Cost-plus contract
A cost-plus contract reimburses the supplier's actual allowable costs and adds a fee, which may be fixed, a percentage of cost, or tied to performance incentives. It is used where scope cannot be priced confidently up front: development programs, defense work, prototype builds, and emergency capacity. The buyer takes the cost risk, which is exactly why the fee structure needs careful design.
Examples
Prototype build, cost plus fixed fee: Estimated cost $220,000, fixed fee $25,000. Actuals land at $268,000 after two design iterations, so the buyer pays $293,000. The fee did not grow with the overrun, which kept the supplier from profiting on the slip.
Incentive fee: A test fixture program sets target cost at $2,000,000 with a $160,000 target fee and an 80/20 share ratio. Actuals finish at $1,850,000, so the supplier's fee rises by 20% of the $150,000 underrun to $190,000, and the buyer still pays $120,000 less than target.
Allowability dispute avoided: An invoice includes $14,000 of expedited freight caused by the supplier's own scheduling miss. Because the contract defined allowable costs and excluded supplier-caused expediting, the line is rejected without drama.
Definition
Cost-plus exists because forcing a fixed price onto genuinely uncertain work produces either a padded bid or a supplier going underwater and cutting corners. Paying actual cost plus a fee lets work start before the design settles, which is why the structure shows up in development contracts, tooling programs with unstable requirements, and non-recurring engineering efforts.
The incentive problem is structural: a supplier reimbursed for its costs has no built-in reason to control them, and a percentage fee actively rewards spending more. Standard mitigations include a fixed fee rather than a percentage, an incentive fee with a share ratio so the supplier keeps part of any underrun, cost ceilings that require approval to exceed, and audit rights over what counts as allowable.
Cost-plus also demands visibility that fixed price does not. Buyers need a defined cost breakdown structure, agreed labor rates, and regular actuals reporting, in effect a contractual version of open-book costing. Teams that skip this discover at invoice time that "actual cost" is a negotiation, not a number.
Frequently asked questions
What is a cost-plus contract?
A cost-plus contract reimburses the supplier's actual allowable costs and adds a fee, which may be fixed, a percentage of cost, or tied to performance incentives. Buyers use it where scope cannot be priced confidently up front, such as development programs, defense work, prototype builds, and emergency capacity.
When should you use a cost-plus contract instead of a fixed price?
A cost-plus contract fits genuinely uncertain work. Forcing a fixed price onto an unsettled scope produces either a padded bid or a supplier going underwater and cutting corners, while paying actual cost plus a fee lets work start before the design stabilizes. Development contracts, tooling programs with unstable requirements, and non-recurring engineering are the classic cases.
What is the main risk of a cost-plus contract for the buyer?
Under a cost-plus contract the buyer carries the cost risk, and the incentive problem is structural: a supplier reimbursed for its costs has no built-in reason to control them, and a percentage fee actively rewards spending more. That is why the fee structure and cost visibility need careful design before signing.
How do buyers control costs under a cost-plus contract?
Standard mitigations in cost-plus contracting include a fixed fee rather than a percentage, an incentive fee with a share ratio so the supplier keeps part of any underrun, cost ceilings that require approval to exceed, and audit rights over what counts as allowable. A defined cost breakdown structure, agreed labor rates, and regular actuals reporting keep "actual cost" a number instead of a negotiation at invoice time.
How does an incentive fee work in a cost-plus contract?
An incentive fee sets a target cost, a target fee, and a share ratio that splits any cost variance. In one example, a program with a $2,000,000 target cost, a $160,000 target fee, and an 80/20 share ratio finished at $1,850,000, so the supplier's fee rose by 20% of the $150,000 underrun to $190,000 while the buyer still paid $120,000 less than target.
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