This article is written by Aarlin Moncy, pursuing a Certificate Course in Arbitration: Strategy, Procedure and Drafting from LawSikho.com. This article will give you a complete overview of cost-reimbursement contracts.
Think of a contract, where one party gets reimbursed or compensated or refunded for all the expenses and losses incurred while performing the work mentioned as per the contract, and also gets an additional fee, or a fixed income or some percentage share for carrying out the work diligently as per the contract’s requirement. Such contracts are called cost-reimbursement or cost-plus contracts. The party who gets reimbursed for the work is called the “contractor”, and the party who takes all the risk can be termed as “owner”/ “company.”
Why do parties prefer these types of contracts?
Parties enter into these types of contracts when parties are unable to determine the overall cost and scope of the work/project. When the cost of the work is uncertain, the risk involved is high, and when such work requires technical and professional assistance, then it is better, that the company/owner doesn’t rely on itself and rather outsource or hire external help, as the scope of the work requires professionals and involves technicality, such contracts are entered usually through a tender or by mutual agreement between the parties.
Since these contracts provide reimbursement to the contractor for all the expenses incurred during the enforcement of the work/project, it directly shifts the risk from the contractor to the owner/company. As compared to contracts like “fixed-price contracts”, where the parties predetermine the total cost of the work/project and then enter into a contract, it limits the contractor to an extent and shifts the risk of uncertainty upon the contractor. In fixed-price contracts, the contractors try to cut down the cost by purchasing or using low-quality materials, whereas, in cost-reimbursement contracts, the quality of the resources isn’t compromised since the entire cost is reimbursed by the owner/company.
This doesn’t mean that the contractor can charge anything unreasonable from the owner/company, usually, when parties enter into a cost-plus/cost-reimbursement contract, they fix a price cap, and it is a correct move to fix a price limit or a cap in the contract. For example, A & B enter into a cost-reimbursement contract, where A is the contractor and B is a company, and the scope of the project is to build a 10 storey building for B, and B has fixed a price cap that the entire cost for this project shouldn’t exceed to more than INR 100 crores/- and also includes an additional fee for A as INR 10 crore, with a liability clause stating that if the cost of the project exceeds the limit, then it shall be shared in the ratio of 80:20 by both the parties.
From the above example, we can simply understand the whole purpose of such contracts. The main reason why these contracts are preferred over other types of contracts is that when the company wants a project to be undertaken but the same involves technicality as well as requires professional assistance, furthermore, the cost of the project can’t be predetermined as such, and lastly when the company doesn’t want the contractor to compromise concerning the resources used while carrying out the project. These contracts also involve high negotiation between the company and the contractor, as the former wants to spend less and still wants the best quality material/resources used, while the latter wants to be risk-free and earn more profit.
Types of cost-reimbursement contracts
There are different types of cost-reimbursement contracts, and some of the most used and the market relevant are mentioned below:
1. Cost-plus fixed fee
As the name suggests, it’s a contract where the contractor gets the reimbursement for the cost incurred while carrying out the work as per the contract, and also gets an additional fixed fee from the company/owner. The fixed fee is determined by the company itself. In these contracts, the contractor doesn’t have the option to earn profits by increasing the cost of the work, or by any other means.
2. Cost-plus incentive fee
These are those contracts, where the contractor not only gets reimbursed for the cost incurred but also gets an incentive based on the quality of the work, as well as on other factors like, whether the company/owner is satisfied by the work, whether the work has been completed before the term of the contract, etc. These contracts are very helpful, as it encourages the contractor to perform better and utilise all the resources to the maximum to deliver the best possible result, in return of an incentive.
3. Cost-plus percentage of the cost
These are those contracts where the contractors apart from receiving the reimbursement amount, also receives an additional fee based on the percentage (as mentioned in the contract) of the total cost of the work/project. This means that the contractor’s profit will eventually increase with an increase in the cost of the work.
4. Cost-plus award fee
In these types of contracts, apart from receiving the reimbursement from the company, the contractor becomes eligible based on its outstanding performance while carrying out the work/project and receives an award as a fee. The award is predetermined and is given on the basis of the performance of the contractor.
Pros and cons of cost-reimbursement contracts
- More transparency in such contracts, as the contractor in order to reimburse the cost, will have to provide some documentary evidence as proof regarding all the expenses incurred while performing the work, hence the company/owner can easily tally all the recorded transactions, and then pay according to the recorded transaction.
- The risk shifts from the shoulders of the contractor, since all the costs incurred get reimbursed by the company, which makes the contractor free from future uncertainties.
- Through these contracts, the contractors are further encouraged to use efficient and quality material/resources by providing them with an additional fee, incentives, and award. Hence, the work done by the contractors in these contracts is usually satisfactory and outstanding.
- These contracts tend to balance the responsibility and other aspects of a contract equally between the parties.
- One of the biggest disadvantages of these contracts is that even though the parties fix a price cap/limit, and since the scope of the work is not predetermined because of the uncertain cost involved with huge technicalities, the total cost of the work/project tends to increase, and the owner/company has to bear all such costs.
- Due to the uncertainty of the work, the tenure of the work is also unknown and cannot be predetermined.
- The contractor has to justify every cost in order to get the reimbursement of all the expenses incurred, at times it is impossible to track and record every small miscellaneous expense and because of this the contractor may have to face such losses.
- There are chances that the work/project can get delayed or terminated in the middle because of the increase in the overall cost of the work.
- There is a high chance of disputes between the parties involved if they don’t cooperate because of the uncertainty of the work and high chance of risk and huge costs that the owner will have to bear, there can be instances where differences may arise between the parties.
Important clauses to include while drafting
- Title clause: It is important that while drafting a cost-reimbursement contract, firstly, both the parties should decide which type of the cost-reimbursement contract they are entering into, and that should be made the title of the contract.
- Parties clause: While drafting the contract the parties should mention their details properly in the parties clause including their identification number (Aadhar/PAN/CIN, etc) they can also mention here that if they are being represented by a representative or not.
- Recitals/background: In this clause, you will mention the background of this agreement/contract, why the parties entered into this contract, what were the reasons, etc.
- Definition and interpretation clause: In this clause, you will have to mention and define all the important terms under this contract that have been used in this contract multiple times, to explain the exact meaning and ambit of such terms, so that no confusion arises between the parties.
- Scope of the work: This is an important clause, where you’ll have to define the entire scope and purpose of this contract, it would be better if both the parties negotiate and have a clear picture about this contract before drafting this clause, as most of the breaches in an agreement/contract arise because one of the party is uncertain about the scope/purpose of the contract. To protect your client from any such breaches, it is advisable to draft this clause properly by mentioning the entire scope of the work which has to be undertaken by the parties failing to which the contract can be terminated.
- Payment clause: In this clause, the entire payment structure can be mentioned or a reference to a schedule can be mentioned, and the schedule showing the complete structure of the payment cycle and mode can be annexed at the end of the contract. The payment as per this agreement may include the meaning of reimbursed amount.
- Fee clause: In this clause, the fee structure or the incentive structure that has to be given to the contractor by the owner/company after the completion of the work/project needs to be mentioned accordingly.
- Liability clause: After the negotiation, the parties can decide whether they will be individually liable as per their actions or any one of them would be solely liable.
- Limited liability clause: After drafting the liabilities clause it is prudent enough to draft a limited liability clause to cap or limit the maximum amount to be paid in case of any liability.
- Dispute resolution clause: A dispute mechanism clause is mandatory as whether the parties opt for arbitration/mediation or both or litigation, it is important to have a clause mentioning this, including the governing law, the venue, and the exclusive jurisdiction under this contract.
- Termination clause: In this clause, the term of the contract shall be mentioned along with the modes of termination, further, the grace period to prevent termination of the contract can also be included, failing which the contract will stand terminated.
- Event of default clause: In this clause, all the types of an event of default shall be mentioned properly, defining what all comes under the meaning of an event of default should be explained properly so that no confusion arises between the parties regarding the same in the future.
- Representations and warranties clause: In this clause, parties shall mention all the known facts about each other which led to the formation of this contract and will also mention that each of the party gives a warranty to comply with the facts failing to which either the contract will get terminated and/or the innocent party would get compensated or will receive damages for the same.
- Assignment clause: In this clause, parties can mention whether the obligations as per the contract can be assigned to someone else or is transferable to any other party or not.
Summarising the entire article, the reader should keep a few things in mind, while drafting these contracts, as these contracts involve a huge negotiation process, as well as requires good drafting skills as these contracts involve technicalities which means, certain provisions are supposed to be drafted only after proper consultation. It is better than the person drafting such contracts should research more regarding the scope of such contracts, as well as the laws governing such contracts. It is not advisable nor recommended to copy-paste any of the clauses from the templates available online. It is recommended that the concerned person who is drafting these contracts may seek legal assistance as well as get all the required details/information from the parties first, and then draft accordingly. These contracts are highly in demand, as such collaborations between the government agencies/departments or private entities are very common in every jurisdiction.
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