Challenges of A Cost-plus Contract in Oil & Gas

In the Oil & Gas industry it is common to agree on a cost-plus contract. Contracts in Operations & Maintenance, engineering and labour services can be particularly challenging to manage as they tend to involve multiple subcontractors, Joint Ventures and complex framework arrangements.

Revenue model

In a cost-plus contract suppliers pass on costs that they have incurred and make profit on the mark-up applied - without the proper incentives to minimise costs - this means the higher the costs, the higher their profits. It is common for annual contract costs to increase far higher than what was originally agreed so it is essential to retain control over the incentives applied. This is especially pertinent if the supplier is sub-contracting part of the work as, unlike in a normal tender exercise set up to achieve the best value for money, suppliers may seek to bypass this process to keep costs high. Due to the nature of the work in Oil & Gas, the majority of the work is sub-contracted to third parties.

BDO perspective:

Cost-plus contracts must contain explicit cost saving initiatives, which are regularly monitored and the supplier must be kept accountable for achieving the targets.
Management must be involved in the approval of sub-contractors and should regularly cross-check the suppliers to the approved list. The sub-contracts themselves should also be subject to the ‘right to audit’ to identify any clauses which are preventing better value for money being achieved and efficiencies being passed onto the ultimate customer.

Transparency

Detailed information on costs incurred is essential for Management to be able to confidently approve supplier invoices. Suppliers on a cost-plus contract must be able to substantiate the charges that are being passed on and should be able to present the evidence for audit purposes when requested.

It is common in Oil & Gas for staff costs to be particularly challenging to verify due to the concerns over personal data, the volume of the labour work required and the complexity of the calculations. The payments can easily be checked, however, to truly substantiate the charges it is necessary to inspect the underlying data such as timesheets and payslips, then also comparing the charges to market rates.

BDO perspective:

Although it might be difficult to get a breakdown of each employee costs, organisations would need to have some degree of visibility and control over the staff costs that are being incurred. A price range for each role can be agreed as well as the number of roles for each position. Staff costs can then be tracked against the agreed budget. Also, an ongoing benchmarking exercise will help organisations to understand market salary expectations and define a price range for each role.
Cost-plus contracts should contain audit clauses which clearly set out the responsibilities and expectations of both parties. The contract should also define allowable and disallowable costs as without these the contractor may pass on unrelated charges.
There is also the risk of duplicate invoices being passed on and this risk is particularly high if there are a significant volume of charges included on each invoice from the supplier. Data analytics can help to identify potential duplicates which can then be followed up.

Foreign exchange

If the costs of the contract are being incurred in foreign currencies, there is a risk of the transactions being passed on at different rates to when they were incurred. This risk is enhanced if there are significant delays between the costs being incurred and when they are passed on.

BDO perspective:

The contract should include clauses which clearly set out how costs incurred by suppliers in foreign currencies will be passed on. This should include how and when any foreign exchange differences should be calculated and invoiced, and the source which should be used for foreign exchange rates.
Small variations in the exchange rates used can go unnoticed but can add up to significant variations in the cost, in particular where a mark-up is applied to the total charges, therefore these should be audited to assess if the correct process is being applied.

If your business has suppliers on cost-plus contracts, are you confident in the accuracy of the charges being passed on to you?

How BDO can help

Our Contract & Commercial Risk team offers a range of services to optimise your organisation’s contract management:

Pre-award - Business case and procurement

Business case assessments
Financial establishment audits
Procurement reviews
Commercial terms analysis
Contract and commercial management frameworks: design and implementation
Lessons learned review of existing contracts ahead of renewal /retender
Supplier onboarding.

Post award – Contract and commercial management

Cost reduction and recovery programmes
Cost verification
Contract management effectiveness
Contract audit programmes (expenditure and revenue)
Supplier risk profiling and management
Contract performance and compliance
Customer profitability/cost to serve.

Post award – Contract renegotiations and exit

Negotiation strategy development
Contract exit and transition management
Final account settlement
M&A: contract portfolio risk management and optimisation
Lessons learned and commercial improvement advice

Contract lifecycle management – Digital transformation of contracts

Contract Lifecycle Management (CLM) system implementation
Commercial capability assessment and transformation
CLM effectiveness reviews

If you would like to discuss any aspect of contract management, please get in touch.