A cost-plus-incentive fee (CPIF) contract is a cost-reimbursement contract that provides for an initially negotiated fee to be adjusted later by a formula based on the relationship of total allowable costs to total target costs.
Like a cost-plus contract, the price paid by the buyer to the seller changes in relation to costs, in order to reduce the risks assumed by the contractor (seller). Unlike a cost-plus contract, the cost in excess of the target cost is only partially paid according to a Buyer/Seller ratio, so the seller’s profit decreases when exceeding the target cost. Similarly, the seller’s profit increases when actual costs are below the target cost defined in the contract.
Formula and Examples
Incentive contracts allow sharing of the risks between the contractor and the client. The contractor is reimbursed all its justifiable costs in addition to a calculated fee. The basic elements of a CPIF contract are:
- Target Cost: The estimated total contract costs.
- Actual Cost: Constitutes the reasonable costs that the contractor can prove he has made.
- Target Fee: The basic fee to be paid if the Target Cost matches the Actual Cost (target profit). The Target Fee varies between the Minimum Fee and the Maximum Fee according to a formula tied to the Actual Cost (e.g. Target Fee could be 10% of the Actual Cost).
- Sharing Ratio: The agreed upon cost sharing proportion, normally expressed in percentage (e.g. 85% for the client / 15% for the contractor). It is often different for cost overruns and cost underruns.
Cost Plus Incentive Fee Contract
Contracts of this nature include incentives that are negotiated and agreed upon ahead of time. The incentive fee comes into play when the actual cost of the project comes in below the originally agreed upon cost in the contract. A cost plus incentive fee contract should include the following components:
- Target cost
- Base pay for the contractor
- A method to calculate incentive bonuses
- Minimum contractor pay
- Maximum contractor pay.
Additional items that should be covered in the contract include:
- Target fees
- Minimum fees
- Maximum fees
- A method to calculate fee adjustments.
Once a project has been completed, the fee the contractor is entitled to receive should be calculated using the methods built into the contract. Cost plus incentive fee contracts are used in an attempt to share the financial risk of a project between the project’s owner and the contractor.
Contracts of this nature can be considered a hybrid between the firm fixed price and cost plus contract types. These contracts utilize special theories to lay out how the project owner and the contractor will determine the best way to divide this risk. This is based on each party’s respective point of view.
Negotiating the Terms of a Cost Plus Incentive Fee Contract
During the negotiation phase of the contract, both parties will have the opportunity to discuss their point of view and reach an agreement that is optimal for everybody involved. This formula allows for fee increases that can potentially exceed the target fee within reason. However, this should only be allowed when actual costs are below the target costs.
Additionally, the contract should allow for decreases in the target fee if actual costs rise above the target cost laid out in the contract. These potential fluctuations are built into the contract as a method for providing the contractor with additional incentives to manage the project as efficiently as possible.
When the total actual cost is higher or lower than the total target cost laid out in the contract, the contractor will be paid the total allowable cost with one of two possible adjustments, based on the specific situation:
- Minimum incentive fee is applied if total actual costs are higher than the total target cost.
- Maximum incentive fee is applied if total actual costs are lower than the total target cost.