Cost plus

A third basic method by which the contractor may be paid is the cost-plus method, under which the owner pays the contractors costs related to the project plus a fee that covers profit and nonreimbursable overhead costs. This approach seems simple, straightforward and desirable, at first glance. However, there are some disadvantages, as we shall see. Two types of cost-plus contracts are used: (1) cost plus a percentage of costs, under which the fee is an agreed-upon percentage of the costs and (2) cost plus fixed fee, wherein the fee does not depend on the contractors costs. Of particular importance in this type of contract is the need to define costs; Halpin and Woodhead (1998) point out that if the owner is not careful, he may be surprised to find out he has agreed to pay for the contractors new computer.

In Chapter 4, we shall describe methods used by owners to select contractors and we shall find that cost-plus contracts are often, though not exclusively, negotiated rather than subjected to a tender process. Clough and Sears (1994) list four important considerations to be taken into account by owners and contractors when negotiating such contracts, as follows:

a definite and mutually agreeable subcontract letting procedure;
 a clearly understood agreement concerning the determination and payment of the contractors fee;
 an understanding regarding the accounting methods to be followed;
 a list of job costs that will be reimbursable.

Sears and Clough (1994) further note that two categories of expense can be particularly difficult to define and manage. One is contractors general overhead. Are the costs of preparing payroll and working drawings, of engineering and other office functions, and those general administrative costs involving home office personnel reimbursable or are they to be covered by the fee? Clear definition is essential. The other troublesome category of reimbursable cost is that related to construction equipment; if the contractor owns equipment used on the job, some sort of charge rate must be agreed upon.

The American Institute of Architects (1997, 2001), in its standard forms of agreement between owner and contractor for cost-plus-fee contracts, sets forth a detailed list of the labour, subcontract, materials (both incorporated into the work and used on a temporary basis), equipment and miscellaneous costs that will be reimbursed as well as those costs not to be reimbursed. The general idea is that costs directly related to the work will be reimbursed, while those of a truly general, company-wide nature, will not. But often there will be confusion and disagreement, even in the most carefully drawn contract, as to whether certain general overhead costs are to be reimbursed.

In selecting a cost-plus type of contract, the owner will want to recognise that a cost-pluspercentage contract may lead to overspending by the contractor, because there is little incentive to be efficient and economical. Under this system, the greater the costs, the more will be paid as a fee. There is less incentive to overspend under the cost-plus-fixed-fee type of contract and the contractor may be motivated to complete the project quickly in order to save on non-reimbursable overhead expenses and recover the fee quickly. On the other hand, the contractor may tend to skimp on quality, because the fee will be the same no matter how low the costs are. A cost-plusfixed- fee contract requires the project size and scope to be defined reasonably firmly, so that a fair fixed fee can be defined. Another disadvantage to the owner under any cost-plus arrangement is the lack of definition of total project cost until the project has been completed. But the owner can begin the construction early in the design phase using a phased-construction approach, with a contract that simply defines reimbursable costs and the fee arrangement.

It is to the contractors advantage to shift the risk of cost increases to the owner and still be assured of recovering reimbursable costs and being paid some fee. However, financial rewards for innovative construction methods leading to cost savings are for the owners benefit, not the contractors.

Some of the disadvantages of cost-plus contracts noted above can be mitigated to some degree with variations of the basic cost-plus approach. These variations are discussed in the following section.


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