Cost plus contracts provide for payment of allowable actual costs plus an agreed element to cover the profit as incentive.
Cost plus contracts will be entered mainly in the following situations:
(1) Existence of sole supplier of product or service.
(2) Product or service is highly complex in nature and the costs cannot be predetermined.
(3) When the product or service is a new or special one for which no cost estimates are available.
(4) In a highly inflationary situation cost plus basis is more secure when the estimates based on current costs are uncertain.
Cost plus contracts are more popular in Government for defence equipment’s and components, ships, aircraft, etc.
Principles Guiding Cost Plus Contracts:
The important guiding principles in cost plus contracts are as follows:
(1) The costs incurred for the contract should be reasonable. The term costs should be clearly defined at the time of entering into contract. Reasonableness of cost depends on the circumstances of a particular contract.
(2) The costs should be allocable to the contract based on the benefit derived from incurring such costs. The cost allocation should be fairly equitable.
(3) Cost plus contracts are based on Absorption Costing technique in which total allocation of costs will be taken into consideration.
(4) ‘Plus’ in the cost plus formula is to be determined by the parties by mutual agreement. Profit may be added to the allowable cost as an agreed percentage of total allowable cost or it may be added as a markup profit. Return on capital employed for the contract is the prudent and fair policy in allowing profit in cost plus contract.
(5) Usage of material and labour, normal wastage and spoilage allowance, idle time allowance, rate of material and labour should be predetermined. Credits from disposal of waste and scrap should be agreed upon.
(6) Abnormal losses, windfall profits and gains should not be included in cost.
(7) If special machinery and equipment are acquired for the purpose of execution of contract, any wear and tear, obsolescence costs are chargeable to the cost of the contract. If it is partly used, costs should be allocated properly.
Bid Costing and Cost Plus Contract Costing:
The major distinguishing factors between bid costing and cost plus contract costing can be visualized in the following cases:
(a) Cost plus contract costing system protects the contractor from recurring fluctuation in market prices of inputs-material, labour, and overheads. The notional revenue income can be estimated in advance of time on job completion. The risk of loss on the contract costs are covered through agreement with contractor.
Whereas in bid costing, the myopic vision of the contractor do not pave the way to protection. The burden of fluctuation on the cost of inputs generally lies on the bidder alone if he does not foresee the onslaught, and does not incorporate an escalation clause in the bidding contract.
(b) Cost plus contract costing method ensures that the price paid by the contractee depend absolutely on cost rather than on commitment of the contractor. Under uncertainty of expenditure, the contractor pays only the reasonable price on contract. Whereas in bid costing, the bidder have to take into consideration the trends in the market as per inputs. Its availability, cost content and price etc.
(c) Both cost plus contract and bid costing are based on cost estimates as per cost of required inputs from contract commitments. The only distinguishing factor most striking is the certainty and uncertainty elements involved.