Cost Plus Contract
A contract whereby the contractor is reimbursed for all the construction related costs, in addition to an agreed upon percentage of such costs covering the contractor’s overhead and profit. These contracts are typically used when the scope of works is unclear, however they require additional owner supervision (in comparison to Fixed Price Contracts) as the contractor is less incentivized to exercise prudent cost controls.
Putting ‘Cost Plus Contract’ in Context
Scenario Overview:
Crescent Development Group, a real estate development firm based in Nashville, Tennessee, has recently secured a prime site in downtown Nashville for the development of a limited-service hotel. The planned property, named “The Cumberland Suites Hotel,” will cater to the growing demand for mid-scale accommodations in the bustling downtown area, which is increasingly popular with tourists and business travelers alike.
The Cumberland Suites Hotel is projected to be a 120-room hotel spanning 85,000 square feet, with amenities such as a fitness center, a small meeting space, and a grab-and-go café. However, due to the historic nature of the site and the uncertain scope of work required to preserve certain architectural elements, Crescent Development decides to use a Cost Plus Contract with their general contractor.
Application of the Cost Plus Contract:
In this case, Crescent Development enters into a Cost Plus Contract with a local, reputable construction company. The contract specifies that the contractor will be reimbursed for all direct construction costs—such as materials, labor, and equipment—associated with the project. In addition to these costs, the contractor will receive a fee of 15% of the total construction costs, which covers their overhead and profit.
Given that the scope of work involves the potential for unforeseen complications—like preserving parts of a historic façade and working around unexpected site conditions—Crescent Development opts for the Cost Plus Contract to provide flexibility during the construction process. This contract type allows Crescent Development to proceed with the project even though the exact cost and scope are not fully known at the outset.
Challenges and Considerations:
While the Cost Plus Contract offers flexibility, it requires Crescent Development to maintain close oversight throughout the construction phase. Unlike a Fixed Price Contract, where the contractor bears the risk of cost overruns, the Cost Plus Contract shifts this risk to Crescent. Therefore, Crescent’s project management team must diligently review all submitted costs, ensure that only necessary expenses are approved, and regularly monitor the progress to avoid excessive cost escalations.
For example, if the contractor discovers that additional structural reinforcements are needed to preserve the historic façade, Crescent must approve these costs as they arise. While this allows for necessary adaptations, it also demands a higher level of vigilance to prevent budget overruns and ensure that the contractor remains aligned with Crescent’s financial objectives.
Financial Implications:
The initial estimated construction budget for The Cumberland Suites Hotel is $18 million. Based on this estimate, the contractor’s fee (at 15%) would be $2.7 million, bringing the total potential construction cost to $20.7 million. However, due to the Cost Plus nature of the contract, the final cost could vary depending on actual expenditures.
To mitigate the risk of cost overruns, Crescent Development sets a not-to-exceed clause within the contract, capping the total reimbursable cost at $22 million. This provides Crescent with a level of protection while still allowing the contractor the flexibility to adapt to unforeseen challenges during the construction process.
Conclusion:
This hypothetical scenario demonstrates how a Cost Plus Contract is utilized in the context of a development project with uncertain scope—like The Cumberland Suites Hotel in Nashville. While offering flexibility in managing unforeseen construction challenges, this contract type also requires the developer to take on a more active supervisory role to control costs and ensure the project remains financially viable.
Click here to get this CRE Glossary in an eBook (PDF) format.