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.
Frequently Asked Questions about Cost Plus Contracts
What is a Cost Plus Contract?
A Cost Plus Contract is one in which the contractor is reimbursed for all construction-related costs, along with an agreed-upon percentage of those costs to cover overhead and profit.
When is a Cost Plus Contract typically used?
These contracts are commonly used when the scope of work is unclear or subject to change, as they allow for flexibility in addressing unforeseen conditions.
What are the main risks for the owner in a Cost Plus Contract?
The owner assumes the risk of cost overruns since the contractor is reimbursed for actual expenses, which requires the owner to exercise close oversight and cost monitoring.
How was the Cost Plus Contract applied in The Cumberland Suites Hotel project?
Crescent Development used a Cost Plus Contract due to uncertain work related to preserving historic site elements. The contractor was reimbursed for all construction costs plus a 15% fee for overhead and profit.
Why did Crescent Development prefer a Cost Plus Contract for this hotel project?
Because of the historic nature of the site and unpredictable scope, Crescent chose a Cost Plus Contract to allow flexibility during construction despite the lack of fixed costs.
What financial controls did Crescent Development implement in their Cost Plus Contract?
They included a not-to-exceed clause capping the reimbursable cost at $22 million to limit potential overruns and maintain financial control.
How much was the contractor’s fee expected to be in the hotel project?
Based on the initial $18 million estimate, the contractor’s 15% fee was expected to be $2.7 million, for a total estimated construction cost of $20.7 million.
What kind of owner involvement is required in a Cost Plus Contract?
Cost Plus Contracts require more active supervision from the owner to review submitted costs, approve necessary expenses, and monitor construction progress closely.
How does a Cost Plus Contract differ from a Fixed Price Contract?
In a Cost Plus Contract, the contractor is reimbursed for actual costs, while in a Fixed Price Contract the contractor commits to a set price and bears the risk of cost overruns.
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