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This article is written by Jatin Goyal, pursuing Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho. The article has been edited by Ruchika Mohapatra (Associate, LawSikho) and Indrasish Majumder(Intern at LawSikho).

This article has been published by Abanti Bose.

Introduction

The history of contracts is as old as that of human civilization and economic processes itself. At the time when the very concept of currency was absent, there prevailed the barter system which essentially was a simple mechanism of exchange of commodities amongst individuals; this format by itself was also an informal contract wherein a person, say,  A agreed to provide commodity X to person B in exchange of person B providing him with commodity Y. But this system also had key structural issues and therefore the idea of currency as a uniform system of exchange was developed and this only meant development of contracts as we know them today. 

Contracts in India were once governed by the Amending Act of 1781 which was introduced by the British and was based on the English common law. This statute governed the contractual affairs of both the Hindus and Mohammadans alike without paying much heed to the intrinsic nature of the personal laws of the two communities and consequently led to inconveniences. In order to address the inconveniences, it was duly replaced by today’s bread and butter of contract law, the Indian Contract Act, 1872. Indian Contract Act encompasses all forms of contracts and agreements and Reimbursement Contracts are no exception either. Reimbursement contracts refer to a system for payment of expenses incurred by the contractor up to the extent prescribed by the contract.  This article will provide a thorough insight about reimbursement contracts, the various types of reimbursement contracts, their real word usage as well as the things to keep in mind while drafting one. By the end of this article, the reader shall possess a deep understanding of reimbursement contracts.

Difference between reimbursement contracts and  similar contracts

Contracts, by their nature, are dynamic so as to suit the wide array of aspects that they envelop. They can generally be classified on the basis of mode of formation, performance, and validity but in specific cases, the criteria for classification differs; for instance in terms of use in the construction and government contracts the division of contracts is usually done under the headers of fixed-price contract, cost reimbursement or cost-plus contract and time and materials contract. 

To elaborate on each, fixed-price contracts refer to those agreements where the individual signifies to pay the vendor a pre-negotiated fixed amount regardless of the actual expenses incurred. In such contracts, the risk is on the vendor to deliver the product or service under the budget and even make a profit.  Such contracts are usually preferred in circumstances where the knowledge about the object of the contract and the associated risks are known and a set mechanism of the fulfilment of the object is present.

Time and Materials contracts are the ones where the vendor is paid on an hourly basis and for the materials purchased by him.  In such contracts, the majority of risk is on the employer since the vendor is not supposed to make sure of the completion of the project, he is bound to provide the service regardless of the success or failure of the project, such contracts are usually preferred while hiring labour for a particular project whose risks and knowledge are known for instance a site remodelling job. 

Cost-plus or Reimbursement contracts, on the other hand, are agreements where the vendor or the contractor is paid back the costs incurred by them throughout the course of the project and are also paid an additional amount which is their incentive for the job done. In such contracts, the burden of risk is on the employer since the costs are not pre-determined and this could result in the project costs exceeding the budget. These contracts are ideal when the availability of information about the object of the project and the associated perils is limited and when there cannot yet be devised a set standard for production and reproduction of the object in question. The aforementioned can be illustrated in the following format:

Contract TypeDefinitionBurden of RiskIdeal Instance of Use
Fixed CostTo pay the vendor a pre-negotiated amount regardless of the actual expenses incurred.On the Vendor.When knowledge about the project and corresponding risks is available.
Time and MaterialsTo pay the vendor on an hourly basis and for the materials purchased by him.On the Employer.While hiring labourers for a project with known risks and specifics.
Cost ReimbursementTo pay the vendor for the costs incurred by him and an additional amount.On the Employer.When the knowledge about the project and related risks is scarce.

Types of reimbursement contracts 

The reimbursement contracts are also very versatile in their scope. They entail furnishing the vendor with an additional amount on top of the costs involved in the project but, the means for deciding this additional sum are varied and are able to cater to the distinct functional relationships between employer and vendor, the following is the breakdown of these means under the reimbursement contract:

1. Cost Plus Fixed Fee (CPFF)– In this system, the vendor is paid for the expenses incurred and a sum that is pre-decided between the parties. This sum is the fixed reward to the vendor for completion of the job at hand. Since the reward to the vendor is already decided the project is generally undertaken smoothly.

2. Cost Plus Award Fee (CPAF)– Under this paradigm, the vendor is reimbursed for the payments made by him and is paid an amount which is to be finalized by an award board set up by the employer, and the same is undertaken after the completion of the project at hand. Since the reward to the vendor is to be decided after the job, it makes it imperative for the vendor to show utmost diligence and attention to detail throughout the course so that his quality work can fetch him a reasonable paycheck.

3. Cost Plus Incentive Fee (CPIF)– In this format, the vendor is paid back the money spent by him on the project and a denomination of currency which is to be decided later on by the employer but the upper ceiling for this amount is agreed upon at the time of entering in the contract. Having an idea of the maximum compensation and at the same time having ambiguity about the final amount tends to make the vendor undertake the work both smoothly and with utmost caution.

Things to keep in mind while drafting a reimbursement contract

It is evident from the preceding paragraphs that reimbursement contracts have plenty of merits but it would be incorrect to abstain from mentioning the demerits or downsides of these agreements. By the virtue of the fact that the vendor is reimbursed for the expenses he incurs for completion of the project, it becomes peremptory to be aware of how these costs are calculated. To understand this we need to first dissect the expenses under two broad heads – direct and indirect expenses; as the name suggests, direct expenses are those which are undertaken for the goods and services directly related to the project, for instance, raw materials, machinery, and labour while the indirect expenses include charges which are not directly related to the core objectives of the project, for instance, office and staffing expenses. This raises a problem of appropriation of indirect costs to a particular project, to surmount this, the indirect costs are calculated on a pro-rata basis and the employer is allowed to verify these charges by conducting site inspections and scrutiny of vendor’s accounts which are made available on an open book basis. But this becomes complex in a situation when the vendor is acting inefficiently and opens a possibility of overcharging and thus, exceeding the target cost.

It is of vital importance that clauses demarking the margin sharing arrangement, means used for calculation of various indirect and direct costs and the target price is expressly mentioned in the contract as they form the essence of such a contract.

Practical application of reimbursement contracts

In an instance when the actual cost is less than the target cost, the margin is shared between the employer and vendor, thus acting as another incentive for the vendor to finish the project while maximizing cost-saving and yet providing efficient services. This arrangement of cost-plus agreement makes it an ideal choice while contracting for procurement, research, and development projects, means of these contracts are generally used by government agencies when contracting for a weapon development assignment and the same is also undertaken by the universities and institutions while offering grants to research groups as it opens a window for achieving results within the most optimum costs.  A good reimbursement contract must contain the following key clauses:

  • Title- Being the first part of the contract, the title should state the purpose of the said agreement, making it easier to refer to.
  • Definition- Drafting definitions clauses mitigates the chance of misunderstanding interpretations among the parties. The defined terms should be unambiguous and written in plain language.
  • Scope of Work- This section should include the statement of what is expected of the parties including any milestones, reports, deliverables, and end products that are expected to be provided by the performing party.
  • Payment Structure- This section is of critical importance especially in a Reimbursement contract, it provides for the payment plan, mode of payment, provisions for late payment and any other payment related arrangement as agreed upon between the parties.
  • Dispute Resolution Mechanism- Parties often tend to find themselves at crossroads, which makes agreeing to a dispute resolution mechanism beforehand a must. This section includes mode of resolution, payment of legal fees, the scope for appeal and applicable legalities.
  • Termination- It is not uncommon for parties to terminate the agreement prematurely, this calls for a section wherein the grounds for termination are stipulated, this section provides for means of termination, notice period, duties after termination, non-compete or similar provisions, liability on termination (if any).

Conclusion

It is absolutely clear that the cost reimbursement agreements are the result of the development of contract law over the centuries and are an effective tool to be used when entering certain kinds of legal relationships with set expectations as it demarcates an idea of reimbursement which is essentially absent in other forms of contracts. A reimbursement contract should be a result of diligent negotiation, while drafting such a contract one must provide a detailed description to make the agreement comprehensive and clarity amongst the parties about their duties under the contract is also a must. It is needless to point out how the legal system in general and pertaining to contracts has evolved and will continue to evolve in the times to come given how the legal spectrum is wide with numerous possibilities and with its evolution it will complement the structure of the society and further simplify the legal arrangements. 

References

  1. www.jstor.org/stable/1831331. Accessed 30 Mar. 2021
  2. www.jstor.org/stable/4504494. Accessed 30 Mar. 2021
  3. Veolia India Private Limited, New Delhi v Deputy Commissioner of Income Tax, New Delhi, Income Tax Appellate Tribunal, 27 April 2020
  4. http://governmenttraininginc.com/pdfs/Cost-Reimbursable-TOC-Excerpt.pdf
  5. www.jstor.org/stable/3132124. Accessed 31 Mar. 2021

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