Cost-Plus-Percentage Contract: Construction Agreement Insights

An in-depth look at Cost-Plus-Percentage Contracts, their structure, implications, and comparisons with other contract types.

A Cost-Plus-Percentage Contract is a type of construction agreement where the contractor is compensated for all construction costs plus an additional specified percentage as profit. This contracting method is often viewed with skepticism due to its inherent disincentive for cost control.

What is a Cost-Plus-Percentage Contract?

In a Cost-Plus-Percentage Contract, the contractor’s payment is based on the actual costs incurred during construction plus a predefined percentage of those costs as profit. The formula can be expressed as:

$$ \text{Total Payment} = \text{Actual Costs} + \left(\text{Actual Costs} \times \text{Percentage Fee}\right) $$

Key Components

• Actual Costs: All costs incurred directly related to the construction project including materials, labor, and overheads.
• Percentage Fee: A pre-agreed percentage rate that is added to the actual costs to determine the contractor’s profit.

Why Cost-Plus-Percentage Contracts Are Considered Poor Business Practice

Lack of Cost Control Incentive

One major drawback is that contractors might not be motivated to minimize costs since their profit increases with rising costs. This can lead to inefficiencies and inflated budgets.

Risk Transfer

Such contracts transfer the risk of cost overruns from the contractor to the project owner, often leading to budgetary issues and disputes.

Comparison to Other Contracts

• Cost-Plus-Fixed-Fee Contract: The contractor is paid for all allowed expenses to a set limit plus a fixed fee. This offers better cost predictability and incentivizes the contractor to control costs.
• Fixed-Price Contract: The contractor agrees to complete the project for a set price, promoting efficiency and cost savings.

Applicability

These contracts are generally applicable in:

• Construction projects requiring flexibility due to unknown project parameters.
• Government contracts where detailed designs are not finalized.
• Research and development projects where costs are uncertain.

However, such scenarios also warrant vigilance and structured oversight to prevent cost overruns.

Historical Context

Historically, cost-plus-percentage contracts gained traction during wartime or for large-scale government projects where urgency and the need for rapid deployment outweighed cost considerations. Over time, the limitations of this model led to the adoption of more balanced contracts like cost-plus-fixed-fee or lump-sum agreements.

FAQs

Q1: Can a cost-plus-percentage contract be beneficial?

A1: While these contracts can offer benefits like flexibility in dealing with uncertain project scopes, the lack of cost control measures generally outweighs these advantages.

Q2: Are cost-plus-percentage contracts legally regulated?

A2: Yes, in some jurisdictions, regulations may limit or govern the use of cost-plus-percentage contracts to mitigate risks of inflated project costs.

Q3: How can project owners protect against cost overruns?

A3: Owners should enforce strict cost management practices, ongoing audits, and consider alternative contract types to limit financial exposure.

Related Terms

• Cost-Plus-Fixed-Fee Contract: An agreement where the contractor is reimbursed for allowable costs and paid a fixed fee.
• Fixed-Price Contract: A contract where the contractor agrees to provide specified services at a set price.
• Time and Materials Contract: A contract where payment is based on the time spent by the contractor plus the cost of materials.

Summary

Cost-Plus-Percentage Contracts present a flexible but risky construction agreement model. While enabling project adaptability, they often lead to poor cost control, making them less favorable compared to other contract types such as cost-plus-fixed-fee or fixed-price contracts. Understanding their structure, implications, and comparisons advises better procurement strategies and risk management in construction and project management.

References

1. “Construction Contracting: Business and Legal Principles,” by Stuart H. Bartholomew, Richard H. Clough
2. Government Accountability Office (GAO) Reports on Federal Contracting
3. Project Management Institute (PMI) Standards and Guidelines

This comprehensive approach enhances awareness about Cost-Plus-Percentage Contracts and promotes informed decision-making in construction and project management.