What is a cost reimbursement contract?

A cost reimbursement contract is an alternative to a fixed price contract. Also called a cost plus contract, cost reimbursement contracts are used by governments, private individuals and businesses that are embarking on building or construction projects, on research projects or on other endeavors where a certain amount of materials will need to be purchased.

The terms of a cost reimbursement contract specify that the contractor (the builder, researcher or person performing the work) will be compensated for actual costs, which are uncertain at the time the contract is written. Typically, the worker will also be promised additional funds on top of the actual costs in order to provide a profit.

Cost Reimbursement Contract vs. Fixed Price Contract

Often, when a construction or a building project is starting, the actual costs of materials are not known and it can be difficult for a contractor to provide a fixed price contract for completing the project.

A fixed price contract specifies that the entire project will be done for a set amount of money. This means if the materials turned out to be much more than anticipated, the costs could cut into the contractor's profit. In addition, a fixed price contract could create an incentive for the contractor to cut corners on materials. After all, he would be receiving the same fixed amount no matter how much the actual cost of his materials and labor, so if he is able to buy cheaper materials this would automatically translate to more profit.

A cost reimbursement contract allows for these potential problems of a fixed price contract to be avoided. The party who wants the building or project completed promises to compensate or reimburse the contractor for the actual cost incurred, hence the name cost reimbursement contract.

Types of Cost Reimbursement Contracts

A contractor is typically not willing to perform work just to cover costs; making a profit is usually the goal. As such, cost reimbursement contracts usually include some provision for the contractor to make money. There are four different ways that these contracts can be structured in order to allow for a profit: Cost Plus Fixed Fee (CPFF); Cost Plus Incentive (CPI); Cost Plus Award; and Cost Plus Percentage of Cost.

A cost plus fixed fee contract means that the contractor will get back costs plus a predetermined designated amount. This amount does not change regardless of how much is spent on materials.

A cost plus incentive contract means the contractor receives a larger fee if he or she meets certain goals such as keeping costs down or completing the project in a designated time.

A cost plus award contract means that the contractor is paid a higher fee if he meets certain performance metrics or benchmarks for successful performance.

A cost plus percentage of cost contract means that a contractor's fee rises as the actual costs rise. This is disfavored because there is no incentive for cost control on the part of the contractor, and the federal government is prohibited from entering into this type of contract for work performed.

There are also exceptions to the general rule that a contractor will enter into a contract only to make a profit. A not-for-profit entering into an agreement with the government, for example, may agree to simply a cost reimbursement contract where the actual costs of conducting research are paid with no additional payment to provide for a profit.

Entering into a Cost Reimbursement Contract

While cost reimbursement contracts have several advantages, including encouraring the use of higher quality materials, there are also some significant disadvantages as well. The biggest disadvantage is that the cost is uncertain at the time when a project is started and when the parties enter into the contract. This means that the party who is paying the bills may receive a major surprise if the contractor spends more than was anticipated on materials.

To limit the potential adverse consequences of a contractor incurring huge costs, it is generally advisable to have a maximum limit that the contractor can spend (at least without obtaining special permission). There should also be provisions in the contract regarding how costs are to be determined for purposes of reimbursement and the contractor's accounting system must be sufficient to allow for the paying party to have a clear idea for what is being paid.

To ensure that the terms of the contract are sufficiently protective of your legal rights and interests, seek help from an experienced attorney. Having an attorney review a cost reimbursement contract before signing can also be a good way to avoid unexpected and expensive surprises.