Contractors may sometimes accept a contract on the condition that the contractee will bear all costs incurred in executing the contract, plus a fixed rate or percentage of profit calculated based on the total cost.
A contract of this type is known as a cost plus contract. It is generally adopted in cases where the probable cost of the contract cannot be ascertained in advance with a reasonable degree of accuracy.
Cost plus contracts are frequently offered by the government to produce special articles that are not typically manufactured (e.g., newly-designed aircraft components or urgent repair works for ships, vehicles, and powerhouse).
From the contractor's perspective, this method protects them from the risks of fluctuations in market prices of material, labor, and other services.
In these contracts, the contractor knows in advance the profit they can expect on a contract when executed.
From the contractor's point of view, the method ensures that the price will depend on cost rather than on an arbitrary commitment to a specific price.
To reduce the element of risk due to market fluctuations, an escalator clause or escalation clause may be included in the contract.
According to this clause, one of the conditions is that in the event of a change in the prices of materials, labor, and other services during the course of the execution of the contract, the contract price should be adjusted accordingly.
If there is an increase in the prices of materials, labor, and other services beyond a particular level, the contractee will bear such additional costs.
Similarly, if there is a reduction in the price of materials and/or labor beyond the specified level, the contractor shall allow a rebate in his bill to the contractee.
The escalation clause in a cost plus contract states that when there is an increase in the price beyond a particular level, the contractor will bear such additional costs. Similarly, if there is a reduction in the price of materials and/or labor beyond the specified level, the contractor shall allow a rebate in his bill to the contractee.
Escalation means changing prices, whereas indexing means changing price by reference to an index number. Indexing clauses are based on fixed percentage increases or decreases in costs, whereas escalator clauses can be negotiated with the contractee and may include terms such as 'fixed percentage', 'cost plus', 'specified price adjustment' or 'market-based indicator'.
The escalation clause is found in cost-plus contracts, such as those for transportation (e.g., shipbuilding), construction (e.g., road building), equipment supply (e.g., aircraft supply).
Commonly used contracts that do not involve an escalation clause are commodity contracts, e.g.: (i) Contracts with suppliers to provide standard goods or services at a fixed price, for example, a time and materials contract. (ii) Contracts where the supplier is not exposed to any increase in cost through usage of material or labour inputs, for example, purchase contracts based on a fixed formula.
The main disadvantage of an escalation clause is that the final price charged may be uncertain until the work is complete. The contractee may have to finance costly overruns, which might be difficult for them depending on their financial position.
About the Author
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
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