This article is written by Divya Jangid, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho. The article has been edited by Priyanka Mangaraj (Associate, LawSikho) and Dipshi Swara (Senior Associate, LawSikho).
The past few years have seen tremendous growth in the real estate & construction business. The construction contracts accommodate the fluctuation of the prices of raw materials, time factor as well as inflation. These contracts detail out risks, the scope of the work, rights & duties of the parties, amongst other clauses. It is the first document which details the intention of the parties to enter into a construction contract. Every contractor wants a return on their investment and wants to cover its cost on the material. Cost-plus contracts help the contractor to achieve the desired results.
In India, most of the contractors are not good at maintaining records of material, its price with inflation, and expenses. In order to make the management of costing & expenses easier expenses thing easier for the unorganised contractors, cost-plus contracts are generally preferred. This article would discuss the overview of the cost-plus contracts in detail in construction agreements. In such agreements, the contractor had to provide a fixed rough estimate of the cost for the work at the beginning and the cost-saving during the construction will be transferred to the owner.
Various types of construction contracts
There are various types of construction contracts like cost plus fixed-fee contract, cost plus a percentage of cost contract, Re-measure contract, Lump sum contract, and scheduled contracts, sub-contract agreements, unit cost contracts, the specific project contract, the cost-plus fixed fee contract time and material contracts.
Generally, not all contracts mentioned above are used but only a few actually used in businesses. The Lump Sum contracts are one of the very elementary contracts but it reduces the profitability in case of higher fluctuations in the market price. The Lump Sum contract reduces complexity for any agreement or contracts having less time occupancy and short venture work.
Time and material contracts are useful in case there is no defined scope of work. Over time this scope will be defined and the amount of raw material will also be calculated. This will lead to higher losses and is very time-consuming.
Unit cost contracts and guaranteed minimum price (GMP) contracts are also commonly used contracts but the profit sharing is comparatively lesser and it is more time-consuming.
Cost-plus contracts are profit-bearing contracts which are also known as cost-reimbursement contracts, these contracts keep out a percentage of profit over and above the cost of the contracts.
Understanding cost-plus contracts
Cost-plus contracts are one of the most commonly used contracts in case of big projects and are profitable contracts as it reimburses the cost of the contract. In Cost-plus contracts, the owner is responsible for the cost incurred during the project. These contracts cover both direct and indirect costs in addition to the profit percentage decided in advance. Cost-plus contracts are flexible contracts, which allow the parties to be paid for extra time & material but not inaccuracy.
- In the case of a Cost-plus contract, the owner is held responsible for any risk of increasing prices during the project.
- A cost-plus contract seems to play a better role during the high inflation and uncertain future rate of the material, labour, etc.
- A cost-plus contract is preferred when there is not enough information available in advance to detailed calculations of the cost.
Cost-plus contract means those contracts which include profits over and above the cost of the contract. It comprises the profit percentage calculated after the cost of the contract.
- Firstly, the cost-plus contract may include direct costs (such as material, supplies, equipment, professional consultant/engineer/ architects, Labour, etc.).
- Secondly, cost-plus contracts include indirect costs or overhead costs related to business. The indirect costs or overhead cost is essential to perform the contract, such as insurance, electricity and water charges, office rent, stationery, fuel, telephone & broadband expenses, draftsmen’s expenses, the printing of construction drawings.
- Thirdly, cost-plus contracts also include a fraction of the profit as a “fee” and a fixed proportion connected with the work. Profit refers to a specific percentage of income over and above the cost of contracts as agreed by the parties.
Such a contract benefits the owner as it focuses on quality and not expenses, reduces contractor’s risks, covers all connected expenditures, and even then, there remains ambiguity about the final cost & the material consumption is comparatively higher. However, Cost-plus contracts, though very beneficial to the contractor, can be anexpensive affair for the owner at the same time.
- Type of cost-plus contracts
There are different types of cost-plus contracts that can meet the needs of different situations and preferences of the parties.
cost-plus contracts have variations to accommodate different needs based on incentive fees, award fees, fixed-rate contracts, cost-plus fixed-fee.
Types of Cost-plus contracts are as follows:
- Cost-Plus percentage of cost (CPPC): Cost-plus percentage contracts are additional payable fraction of cost on the fixed cost of the contracts & that was agreed on by the parties in advance. For example, it has been agreed that the owner will pay 10% of the cost by the owner along with the reimbursement of the total cost of the contract as contract consideration. So, an additional payment of 10% of the profit over the cost is the extra earnings of the contractor.
- Cost-Plus Fixed Fee (CPFF): In the cost-plus-fixed-fee contracts, the Cost for the project is not assessable in advance, and the profit will be a pre-decided fixed fee above the Cost of the contract. For example, a contractor will receive a fixed sum of Ten (10) thousand on competition of the cost over the cost reimbursement as total consideration of the contract. So, the total earnings will be a fixed cost over cost reimbursement.
- Cost-plus incentive fee (CPIF): When the contract is completed successfully before the expected competition date, an incentive fee is awarded over the cost reimbursement. For example, fixed sum incentives of Rs. ten (10) thousand agreed between parties and are given on outstanding performance over & above the cost reimbursement under the contract as consideration. So, the incentive fee of Ten thousand is awarded if the work is completed in advance.
- Cost-plus award fee (CPAF): Award fee is receivable on good performance or quality work of the contract in addition to the cost. For example, Contractor Completed the project beyond the expected level of quality as 90%, and the quality standards were pre-defined as 85%. Then, the award fee will be over and above the consideration under the agreement. Here, the award fee is provided when the work is at par excellence or above expectation.
- Suitability for Business
A cost-plus contract is suitable for business projects where there are no budget constraints. This kind of a contract will be successful in certain pre-conditions. They are discussed as follows:
- Where there is a presence of an appropriate system check on the expense incurred.
- Where there are possible frequent modifications in the future with the project.
- It is suitable where it is necessary to start work at the earliest.
- Where there is a proper channel to communicate daily updates and progress of the contract.
- Where there are pre-defined terms and conditions.
- It is suitable for those businesses where the contractor has money in hand before starting the project, as most of the time, cost reimbursement took place at the end of the project.
- Where proper business financial records are maintained to calculate the cost incurred during the project.
- The Cost-plus contracts are suitable for businesses where there is no time available to calculate contract price.
Cost-plus contracts in construction business
Construction business is very volatile, and there are numerous modifications before the competition of the contract. Construction contracts are mutual or legally binding agreements.
- Cost plus vs. fixed price construction contracts
Fixed construction contracts are also known as Lump-sum contracts. These contracts have a pre-decided fixed amount for a contract, and the profit percentage is calculated on that cost only. The amount of cost percentage is the total consideration the party will receive for completing the construction contracts. So, when the contract is complete, the cost percentage fees shall be receivable by the contractor. Work certification is a mark of completion of the work. But not the whole amount is paid to the contractor on or before completion. After completion, some fraction of money is kept as retention money for security purposes for a specified time known as retention period & deductions are made in case of delay, penalties for delay, and extra payment for additional work done.
- Price escalation clause in Construction contracts
At times the fixed price or lump-sum contracts contain an escalation clause. Escalation provision is an inculcated estimated cost of labor, raw material, equipment, etc., due to inflation and continuous price change. It is an estimated calculation of the future cost based on different historical parameters.
Escalation cost includes changes in prices, inflation, risk factor, market conditions, etc. It is essential to calculate the risk of price escalation as it can be a substantial part of the big and long-term projects due to more uncertainty.
Price escalation is dependent upon input cost, actual or anticipated market changes. Price escalation should never be confused with the changes in the quantity of the input.
It is essential to inculcate reasons for a fall in prices during the construction while deciding the estimated cost of escalation for a more accurate escalation effect. The contractor will face financial difficulties if the escalation price is not estimated correctly.
Price escalation is quite different from cost-plus contracts, and there is nothing in common. Price escalation means calculation of future prices from present data or calculating the current prices from historical data. In a cost-plus contract, the cost is the total expenses incurred (both direct & indirect) plus a percentage of the cost as a fee. A Price escalation clause reflects the future price of the project, and on the other side, cost-plus contracts are to calculate the cost at the end of the contract.
- Construction contracts and need for cost plus contracts
A construction contract lays out the terms and conditions under the construction project. It is a document legally binding the parties involved therein. In simpler terms, it says that construction contracts between the property owner, contractors, and the person or company who hires the contractor to do the work.
Cost-plus contracts are the opposite of fixed-cost projects. Cost-plus contracts refer to a contract in which a fee over the cost is provided. In a cost-plus contract, a sum payable to the contractor is not fixed; rather, it is the total cost of the contract calculated at the end of the contract.
It is not possible to estimate its cost with accuracy due to fluctuations in prices in the market every day, the inflation rate is not stagnant, due to no time for negotiations on cost, etc. In construction contracts, there is a need for future modifications if the project is extended.
Construction contracts guard both parties involved in construction work. Without a legal written contract, there will be disagreements, miscommunication, confusion, and a late payment which could turn into a legal battle.
Key clauses of cost-plus contracts in construction business
The contract should include several clauses such as defining the recital, scope & objective, terms, & conditions, schedule, consideration, and how a dispute is going to be resolved. While starting to draft a contract, an introduction is the first part to start as it will introduce the binding parties to what they have agreed for.
The introduction part shall identify the document title as “Cost-plus Contract”, it identifies both the parties, effective date, identifies the hiring part as “Owner” and the contractor as “Contractor”.
Recital clause will mention the reason for entering into a contract, details about the Parties business which was not earlier mentioned in the introduction part.
Key clauses in cost-plus construction contracts are:
- Details of the project Scope of the Work: This clause will be specifying the work set out under this agreement. It will include the description of the property (address & area), contains a list of the work to be done by the contractor, obligations of the contractor, exhibit the layout of the drawing of the site, etc.
- Time of Commencement & Completion: Time of completion & commencement of the contract is very essential for cost-plus contracts so that there is no unpredictability over the term of the contract. It shall include the effective date and end date, any penalty for/if work is not completed on time. This clause is a highly negotiable part of the contract due to penalty.
- Rights and the duties of the owner and the contractor: The parties are supposed to have different roles to perform in a contract and each duty/role and right shall be decided in advance. The cost-plus contracts are always beneficial for the contractors so that the contractors know the limitation before misusing them their rights and not fulfilling their duties.
- Fee of the project/compensation/consideration: The compensation part shall discuss in detail, and is highly negotiable to decide on inclusion and exclusion of the different costs. It is the most complicated part of the cost-plus fee agreement as there would be agreements & disagreement upon inclusion or exclusion of a particular expense. It is always beneficial to decide about the expenses in advance. Expenses could be based on actual cost or it includes additional fees. Further, it is necessary to identify what falls under the category of costs. Parties can include employee salary, overtime, any direct charges, taxes, etc. The percentage of fees is fixed and is defined in advance, and in case of cost overrun, the contractor doesn’t have to bear the extra cost.
- Payment schedule: A Contractor is required to update the owner about the progress of the work done and payment pattern/intervals, based on which invoices will be raised, liens on material or equipment, withholding payment in case of non-satisfactory work done, maintaining financial records, the requirement of sub-contractors, etc. It is also equally important to bifurcate different expenses that are payable by owner and the contractor differently.
- Extension of the contract: This clause will be detailed out in advance mentioning that if the work is not completed with the time already framed then the parties are eligible for an extension on some conditions.
- Right to cancel the Contract: Specify if the contract is cancellable or not then the period during or within which the contract may cancel. Also, disclose which party has the right to cancel the contract. But this clause does not mean that one could cancel the contract anytime they feel like but there are a few exceptions. In only some exceptional cases any party could cancel the contract.
- Alteration in Order placed: During the construction, it may be possible that the requirements of the owner change, and it may be pre-decided by both parties if the contract alteration is agreeable for both parties. This clause is beneficial for the owner but may not be for the contractor. The contractor used to allot their time for the project, so any alteration will disturb their time and schedule.
- Raw material: The raw material is the key ingredient; its quality should be decided under this clause along with a warranty if any. Also, ownership of the raw material shall also be decided in advance in order to avoid any ambiguity later on while calculating the cost of the contract.
- Financial records of the Owner: A cost-plus contract is not beneficial when the contractor does not maintain physical records of documents and bills and will need to show them in case of cost overrun to justify the increase in the cost. Cost-plus contracts may not work for businesses where no financial records are maintained.
- Force majeure: This clause shall interrupt in case of the execution of the contract in case of force majeure condition.
- Representations and warranty: Each party promises something or the other under an agreement, and this clause inculcates these representations. It gives assurance or promises about their capacity to enter into the contract and declaration that they will perform their obligations. Under the warranty clause, the contractor gives assurance to correct the defective work and correction for normal wear or tear. It set some standards for the work output quality, so that in case of any defect it could be asked for a repair or correction.
Warranty can be extended by correction of the defective work and that too within a specified period, after the expiry of that period warranty expiries. Also, specify the number of years this warranty will last.
In case of normal wear and tear the owner is not responsible, if the category of normal wear & tear asked is not falling under the list shared between the parties. An exhibit of the list of normal wear & tear items shall also be shared in exhibits.
- Liability: Accidents happen every day on the construction site and the team of the contractor is always present on the site and the liability is upon the Owner which is waived if agreed by the parties but subject to the prevailing law of the land.
This clause will detail out the responsibility of the owner in case of breach of safety standards at the construction site.
- Retention money: A percentage of the amount due is retained as surety on work done as a surety and to check if work is completed or efficiently done. The retained money will be refunded only when the work is completed and retention time has expired.
- Nature of relationship: explains that the contractor is not a partner of the Owner nor employee. It is vital for the contract to explain the relation for addressing the accountability in payment of taxes, salaries to the employee liability, etc. The role of the employed contractor and the independent contractor is completely different.
- Confidentiality: The information shared during the term of the contract or before can be kept confidential by the parties as long as they wish. They can do so at the time of signing of an agreement, or at the time of the expiry or termination of this agreement obtained before or during this agreement.
- Taxes and duties: This clause will limit the liability of the owner in case of and for any requirements they need to have prior approval of the owner.
- Licenses and permit: This clause requires the parties to obtain the necessary permit and licenses to perform the work under the Agreement. Without proper permits & licenses one cannot start the work.
- Liability and Indemnity: This clause will detail out liability of the parties in case work is not completed as agreed. Under this clause, the owner indemnifies itself against any negligent act of the contractor while performing the duties.
- Facilities: Under construction contracts, one is not able to find space to keep their equipment store the raw material, therefore it is of vital importance to allocate a space to the contractor by the owner.
- Termination: This clause will detail out the liability of the parties in case work is not completed as agreed. Under this clause, the owner indemnifies itself against any negligent act of the contractor while performing the duties.
- Remedies: Usually, the contract of construction work is of specific performance and specific performance can pay it back. The remedies could be a breach of contracts, compensation/penalty, damages could also be asked for.
- Notice: This clause details the contact address to which official legal correspondence should be sent, along with the physical addresses and the email addresses of the parties.
- Ownership of the drawing and architectural work: The ownership credit shall be given to the proprietor of the copyrighted material.
- Jurisdiction: This clause allows the parties to choose the laws of a particular state, wherein the contract will be interpreted in any mutually agreeable language. The contractor needs to decide on jurisdiction at the place of their convenience.
- Dispute resolution: An arbitration clause will be better to save time from litigation, and under this clause, the venue of the arbitration shall be specified along with the number of arbitrators presiding.
Exhibit A: Scope of the work will describe what should be done, and how it is to be done. Prepare an exhaustive list of the requirements of the project.
Exhibit B: Drawing and specifications shall be exhibited in a clear manner; it will physically represent the property.
Cost-plus contracts are majorly found in the Construction Industry, where the expenditure of the contracts is reimbursed and a fixed percentage of fees of the contract cost is given to the contractor.
Those cost-plus contracts were initially designed for research & development but this won’t work until the financial records are perfectly maintained. The art of drafting a good construction contract is a mixture of so many clauses which depend upon the situation. Time is the essence of the construction contracts and profit and loss depends upon completion of the project on time.
With time, the cost-plus contracts are transforming and successful contract negotiations at the stage of drafting the contract could save one from losing millions and could avoid dispute in the future. To reduce the procedure of complex situations, parties used to add price escalation clauses if the work is not a detailed one.
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