Value of the contract is ascertained by adding a certain percentage of profit

Cost plus contract is a contract in which the value of the contract is ascertained by adding a certain percentage of profit over the total cost of the work. It is generally adopted in those cases where the probable cost of the contract cannot be computed in advance with a reasonable degree of accuracy. Such contracts are undertaken for production of special articles not usually manufactured e.g., production of newly designed aircraft component or in case of urgent repair of ships, or in case of construction during war time. Government prefers to give contract on cost plus basis. From the manufacture’s point of view, this method protects him from the risk of fluctuations in market prices of materials, labor and other services. He knows in advance the profit he can expected on the order when completed. Moreover, there is no risk of incurring loss on the contract as all agreed costs are recovered. If the contractor is unscrupulous, he may deliberately inflate cost in order to obtain higher profit. In order to avoid disputes in future, he must settle the admissible costs such as supervision, fixed overhead and losses such as allowances for wastage, scrape, normal loss etc. when bills are tendered, the burden of proving each item charged falls on the shoulder of the manufacturer. However, this system may put a premium on inefficiency in so far as the contractor, whose costs are highest, obtains highest profit. There is no incentive to find more efficient methods of production or to reduce costs, as the contractor can obtain no benefit from any saving thereby affected.

From buyer’s point of view, this method ensures that the price paid will depend on cost rather than on arbitrary commitment to specific price. Thus in uncertain market the buyer is suitably fortified and he pays only reasonable price. This method is suitable when he provides raw materials, tools etc. to manufacturer. In general, it is observed that the cost to the buyer tends to be higher than the cost which could be obtained by other forms of contract.

Target costing method the targets of volume of production and targets of various expenditures of production are fixed before hand and constant efforts are made not to exceed the expenditure targets unless there is corresponding increase in the volume of production over the fixed. Thus the contractor receives an agreed sum of profit over his predetermined costs. If actual costs are below the target fixed, the contractor is entitled to a bonus which is a proportion of saving thus made. Escalation Clause which provided in the contract to cover up any changes in the price of contract due to changes in price of raw materials and labor or change in utilization of factor of production. The object of this clause is to safeguard the interest of both sides against unfavorable changes in price.