Contractors have a variety of contract types to choose from when pricing construction-related projects. Two of the more flexible types are time and materials (T&M) and cost-plus. Both options can work when establishing a firm estimate for an entire project is challenging, such as when the scope of work isn’t clearly defined. The primary difference, however, lies in how each type of contract enables the contractor to account for profit.
Time & Materials Contract vs Cost-Plus Contract
T&M and cost-plus contracts are two ways businesses, particularly in the construction industry, bill clients for projects. Both contract types are useful when it’s difficult to determine a project’s final cost before work begins. Each stipulates hourly wages for labor (employees and subcontractors), materials required for the job, and associated indirect costs (overhead, administration). Yet the complete estimate is left open to allow for flexibility should the scope or duration of the project change. The main difference is the way profit is handled. With a T&M contract, fees are marked up, so the contractor makes a profit. With a cost-plus agreement, a contractor bills for expenses at cost plus an additional, separate fee that represents its profit. That fee may be either fixed or based on a percentage of the project’s total cost.
What Is a Time & Materials (T&M) Contract?
A T&M contract may be preferred when the exact scope or duration of a construction project is difficult to pinpoint at the outset. Rather than establishing a fixed price for the entire project, a contractor establishes prices for labor rates and specifies job materials to be used along with a markup rate (typically 15% to 35%) to account for profit. If anything about the project changes — such as the need for additional labor — the cost is already predetermined.
A T&M contract may also include a “not-to-exceed” clause, which sets a ceiling for the maximum number of labor hours should the project grow. The price of the entire project may be capped, as well. Depending on the terms, a contractor will bill the client at agreed-on intervals, such as monthly or by predetermined stages of work, rather than in a lump sum at the end of the project.
The key advantage of a T&M contract lies in its flexibility, which protects both the contractor and the client. The contractor assumes fewer risks because it can bill for added labor at already negotiated rates and/or materials, while the client can see exactly what they’re paying for. Additional benefits of a T&M contract include:
- Individual prices are spelled out at the project’s outset, so a contractor doesn’t have to worry about underestimating or overestimating a project’s total cost. Either scenario is a risk: Bid too low and the contractor may not be able to cover its expenses or turn a profit. Bid too high and a lower-priced competitor may be awarded the project instead.
- A project can start sooner because the need for to-the-penny estimation is alleviated.
- Profit is predictable.
- Adjustments are easy if the client wants to modify the project.
- Cost transparency builds trust between the contractor and client.
A T&M contract is not without several disadvantages. Chief among them: The contractor could lose some profit if the project surpasses the contract’s not-to-exceed terms. In addition:
- Contractors must be very diligent about tracking the number of hours each worker works and the materials purchased and used, and make sure all costs fall within maximum allowances.
- Given the open-endedness of a T&M contract in terms of a project’s completion, the client may worry that some contractors may not work as efficiently as they otherwise would.
- Contractors have to front project costs, which may hurt cash flow.
- Even though pricing has been stipulated, conflicts may nevertheless arise, leading to delays in reimbursement.
When to use a T&M contract:
T&M contracts are a smart option for long-term projects where the exact scope or duration is difficult to calculate upfront. This type of contract offers flexibility, safeguards a contractor’s profit and minimizes the likelihood of disputes because costs are predetermined. A contractor that is new to the industry and still learning the estimating ropes may want to opt for a T&M contract, as well.
Like a T&M contract, a cost-plus contract is useful when the nature of the project makes it difficult to predict its entire cost. The difference is instead of building profit into expenses, the contractor bills for actual costs plus its profit — a separate, predetermined fixed fee or percentage of the project’s total cost. A cost-plus contract may also account for increases in the cost of materials and include financial incentives if, for example, a contractor hits all performance targets. At the customer’s request, this type of contract may include a cap on total expenses.
Besides the construction industry, many government and defense agencies prefer to use a cost-plus contract, also known as a cost-reimbursement contract. The reason? They say these contracts result in proposals from better-qualified contractors, rather than those producing the lowest-cost bids. Corporations also may use cost-plus contracts when outsourcing projects.
Like a T&M contract, a contractor is reimbursed for all costs specified in a cost-plus agreement. But by including a separate, predetermined and fixed profit, a contractor may actually make more than expected, should actual costs be lower than anticipated. Among some other benefits of a cost-plus contract:
- If costs for materials, labor and other expenses spike, a contractor can bill the client for the increases, rather than having to absorb them — but only if the contract stipulates this.
- Overall, there is less risk for the contractor.
- In addition, the contractor can focus not on costs, but on performing quality work.
- Inclusion of possible financial incentives can further motivate contractors.
- Large projects can get under way more quickly than when having to determine an exact estimate.
The main drawback? A cost-plus contract requires the contractor to fiercely track and manage its costs. Anyone less than organized runs the risk of bearing expenses that should have been billed to the client, which may also occur if a project’s costs exceed the contract’s stated cap. In addition, if the contractor’s profit is based on a percentage of the project’s total fee, any missed or mismanaged expenses will likely decrease profit. A few other cost-plus disadvantages include:
- Disputes may arise when trying to recover construction-related expenses.
- Projects can take longer to complete.
- As with a T&M contract, the contractor has to handle project costs up front, which may affect cash flow.
When to use a cost-plus contract:
A cost-plus contract comes in handy when it’s unclear how long a project will take to complete or the scope of work can’t be accurately assessed. As a result, total costs for materials, labor, overhead and administrative expenses are hard to pin down before a project begins. What a cost-plus contract does make clear is the contractor’s profit, presented as either a fixed sum or a percentage of the project’s total cost.
Choosing Time and Materials vs Cost Plus: Which Contract Is Best?
T&M and cost-plus are two flexible types of contracts used by contractors when the scope of the job or its duration are difficult to predict. One isn’t inherently better than the other. In both cases, prices are fixed for various project elements — for example, labor and materials — but the final price is determined at completion. The key difference between the two lies in the way a contractor factors for profit. In a T&M contract, the contractor adds a markup rate to its costs. In a cost-plus contract, the contractor bills for actual costs plus a separate amount for profit, either a fixed fee or a percentage of the project’s total cost.
When to choose time and materials (T&M):
A T&M contract is practical for any project where it is difficult to predict total costs for materials and labor. For example, a client may know overall what they want but not be ready to decide on the details. Or the contractor may have a sense more will be involved in a project than meets the eye. For example, from experience, contractors know renovation of an older building may uncover hazardous conditions whose repair or remediation was not part of the original scope of work.
When to choose cost-plus:
A cost-plus contract is beneficial when a contractor wants to take on the least amount of risk but be assured of making a reasonable profit. This contract type works well when the project’s cost may be unpredictable, particularly if the client is prone to making changes or in times of economic changes. A cost-plus contract is also useful when the quality of the finished project is more important than cost, even for a client with a finite budget.
T&M and cost-plus contracts are more similar than different — the main distinction is how each handles profit. With a T&M contract, project costs include a markup fee, which represents the contractor’s profit. In a cost-plus contract, profit is calculated as an agreed-on fixed fee or percentage of the project’s full cost. The two contract types are both used in situations where it’s difficult to determine a project’s total cost up front. They also put more of the onus on the contractor to keep accurate records of all costs. An advanced project accounting system for tracking these costs can help.
Time and Materials vs Cost Plus FAQs
Is cost-plus the same as time and material?
While there are many similarities between the two contract types, a cost-plus contract separates profit from all other expenses. An agreed-on fee is either a fixed amount or based on a percentage of the project’s total cost. Contractors who use a T&M contract mark up costs of materials and other expenses to earn their profits.
What is the difference between fixed price and T&M?
A fixed-price contract, also referred to as a lump-sum contract, determines the exact price of a project before it begins. A T&M contract may be used when it’s difficult to accurately determine that final figure because the exact scope or duration of the project is unclear. Rather than establishing a fixed price for the entire project, a contractor sets fixed prices for labor rates and job materials, which are marked up to include a profit for the contractor.
Is T&M a cost-type contract?
A time and materials contract is similar to a cost-plus contract in many ways, but not in the way it handles profit. Profit comes from the markup of costs in a T&M contract, whereas profit is a separate fee in a cost-plus contract.
What is included in a cost-plus contract?
A cost-plus contract includes the cost of goods sold (COGS), including materials and labor, as well as overhead, such as administrative costs, insurance, permits, transportation and utilities. A cost-plus contract also stipulates the contractor’s profit, typically a fixed fee or percentage of the project total.