What Are the Main Differences Between a Fixed Price and Cost Reimbursement Arrangement?

Fixed price and cost reimbursement are two approaches to creating contracts for service work. With the fixed price method, the contract and hiring party agree to a fixed price at the start of the project that doesn't change. With cost reimbursement, the contract allows for recovery of costs for materials and supplies that were purchased for the project, as outlined in the terms of the agreement.

A fixed price contract means that the service provider offers or accepts an agreement to complete a contracted project for a set fee stated at the onset of the work. In a government bidding process for road work, for instance, construction companies might be asked to submit bids based on fixed price contracts for the entirety of the work. The company estimates labor expenses, materials costs, and a mark-up for profits to submit the bid.

With government jobs, companies are usually required to submit bids in certain ways, which often mandate a fixed price for the entire project. Companies providing services to private businesses and consumers would look at the strengths and weaknesses of fixed price contracts relative to other options. Consumers increasingly prefer fixed pricing because of the transparency in knowing the price up front. For providers, fixed fee pricing can simplify sales forecasting methods. The main drawback, though, for service providers is the risks of setting a fixed price that is too low, and then putting in lots of uncompensated man hours and materials expenses.

A cost reimbursement contract is typically a more detailed arrangement that sets up acceptable materials costs the provider can seek reimbursement for as part of a project. Types of contracts vary, but include simple cost contracts with no service fee, cost-plus-incentive contracts, and the common cost-plus-fixed-fee contract. In this scenario, the contract states the fee the provider earns for the project on top of reimbursement he receives for agreed-upon expenses. For instance, the contract might allow for costs plus a $10,000 fee. Thus, if reimbursed costs for materials and labor are $20,000, the total bill would be $30,000.

The major advantage for a provider is knowing what amount will be realized on a project regardless of the time and materials costs. This minimizes the risks. The contract also guides the acceptable use of materials and supplies. A minor downside is a cap on potential earnings. Regardless of how efficiently the provider works, the fee is limited to the contracted amount. There also are risks in purchasing materials and supplies and getting into a dispute over reimbursement. In the business and consumer markets, customers are likely to be unwilling to set up a contract with an open-ended total cost.