Payment ceilings in cost-plus contracting

Cost-plus procurement contracts are widely used by the government. Although prior studies have recognized that payment ceilings are a common element in cost-plus procurement contracts, these studies have not examined the endogenous determination or the welfare effects of such ceilings. In this paper, a simple agency model is used to examine the optimal level of a payment ceiling in the context of cost-plus contracting in sole source procurement. It is demonstrated that the optimal cost-plus contract with payment ceiling dominates the optimal cost-plus contract without ceiling. This is because the use of a payment ceiling has two benefits. First, the payment ceiling serves as a de facto means of delegating the decision as to whether or not the project should proceed. Thus, the contract with payment ceiling takes advantage of the supplier's private information. Second, the payment ceiling, along with the optimal choice of the fixed fee, helps to mitigate moral hazard problems associated with cost-plus contracting.