Cost Reimbursement Contract

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Cost Reimbursement Contract

A Brief Introduction About the Cost Reimbursement Contract

A Cost Reimbursement Contract is also known as a Cost-Plus Contract. Governments, private individuals, and businesses in construction and building projects or transactions use it when it is not commercially feasible to determine the exact cost of the project in advance.

As opposed to a Fixed-Fee Contract, a Cost Reimbursement Contract enables the contractor to be compensated for actual costs, which are otherwise uncertain at the time of signing of the contract. Under such contracts, the worker is also promised a stipulated fixed fee in addition to the cost of materials or purchases made. A Cost-Reimbursable Contract allows an employee or contractor to protect his assets and profits with minimum commercial cost

Who Takes the Cost Reimbursement Contract? – People Involved

A Cost Reimbursement Contract is usually entered into by Governments, Private Individuals and Businesses who are involved in large construction/ research projects or business transactions wherein the cost and quantity of materials required is not very clear at the start. The contract first came into use in the United States when the Government wanted to engage with large multinational companies for wartime production during the World Wars.

The terms of the contract at that time has enabled organizations such as Hewlett-Packard to charge the Department of Defense for the actual cost of the research and development undertaken as opposed to being paid a fixed fee. As of today, the Cost Reimbursement Contract is widely used by organizations and Governments in business transactions that require the payment of actual costs and expenses (as opposed to a fixed sum) in addition to a fixed fee.

Purpose of a Cost Reimbursement Contract – Why Do You Need It?

The main purpose of a Cost Reimbursement Contract, as the name suggests, is to enable vendors/ sellers in a business transaction to be adequately and fully reimbursed for the expenses that they incur over and above the standard contract fee. The agreement works on the reimbursement principle, and that transacting parties should be allowed to protect their interests by engaging in fair business practices at all times.

Cost Reimbursement contracts are brought in a place where Fixed Fee Contracts absolutely wouldn’t work. For example, in case of a high-cost construction project, being paid a fixed fee could mean that the vendor ends up running losses. This is because the timeline, cost/quantity of materials, and workforce needs cannot always be anticipated in advance or may vary during the project.

In such a scenario, a cost-plus contract provides the vendor with a mechanism to be paid for actual expenses incurred as assessed at the end of the contract or as per the agreed-upon milestones during the term of the contract. As a remedy, the contract enables the contractor to stop working after the available funds have been spent or, if necessary, to receive additional funding to continue the project.

Contents of a Cost Reimbursement Contract – Inclusions

As discussed earlier, a Cost Reimbursement Contract should contain a clear flow of payment from the buyer to the seller in full reimbursement of the seller’s costs (over and above the fee, which is also known as the seller’s profit). To enable such a mechanism, it becomes important to spell out the scope of the work and an anticipated timeline over which it will be completed. As far as the reimbursement of the expenses is concerned, the contract should specify the types of expenses which could be incurred (including a breakup or direct and indirect costs) and an estimated figure for the same.

It should also be sufficiently representing that the figures so provided only mark an estimate and that the seller is liable to be paid in full, basis the proof of expenses submitted. Additionally, the contract should also stipulate how and when the expenses will be reimbursed (reimbursement clause), i.e., at the end of the whole term or in installments throughout the contract period. While the ‘scope of work’ and ‘payment terms’ may look like the most crucial clauses of this contract, it is equally important for such an agreement to specify what happens when the buyer refuses to pay for the expenses. To this effect, clauses such as remedies, dispute governance, and termination clauses should also be drafted with utmost scrutiny while preparing a cost-plus or cost-reimbursable contract.

How to Draft a Cost Reimbursement Contract?

Since this contract isn’t the simplest one to exist, drafting it could become a tedious task. Before writing a Cost Reimbursement agreement, it is advisable to ascertain whether it is indeed needed or if a simpler fixed-fee contract would suffice in its alternative. While writing a cost-plus contract, it is also important to include clauses that sufficiently secure the seller’s position without jeopardizing the buyer’s terms. It is important to ensure that the contract doesn’t appear too difficult in the eyes of the buyer.

As also mentioned previously, a cost-plus contract, more than anything, requires immense clarity around payment terms and timelines. It also requires stringent drafting in terms of remedies for non-payment, including but not limited to termination. While negotiating and drafting a cost-plus agreement, it also holds good to have well-drafted dispute resolution clauses[2]. Typically, the emphasis should be on mutually agreeing upon differences in the contract (if any) with the help of governance meetings or mediators.

Negotiation Strategy

It isn’t uncommon for a Cost Reimbursement Contract to receive major pushback from the buyer. It thus becomes vital to utilize sound negotiation skills while agreeing upon or discussing cost-plus agreements. Given its complex nature, it is advisable to involve an attorney while negotiating this contract. An experienced commercial lawyer will be able to protect your legal rights and interests in the transaction while also helping you avoid any unexpected and expensive surprises in the future.

Benefits and Drawbacks of a Cost Reimbursable Contract

Much like any other agreement, a Cost Reimbursement Contract carries its own set of advantages and disadvantages. While the cost-plus contract provides security to the seller, the buyer is benefited by clear cost terms and better work quality. For the sake of convenience, below is a brief overview of the several benefits and the possible drawbacks of this contract:

Benefits for the Seller:

  • Fair compensation and no risk of losses from wrong estimates, underestimated quotation and changing prices
  • Flexibility and coverage for price inflation, steep material costs, etc.
  • Ability to undertake projects in which the scope and design of the work aren’t entirely clear.
  • Chances for more earning more profit with performance incentives.

Benefits for the Buyer:

  • Assurance of better quality since the seller is incentivized and given flexibility in terms of buying high-cost materials.
  • Advantage of paying a final cost that could be less than that in a Fixed Price Contract.
  • It allows more oversight and control over the seller’s work.
  • No time wasted in bargaining.

Drawbacks for the Seller:

  • Advantage of being paid a fixed sum that could potentially be more than the expenses is denied.
  • Additional oversight and micro-management from the buyer could result in hindrances.

Drawbacks for the Buyer:

  • Additional administration expenses to ensure that the seller adheres to cost controls and other measures.
  • Risk of paying higher amounts against a Fixed Fee Contract.
  • Lesser work efficiency on the seller’s part since he/she will anyway earn a profit.
  • Forces Owners/Buyers to assume all the risk in some cases.

What Happens in Case of Violation?

The seller is adequately protected in case of a violation of a Cost-Plus Contract by the buyer. For instance, if the buyer refuses to pay for the estimate of materials, the seller can halt the work until the funds are released or even terminate the contract as needed. Similarly, if the seller violates the contract by overrunning cost controls or by overcharging for the expenses, the buyer can claim adjustments in the next phase of work or obtain damages as specified. Breaches[1] of Cost-Plus work, if adequately covered in the contract via remedies can be tackled with the help of damages or termination in some cases.

A cost-plus contract should be drafted when it is desirable to shift some risk of contract performance from the seller to the buyer. Different types of Contracts are available to suit different business needs.

Similarly, the agreement holds several advantages as well as disadvantages for both the parties to the contract. Owing to its complex nature, a cost-plus agreement can be full of challenges for the owner and contractor. However, with careful drafting and negotiation, the contract can reap benefits for both parties.