Under the terms of a cost reimbursement contract, the contractor is paid for all of their allowed expenses within a set limit. An additional payment is then added to this set limit to permit a profit to be earned. It is a structure that is different than a fixed-price contract, which permits a single negotiated amount, no matter what expenses are incurred by the contractor.
A cost reimbursement contract depends on the contractor’s ability to make a good-faith effort to meet the needs of their client within an estimated cost. To that extent, the contract must include an estimate of contractor expenses to create the set limit. That limit creates a ceiling which a contractor would then exceed at their own risk.
These contracts are not required to offer a guaranteed completed end-item or service completion date.
List of the Advantages of Cost Reimbursement Contracts
1. It can lead to a higher quality project at the completion date.
Because the expenses are not the complete responsibility of the contractor, an accurate estimate of costs helps to create a higher quality project at the end of the day. Up until the cost limit, contractors know that they’ll be paid for all the expenses they incur, plus an extra amount on top of that to create a profit for themselves or their company. There are fewer shortcuts taken because there are more guarantees when compared to a fixed-cost contract.
2. It can be cheaper than other contract options.
When fixed costs are the primary negotiating point for new contracts, a bidding process is often implemented to determine the best possible rate. Going with the lowest possible bidder may increase the final costs of a project because the work being done may have higher maintenance costs because it is completed at a potentially lower quality. By estimating high-quality work before a project begins, the long-term savings can counter the upfront capital cost increases that may be experienced.
3. It allows for a job to be completed when unknown situations exist.
There are some projects that contractors may be hesitant to take because there are too many unknowns that may happen over the course of the work being done. If a fixed contract were in place, then materials, subcontractors, and other common costs would be over-estimated to compensate for these situations. Because contractors can have confidence that unknown situations will not set them back financially, they have less risk to themselves in signing the contract.
4. It creates a verified list of expenses.
Contractors must itemize their costs to receive compensation for the expenses they incur when completing work under this contract structure. That allows the customer to inspect the invoices to determine if the items are actually present or being used at the work site. It encourages accountability in the contracting process because communication between all parties involved is mandatory for contractors to receive payment for their expenses. It is an open-book process where all hard costs must be documented.
5. It allows for awards and bonuses to be built into the contract.
Many cost reimbursement contracts incorporate time-based and spending-based awards or bonuses to encourage contractors to maintain efficiencies. They might receive an extra percentage point or two on their profit, a specific bonus, or some other type of agreed-upon reward. For long-term projects, some contractors may agree to split the cost-savings with their clients as a way to encourage this type of contract, so risks can be reduced whenever possible for the project and contractor profitability.
6. It offers more flexibility in the decision-making process.
Some projects are highly customized. The cost reimbursement contract permits decisions to be made at a comfortable pace or for changes to be made after the project has started. Although there are higher costs when changes are made, it gives the owner of the project the extra time they need to make up their mind, or change their mind, if circumstances require it.
7. It allows owners to take advantage of discounts on materials and labor.
In many industries, contractors have access to specific material discounts. They may be able to access labor discounts through subcontracting. Under the structures of a cost reimbursement contract, there would be no upcharge on these items. That allows owners another avenue toward saving money because they would be able to take advantage of these discounts.
List of the Disadvantages of Cost Reimbursement Contracts
1. It doesn’t offer a final cost estimate.
Cost reimbursement contracts allow for a maximum cost projection. The exact costs of the project, however, are not known until it has been completed. That leads to high levels of budget uncertainty, which can be dangerous to businesses or government entities which are working on a fixed budget.
2. It can lead to inefficiencies.
Contractors who are compensated using this type of contract have less incentive to create efficiencies within their work. Until the cap is reached with the expense spending, a contractor knows that they’ll be compensated. That encourages some contractors to delay the completion of a project to maximize the compensation they’ll receive. They’ll still receive profits from their work as well, despite the inefficiencies that are present within their approach. In some contracts, an administrator can even approve additional expenses, which further increases the chances of inefficiencies being present within the system.
3. It offers positive practices which are not usually followed.
Although cost reimbursement contracts encourage contractors to provide itemized lists for their hard expenses, in practice, this requirement is rarely followed. Unless a client requests these itemized lists, a contractor will generally not provide them proactively. That means a contractor may not have this information immediately available if it is requested, which adds more uncertainty to the relationship.
4. It requires additional oversight to be effective.
Most cost reimbursement contracts will outline specific costs and fees that will be paid as part of the project. To ensure that only authorized expenses are receiving compensation, clients are required to provide additional oversight of the project than they would under other contract structures. That means there are higher administrative costs which must be considered when budgeting the expenses for each specific project. If bonuses are incorporated into the contract, another level of administrative costs must be considered too.
5. It may be limited in the scope of what is allowed.
Some jurisdictions may only allow this type of contract under specific circumstances. In 2006, Victoria, Australia required that all domestic building contracts must be a fixed-price contract unless specific circumstances were present for the project. Builders were not permitted to enter into a cost reimbursement contract that was $500,000 or more in value. There were restrictions added to the contract requirements as well. If a fair and reasonable estimate was not provided as part of the contract, then it couldn’t be enforced.
6. It forces owners to assume all of the risk.
Contractors receive most of the benefits that come with this type of contract. That is because the owners are the ones who face all the risks. Owners must assume the risk of a potential cost blow out, especially if the terms of the contract are not very favorable. They also face the risks that the work might spiral out of control, even for legitimate reasons, without many incentives for the contractor to work with owners to maximize cost savings.
The advantages and disadvantages of a cost reimbursement contract can provide benefits to both parties when an ethical approach to a project is taken. It may also encourage some contractors to take advantage of the structure of this contract to maximize the benefits of having their expenses automatically covered. Before deciding on this type of contract, be sure to review all your available options and perform your due diligence on any contractor considered.