Definition of a Cost-Plus Contract

A cost-plus contract agrees to a fixed markup rate over the cost of raw materials for a vendor. The merchant, customer or retailer purchasing a set amount of goods agrees to reimburse the vendor for 100 percent of accepted expenses plus the fixed markup. Cost-plus contracts benefit purchasers because they offer price transparency. Vendors benefit by knowing their profit in advance and having a guarantee expenses will not cut away from their bottom line. 

Four Types of Cost-Plus Contracts

There are several ways to structure a cost-plus contract.

  1. Cost plus fixed fee (CPFF)--In this scenario, the purchaser agrees to pay a flat fee in addition to cost. The fee is set up in a contract prior to acquisition of the goods. For example, Susie agrees to buy curtains from a seamstress for a fee of cost plus $50. The vendor provides a list of expenses, including the cost of the fabric, thread, transportation of goods and payments to assistants, and then makes an additional $50 for delivering the finished curtains.
  2. Cost plus incentive fee (CPIF)--Incentive implies that a vendor will be rewarded for hitting a specific goal. The goal can be cost savings, acquisition of a specific or rare product, or any target the purchaser sets. For example, John wants a diamond between 2 and 3 carats for a piece of jewelry. He agrees to pay a diamond dealer cost plus $300 for each half carat over 2. If the jeweler finds a 3-carat diamond, the jeweler will earn $600. 
  3. Cost plus award fee (CPAF)--An award fee is like an incentive fee, but it usually involves performance rather than acquisition. For example, an engineer may receive a CPAF contract from a car manufacturer for creating a car that meets certain fuel economy regulations.
  4. Cost plus percentage of cost--This agreement is rare because it actually rewards a vendor for raising the cost of goods. The vendor would be given a percentage of the total cost of the good delivered.

Problems with Cost Plus Contracts

From a purchaser's perspective, cost plus is an excellent model for operation. A purchaser can control how much he or she is paying a "middleman" for his or her work. For example, many purchasers pay a broker or agent a cost-plus structure. This ensures the agent will not arbitrarily "mark up" the price of a good or service in order to take a cut and earn a profit. From the eyes of the middleman or vendor, though, cost-plus contracts can be problematic. Many vendors make their money by marking up products a very high amount. Car dealers, jewelry dealers and restaurant owners are good examples of this phenomenon. A car dealer pays only a small portion of a car's retail sales price and turns a large profit on the sale. A restaurant owner may mark up the price of a bottle of wine 50 percent or more. These vendors do not use cost-plus contracts because they do not want to give up their large markups.