A cost plus reimbursement contract is an agreement in which the client pays the contractor for every allowable project expense and then pays a separate fee on top as profit. The structure exists because some projects are too uncertain at the outset to pin down a total price, so the client agrees to cover actual costs as they come in rather than locking in a number that might be wildly wrong. You will see this arrangement most often in federal procurement, aerospace and defense work, and residential construction where the full scope only becomes clear as the job progresses.
The Federal Acquisition Regulation permits cost-reimbursement contracts only when the agency either cannot define its requirements precisely enough for a fixed-price contract or faces uncertainties that prevent accurate cost estimation.1Acquisition.GOV. 48 CFR 16.301-2 – Application Cost-reimbursement contracts are also prohibited outright for purchases of commercial products and services.2Acquisition.GOV. 48 CFR 16.301-3 – Limitations
The Two Payment Streams
The contract has two distinct payments. The first is reimbursement: the contractor tracks and bills every qualifying expense, from labor and materials to equipment rental. The second is the fee, which is the contractor’s profit. How that fee gets calculated varies by contract type, but it is always a separate line item negotiated before work begins.
Because the final price depends on what the work actually costs, the financial risk sits mostly with the client. The contractor is made whole on expenses regardless of overruns. That tradeoff makes sense when the client needs something built or developed but cannot write a specification detailed enough for a firm quote.
Which Costs Get Reimbursed
Not every dollar a contractor spends qualifies. Especially in government work, the rules are detailed and heavily policed.
Direct and Indirect Costs
Direct costs tie specifically to the contract: wages for engineers assigned to the project, raw materials consumed, equipment rented exclusively for the work. These get billed straight to the contract with supporting documentation like timesheets and purchase orders.
Indirect costs are shared expenses that benefit more than one contract or the business as a whole. Facility rent, utilities, IT infrastructure, and the salaries of executives and administrative staff all fall here. Because you cannot neatly assign these to one project, contractors calculate an indirect cost rate (often called an overhead rate) as a percentage of a direct cost base and apply that rate across their contracts. The government establishes final indirect cost rates through either a contracting officer determination or an auditor determination at the end of the fiscal year.3Acquisition.GOV. 48 CFR 42.705 – Final Indirect Cost Rates
Provisional Rates During the Year
Contractors cannot wait until year-end to bill indirect costs. They use provisional billing rates throughout the year, set by the contracting officer or cognizant federal agency official based on recent audits, prior-year experience, or other reliable data. The aim is for provisional rates to land as close as possible to the final rates so neither side ends up significantly overpaid or underpaid.4Acquisition.GOV. 48 CFR 42.704 – Billing Rates
Either party can request an adjustment during the year. If they cannot agree, the contracting officer can set the rate unilaterally. After the contractor submits a certified final indirect cost rate proposal following year-end, provisional rates get trued up to final rates through audit and negotiation. The difference is settled as additional payment to the contractor or a refund to the government.4Acquisition.GOV. 48 CFR 42.704 – Billing Rates
Allowable Versus Unallowable Costs
Even a reasonable business expense can be ineligible if the FAR’s cost principles say so. To qualify, a cost must be reasonable, allocable to the contract, consistent with Cost Accounting Standards (or GAAP where CAS does not apply), permitted under the contract terms, and not excluded by any specific cost principle.5Acquisition.GOV. 48 CFR 31.201-2 – Determining Allowability
Certain categories are always unallowable, no matter how reasonable they might look. Entertainment expenses (event tickets, social outings, meals at country clubs, and associated lodging and transportation) are unallowable, and club memberships are also excluded.6Acquisition.GOV. 48 CFR 31.205-14 – Entertainment Costs Lobbying and political activity, including costs of influencing elections, contributing to campaigns, lobbying legislators, or organizing public campaigns to influence legislation, are unallowable.7Acquisition.GOV. 48 CFR 31.205-22 – Lobbying and Political Activity Costs Fines and penalties resulting from violations of federal, state, local, or foreign law are unallowable, with a narrow exception for fines incurred because of specific contract terms or written direction from the contracting officer.8Acquisition.GOV. 48 CFR 31.205-15 – Fines, Penalties, and Mischarging Costs
Contractors who include unallowable costs risk disallowance of those charges and, in serious cases, penalties for mischarging. The contracting officer can disallow all or part of any claimed cost that lacks adequate supporting documentation.5Acquisition.GOV. 48 CFR 31.201-2 – Determining Allowability
How the Fee Is Calculated
The “plus” side of the contract is the contractor’s profit, and how it gets set varies. Each structure creates different incentives.
Cost-Plus-Fixed-Fee (CPFF)
A CPFF contract sets a dollar amount for the fee at the start, and that number does not change no matter what the project ends up costing. If the work runs over budget, the contractor still collects the same fee. If it comes in under budget, the fee is the same. The FAR describes this type as suitable for research, preliminary studies, or development and test work where the level of effort is unknown and an incentive-fee arrangement is not practical.9Acquisition.GOV. 48 CFR 16.306 – Cost-Plus-Fixed-Fee Contracts It is the most common cost-reimbursement arrangement in federal contracting. The contractor has minimal incentive to control costs, but the structure also avoids rewarding cost growth the way a percentage fee would.
Cost-Plus-Incentive-Fee (CPIF)
A CPIF contract starts with a target cost and an initial fee, then adjusts the fee up or down using a formula tied to how actual costs compare to the target. Beat the target, the fee increases. Overrun, the fee shrinks. The formula is negotiated upfront, typically with a minimum and maximum fee to cap both the reward and the penalty.10Acquisition.GOV. 48 CFR 16.304 – Cost-Plus-Incentive-Fee Contracts These work well when the government wants to motivate cost efficiency but the project is still too uncertain for a fixed price.
Cost-Plus-Award-Fee (CPAF)
A CPAF contract splits the fee into a base amount (which can be zero) fixed at the start and an award pool that the government distributes based on a subjective evaluation of the contractor’s performance. Instead of a mathematical formula, the award relies on judgment: a government evaluation board periodically reviews the work and decides how much of the available pool to pay out.11Acquisition.GOV. 48 CFR 16.305 – Cost-Plus-Award-Fee Contracts This is used when the government wants to incentivize performance dimensions that are hard to reduce to a formula, like quality of technical work, responsiveness, or management effectiveness. The downside is subjectivity, which can lead to disputes.
Cost-Plus-Percentage-of-Cost (CPPC)
Under a CPPC arrangement, the fee is a fixed percentage of total costs. Every additional dollar the contractor spends increases the fee by that percentage, so the contractor profits more when the project costs more. That is precisely the wrong incentive from the client’s perspective.
Federal law flatly prohibits CPPC contracting. Under 10 U.S.C. § 3322 (for defense) and 41 U.S.C. § 3905 (for civilian agencies), the cost-plus-a-percentage-of-cost system may not be used. The FAR extends this prohibition to subcontracts as well.12Acquisition.GOV. 48 CFR 16.102 – Policies CPPC contracts remain legal in the private sector, however, and they show up regularly in residential construction.
Federal Fee Caps on CPFF Contracts
Federal law limits how large the fee can be on a CPFF contract. The ceilings, based on the contract’s estimated cost (excluding the fee itself):
- 15 percent for experimental, developmental, or research work
- 10 percent for all other cost-plus-fixed-fee contracts
- 6 percent of estimated construction cost for architect-engineer services on public works
These are ceilings, not targets. Contracting officers negotiate fees below these limits using a structured profit analysis that weighs factors like contractor risk, investment, and performance history.
Cost Plus in Residential Construction
Outside federal work, cost plus contracts show up most often in home building and renovation. The mechanic is the same: the homeowner pays all labor and materials at actual cost, plus a markup that covers the contractor’s overhead and profit. A contractor might frame it as “for every dollar we spend on your project, we charge you $1.15,” meaning a 15 percent markup.
The appeal is transparency. You see every receipt. There is no hidden margin baked into inflated material quotes. If the project comes in cheaper than expected, you pay less. The tradeoff is uncertainty: you cannot know the total until the work is done, which makes budgeting difficult, especially on renovations where surprises behind walls are routine.
A few protections worth negotiating if you are signing a residential cost plus contract:
- A guaranteed maximum price (GMP) that caps total reimbursable costs, with the contractor absorbing anything above the ceiling.
- Detailed cost reporting, with itemized invoices and receipts at regular intervals rather than a lump sum at the end of each month.
- Pre-approval for expenses above a threshold, such as $500 or $1,000, requiring your written approval before the contractor spends.
Without these guardrails, residential cost plus contracts carry real risk of budget overruns, particularly with the percentage-of-cost fee structure that is prohibited in government work but perfectly legal between private parties.
Documentation and Audit Obligations
The administrative burden on a cost plus contract runs heavier than a fixed-price deal because every dollar has to be documented, categorized, and justified.
Invoicing
Contractors typically submit detailed invoices monthly, breaking out direct labor by person and hours, direct materials by item and purchase order, and indirect costs using the applicable billing rates. Each submission must clearly separate the reimbursable costs from the fee payment being requested.
For federal contracts, indirect cost proposals require a formal certification. The contractor must certify that all costs in the proposal are allowable under the FAR’s cost principles and that the proposal does not include any expressly unallowable costs. That certification carries legal weight: a knowingly false statement can trigger fraud penalties.14Acquisition.GOV. 48 CFR 52.242-4 – Certification of Final Indirect Costs
Records
Every claimed cost needs proof. Direct labor requires auditable time records showing which project and task each employee worked on, approved by a supervisor. Materials need vendor invoices, purchase orders, and receiving reports tying the item to the contract. Indirect costs require documentation of the allocation methodology and the underlying expenses feeding the rate calculation.5Acquisition.GOV. 48 CFR 31.201-2 – Determining Allowability
Contractors must retain these records for at least three years after final payment. If a contractor misses the deadline for submitting final indirect cost rate proposals, the retention clock extends by one day for each day the submission is late.15Acquisition.GOV. 48 CFR Subpart 4.7 – Contractor Records Retention
Audits
The government has a broad right to examine and audit all records related to cost-reimbursement contracts, including physical inspection of the contractor’s facilities. This right extends to any costs claimed or anticipated, whether direct or indirect.16Acquisition.GOV. 48 CFR 52.215-2 – Audit and Records-Negotiation For Department of Defense contracts, the Defense Contract Audit Agency handles the bulk of cost auditing, and one of the most consequential reviews is the incurred cost audit that settles the contractor’s final indirect rates for a given fiscal year.17Office of the Law Revision Counsel. 10 USC 3842 – Performance of Incurred Cost Audits Disorganized records are the fastest way to have legitimate costs disallowed.
How Cost Plus Compares to Other Contracts
A fixed-price contract sets the total price before work begins. If the contractor finishes for less, the savings are profit. If costs overrun, the contractor absorbs the loss. The risk picture is the mirror image of cost plus: the contractor bears nearly all the financial risk, and the client knows the price from day one. Fixed-price works best when the scope is well-defined.
Time and materials (T&M) contracts occupy a middle ground. The client pays a fixed hourly rate for each labor category, and that rate is an all-in number bundling wages, overhead, and profit into a single figure. Materials are reimbursed at cost.18Acquisition.GOV. 48 CFR 16.601 – Time-and-Materials Contracts The structural difference from cost plus is where the profit lives. In T&M, profit is embedded in the hourly rate. In cost plus, profit is a separate fee calculated independently from costs. T&M contracts are common for short-term professional services where labor hours are uncertain but the hourly value of each skill category is known.
The choice comes down to how well the work can be defined upfront. When the scope is clear, fixed-price is usually the best deal for the client. When the scope is murky, cost plus protects the contractor from losses on work they cannot yet estimate. T&M splits the difference where the effort is variable but the unit costs are predictable. No structure is inherently better; the question is which one matches the uncertainty of the project at hand.