My family has been involved in both mining and construction at various times past and present so I've seen a couple of areas where "cost plus" pricing is used.
Generally speaking, it's a recipe for the provider to stick their snout in the trough as far as it will go. There is absolutely no incentive to lower costs or improve efficiencies. It does indeed become a game of brinkmanship between maximizing costs (profits) and cancellation.
I have seen it used in construction to mitigate risk. One example springs to mind. A particularly wealthy but eccentric individual wanted to build a lavish home. He was notorious for changing his mind, adding to the project and so on. The only way the company in question would touch the construction contract was on a "cost plus" basis.
Whenever you do this you basically have to trust the provider to a certain extent and it only really works if they trade on reputation and a hit to their reputation actually matters (often it doesn't).
>There is absolutely no incentive to lower costs or improve efficiencies.
This is almost never true with cost-plus contracts. There are normally all sorts of incentives and written into the contract. For example, bonuses might be paid if particular milestones are achieved ahead of schedule, or if certain costs come in below estimates. Also, there are usually limits on reimbursement (typically at the level of components rather than the entire project).
If used properly, these incentives and restrictions make it in the contractor's best interest to control costs. I've never seen them used perfectly, but they're often used reasonably well. I've also seen incentives that were designed so poorly that the contractor just ignored them because they weren't worth the effort to try and earn.
I think the main problem is that cost-plus pricing is often used in circumstances where it is not appropriate. Cost-plus should generally be used only for high-risk projects.
Generally speaking, it's a recipe for the provider to stick their snout in the trough as far as it will go. There is absolutely no incentive to lower costs or improve efficiencies. It does indeed become a game of brinkmanship between maximizing costs (profits) and cancellation.
I have seen it used in construction to mitigate risk. One example springs to mind. A particularly wealthy but eccentric individual wanted to build a lavish home. He was notorious for changing his mind, adding to the project and so on. The only way the company in question would touch the construction contract was on a "cost plus" basis.
Whenever you do this you basically have to trust the provider to a certain extent and it only really works if they trade on reputation and a hit to their reputation actually matters (often it doesn't).