Cost-Plus-Percentage Contract

Definition of Cost-Plus-Percentage Contract:

A cost-plus-percentage contract is a type of construction agreement where the contractor is compensated with a specified percentage profit over and above the actual construction costs. This means the final payment to the contractor covers all expenses incurred during the project, plus an additional percentage as profit. These contracts can lead to higher project costs since the contractor lacks a strong incentive to minimize expenses.

Examples:

Smith Construction Company: Smith Construction Company entered into a cost-plus-percentage contract to build a new high school. If the agreed percentage is 10% above the actual construction costs and the project costs $10 million, Smith Construction will receive a total of $11 million ($10 million + $1 million profit).
Urban Developments Inc.: Urban Developments Inc. signs a contract with a local government to renovate a public library under a cost-plus-percentage agreement at 15%. If the total renovation expenses amount to $5 million, Urban Developments will be paid $5.75 million.

Frequently Asked Questions:

Q1: Why are cost-plus-percentage contracts considered poor business practice? A1: Such contracts are often criticized because they can lead to inflated project costs. Since the contractor’s profit is a percentage of the total expenses, there is little motivation to control or reduce costs, potentially leading to higher overall expenses.

Q2: What alternative contract type is recommended instead of cost-plus-percentage? A2: A cost-plus-fixed-fee contract is generally a better alternative. Under this agreement, the contractor is paid for the actual costs incurred plus a predetermined fixed fee, regardless of the total costs. This structure provides some incentive to manage costs effectively.

Q3: Are cost-plus-percentage contracts ever beneficial? A3: While typically viewed with caution, these contracts might be beneficial in complex or uncertain projects where comprehensive cost estimation is difficult. They ensure the contractor is compensated for their effort without the need to underbid.

1. Fixed-Price Contract:

An agreement where the contractor agrees to complete a project for a predetermined lump sum, irrespective of actual costs. The contractor bears the risk of cost overruns.

2. Cost-Plus-Fixed-Fee Contract:

A contract where the contractor is reimbursed for actual costs incurred plus a fixed fee as profit. This can incentivize the contractor to control costs better than a percentage-based arrangement.

3. Guaranteed Maximum Price (GMP) Contract:

This type of contract states that the contractor will perform the specified work and deliver the project for a maximum price. Any costs incurred above this price must be absorbed by the contractor.

Online Resources:

National Association of State Procurement Officials (NASPO): Guidance on different contract types and best practices. NASPO Guide
Project Management Institute (PMI): Detailed resources on project procurement and contract management. Project Management Institute
American Institute of Architects (AIA): Standards and practices in construction contracts. American Institute of Architects

References:

“Construction Contracting: A Practical Guide to Company Management” - Jimmie Hinze
“Legal Aspects of Architecture, Engineering, and the Construction Process” - Justin Sweet, Marc M. Schneier
“Management of Construction Projects: A Constructor’s Perspective” - John E. Schaufelberger

Suggested Books for Further Studies:

Construction Contracts, by Jimmie Hinze: Comprehensive view on construction contracts and management.
Contracts and the Legal Environment for Engineers and Architects, by Joseph Bockrath: Explores legal implications and framework for different types of construction agreements.
Construction Law for Managers, Architects, and Engineers, by Nancy J. White: A detailed look at legal considerations in the construction industry, including contract types and their implications.

Real Estate Basics: Cost-Plus-Percentage Contract Fundamentals Quiz

### What is a cost-plus-percentage contract? - [x] A contract where the contractor is paid actual costs plus a percentage profit - [ ] A contract with a fixed fee regardless of actual costs - [ ] A contract that specifies a fixed price for the entire project - [ ] A contract with a cost ceiling agreed upon at the outset > **Explanation:** A cost-plus-percentage contract involves paying the contractor the actual construction costs plus a specified percentage profit. ### Why might a cost-plus-percentage contract lead to higher project costs? - [ ] Because contractors receive a large fixed fee - [x] Because contractors lack incentive to minimize costs - [ ] Because the project has a fixed budget ceiling - [ ] Because contractors are usually underpaid > **Explanation:** Contractors may not control costs effectively since their profit increases with the total expenses under a cost-plus-percentage contract. ### What type of contract is often recommended over a cost-plus-percentage contract? - [ ] Lump sum contract - [ ] Time and materials contract - [x] Cost-plus-fixed-fee contract - [ ] Unit price contract > **Explanation:** A cost-plus-fixed-fee contract is generally considered more favorable as it includes a fixed fee, incentivizing cost control. ### In a cost-plus-percentage contract, what determines the contractor's profit? - [ ] The overall time spent on the project - [ ] The total number of materials used - [x] A percentage of the total project costs - [ ] The initial project estimation > **Explanation:** The contractor's profit is determined as a percentage of the total project costs in a cost-plus-percentage contract. ### What is a potential drawback of a cost-plus-percentage contract for the client? - [ ] Reduced transparency in cost reporting - [x] Increased total project expenditure - [ ] Reduced project scope flexibility - [ ] Decreased contractor accountability > **Explanation:** Due to minimal incentives to control costs, the client might face increased total project expenditure. ### What type of project might benefit from a cost-plus-percentage contract despite its drawbacks? - [x] A project with substantial uncertainty in costs - [ ] A routine maintenance project - [ ] A fixed budget government project - [ ] A project necessitating cost minimization > **Explanation:** Projects with significant uncertainty may benefit since this contract ensures the contractor is paid for their effort without underbidding. ### Which term describes a contract where the contractor bears costs exceeding a maximum price? - [ ] Cost-plus-free - [ ] Cost-time-sharing - [ ] Lump-sum - [x] Guaranteed Maximum Price (GMP) Contract > **Explanation:** In Guaranteed Maximum Price (GMP) contracts, the contractor bears any costs that exceed the maximum price agreed upon. ### What incentive structure does a cost-plus-fixed-fee contract provide? - [ ] Incentive to increase costs - [x] Incentive to control costs - [ ] Incentive to maximize material usage - [ ] Incentive to shorten project duration > **Explanation:** By providing a fixed fee, this contract incentivizes better cost control while ensuring a reasonable profit for the contractor. ### Identify one advantage of using a fixed-price contract. - [ ] The contractor profits from increased costs - [ ] It makes the project costlier - [x] The project cost is known upfront - [ ] The client must bear all cost overruns > **Explanation:** Fixed-price contracts are advantageous as the project cost is determined upfront, limiting financial risk for the client. ### Why might a cost-plus-percentage contract be avoided in large-scale public projects? - [ ] Because contractors may face high penalties for delays - [ ] Because project duration is less - [x] Because the total cost becomes unpredictable and potentially very high - [ ] Because contractors prefer less complex contracts > **Explanation:** Due to the large scale and potential for high costs, unpredictability in total cost makes this contract less favorable for public projects.