow them to select the best qualified contractors rather than the lowest bidder.

Components of a cost-plus contract

The three main components of a cost-plus contract are :

• Materials, equipment, supplies, and professional advisors are all considered direct costs.

• Overhead costs, also known as indirect costs, are business-related expenses incurred in order to carry out the contract’s conditions. Office supplies, insurance, office rent, labour expenses, drawing and printing charges, and communication expenses are all examples of overhead costs.

• A fee, also known as profit, is a fixed percentage calculated using the labour costs directly associated with the contracted work.

Types of cost-plus contracts

 The different types of cost-plus contracts are as follows:

  1. Cost-plus-award fee: This is a contract between project managers and contractors that specifies a predetermined awarded payment that contractors can receive if they execute a project accurately, on schedule, and within the agreed-upon budget. Contractors are subject to a penalty fee if they fail to meet these objectives.
  2. Cost-plus fixed fee: In this type of contract, the project managers cover both direct and indirect costs and pay the contractor a fixed price that all sides agree on.
  3. Cost-plus-incentive fee: These fees are determined by how effectively the contractor performs. If they obey all of the rules and provisions outlined in the contract they will receive an impressive incentive fee.
  4. Cost-plus-percent-of-cost: If the contractor spends more on direct and indirect costs than expected and it can be demonstrated that they require the additional funds to execute a quality project, they will be reimbursed along with the cost numbers.
  5. Cost-plus-fixed-rate contract: In this contract, the project manager examines the contractor’s previous cost sheets and uses that information to set predetermined labour rates that both parties have agreed on.

Advantages

Tools and materials are purchased for the project without risking the quality of the final outcome which is made easier by Cost-plus contracts. The pros of cost-plus contracts are:

  1. Enables contractors to purchase high-quality tools and equipment.

When the expenses of tools and equipment aren’t deducted from the contractor’s income, they are less hesitant to make purchases that increase the project’s overall quality. This means the project manager will be able to create a high-quality end product that will satisfy customers

  1. Lowers contractor’s risks

There are times when a contractor is unable to produce a detailed cost estimate owing to a variety of factors such as building site damage, inclement weather, or confusing project plans. In these situations, if a contractor spends more than the agreed-upon anticipated amount, they risk losing that money. Maintains a steady and manageable budget for the project.

  1. Keeps the project’s budget consistent and manageable.

Before the start of the project, project managers might meet with contractors to set a budget for the project’s tools, equipment, and labour costs. This encourages contractors to stick to the budget they’ve set because they’ll make money if they finish the task on time and within budget. This also protects project managers from receiving unexpected equipment invoices.

Disadvantages

Though cost-plus contracts can be beneficial for both contractors and project managers, some drawbacks could negatively impact the project. The cons of cost-plus contracts are:

1. May result in a longer project timeline.

Contractors and project managers must negotiate and approve budgets and certain item purchases, which may cause contract projects to take longer than intended.

2. Involves the contractor paying for tools in advance.

Contractors are reimbursed for their expenditures once the projects are completed; however, they are responsible for purchasing materials, tools, and equipment on their own. If contractors don’t have the funds to purchase pricey materials, this could be a problem, lowering the project’s overall quality.

3. Additional effort is required to justify and track all expenses.

A cost-plus contract often requires contractors to keep track of all expenses and submit them to project managers. Contractors are sometimes asked to explain their justification for each transaction. This can take a long time for contractors to accomplish, which may affect the construction project’s timeframe.

Important clauses

There are a few key clauses that must be included in order for a contract for the cost plus agreement. The following are the details:

  1. Title of documents

Title to a document differentiates it from the other documents. It makes it more specific as to what and which subject-matter it deals with. It gives an identity to a document. 

  1. Name the parties to the contract

The name of the owner and contractor must be mentioned in the contract. Beside this, the addresses of the parties must be mentioned to ensure accountability and transparency for future contingencies. 

  1. The recitals

The ‘Whereas’ clause is seen in almost every contract. These are known as ‘recitals’. The whereas clauses are added to understand the objective of the parties for entering into the contract. Recitals act as primary statements for the effective enforceability of the agreement. 

  1. Scope of Work

The owner and the Contractor agree that the Contractor will be constructing fixtures, structures etc and also providing services on the property described, on which the work will take place (e.g., address and area on the property, if relevant). 

  1. Time of Completion

There should be an approximate commencement and completion date of the project. Setting time boundaries up front is a good way of ensuring your project will remain on track.

  1. Compensation

In a cost-plus fee agreement, the compensation clauses are the most complicated because both parties must agree on what is and is not an included cost that must be returned. It’s a good idea to try to spell this out in the Agreement to avoid future conflicts regarding purpose.

  1. Progress Payment

Although the parties must have already agreed on the estimated full price of the contract, the parties must decide how these payments will be made. There are no absolute rules about how a contractor will collect its fees. Some don’t collect anything until the work is completed.

  1. Duties of Contractor 

This clause spells out the duties of the contractor that he needs to perform which could vary in types and the amount from contract to contract. Some generic duties that are found in a construction contract are:

  1. All work shall be in accordance with the provisions of the contract. 
  2. All work shall be done by licensed individuals.
  3. Contractor shall obtain the permit to do the work.
  4. Contractor shall remove all the debris after the completion of work.
  1. Insurance 

A provision for unforeseen circumstances must also be made in the form of insurance to avoid disputes later on. A sample clause can be in the form of: “The contractor shall purchase and maintain the insurance of the property, machinery, site, etc. in case of unforeseen circumstances like fire, earthquakes etc.” 

  1. Warranties

The Contractor guarantees that the job it does will meet specific criteria.

(a) Defective Work Correction: It specifies that any flaws discovered in the work within a specific time period will be remedied or otherwise fixed at the Contractor’s expense. The length of time for which this warranty will be valid should also be specified

(a) Normal Wear and Tear Only: This clause states that the Contractor is only liable for damage caused by normal events. In other words, if you do something to the property that is harmful or dangerous, the Contractor will not be held liable.

11. Arbitration of Disputes

Arbitration is a method of resolving disputes outside of the courtroom. In the event of disagreements or conflicts, an arbitration provision must be incorporated into the contract of sale of products as a means of resolving future situations. Arbitration is less expensive and time-consuming.

12. Termination of Contract

It specifies that specific actions or circumstances, such as written notification or substantial breach, will result in the agreement being terminated early (i.e., before the work is completed or the end of the term, if any). The amount of notice a party must give of its desire to terminate or to warn the other of a breach will be written down by the parties.

13.  Licenses and Permits

It is required by the Contractor to obtain any necessary permits and/ or licenses to perform the work under the Agreement. 

Conclusion

Only if specific mechanisms are in place before the contract is executed will the cost-plus agreement be successful.

  1. There is a proper system in place to keep track of the costs incurred during the contract’s construction.
  2. To keep track of the contract’s development, a proper communication channel is established between the contractor and the contractee.
  3. To minimise future problems, all terms and conditions must be clearly stated in the contract.
  4. A contractor must have sufficient finances to complete the contract because the contract cost will not be paid to him instantly; he must first pay for the expense. 
  5. A team should be in place to ensure that correct accounting, budgeting, auditing, and other records for the contract in question are kept.

References

  1. https://www.upcounsel.com/cost-plus-contracts  
  1. https://www.wallstreetmojo.com/cost-plus-contract/#:~:text=Cost%2Dplus%20contracts%20are%20majorly,profit%20me%20on%20the%20 contract
  1. https://www.indeed.com/career-advice/career-development/cost-plus-contract.

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