GOVERNMENT SELECTION OF CONTRACT TYPES

The government generally determines the contract type to be used. However, contract type is theoretically a matter for negotiation. The contract type and the contract price are closely related and are usually considered together. The government’s overall objective is to establish a contract type and price that will result in reasonable contractor risk and provide a contractor with the greatest incentive for efficient and economical performance. Generally, a firm-fixed-price contract, which makes best use of the inherent profit motive, is used when the contractor risk involved is minimal or can be predicted with an acceptable degree of certainty. When a reasonable basis for firm pricing does not exist, other contract types are used.

For major acquisition programs, a series of contracts may result in a different contract type in later periods than that used at the start of the program. Contracting officers are discouraged from protracted use of a cost-reimbursement or time-and-materials contract if experience provides a basis for firmer pricing. Fixed-price contracts have been found unacceptable for research and development work. Under these contracts, a contractor may be required to research and/or develop an item at a fixed price, which may be impractical. The use of fixed-price contracts for research and development has proven to be disastrous. Contractors cannot afford the risks under these conditions, and when failure occurs the outcome is not good—default, lawsuits, etc. A contractor invariably loses money and the government may not get the work expected.

The government considers many factors in selecting the contract type. Effective price competition results in realistic pricing and thus a fixed-price contract is usually appropriate. Price analysis with or without actual price competition may also provide a basis for selecting the contract type. The government also considers the degree to which price analysis can provide a realistic pricing standard.

In the absence of effective price competition and if price analysis is not sufficient, the cost estimates of the offeror and the government may provide the basis for negotiating contract pricing arrangements. The uncertainties involved in performance and the possible impact on costs are evaluated, so that a contract type that places a reasonable degree of cost responsibility on the contractor can be negotiated.

A firm-fixed-price contract is suitable for acquiring commercial items or for acquiring other supplies or services on the basis of reasonably definite functional or detailed specifications when the contracting officer can establish fair and reasonable prices at the outset. This occurs when: (1) price competition is adequate; (2) price comparisons with prior purchases of the same or similar supplies or services made on a competitive basis or supported by valid cost or pricing data are reasonable; (3) available cost or pricing information permits realistic estimates of the probable costs of performance; or (4) performance uncertainties can be identified and reasonable estimates of their cost impact can be made.

If urgency is a primary factor, the government may choose to assume a greater proportion of risk or it may offer incentives to ensure timely contract performance. In times of economic uncertainty, contracts extending over a relatively long period may require economic price adjustment terms. Before a contract type other than firm-fixed-price is used, a contractor’s accounting system must permit development of all necessary cost data required by the proposed contract type. This factor may be critical when a contractor is being considered for a cost-reimbursement contract. If performance under a proposed contract involves concurrent operations under existing contracts, the impact of those contracts should be considered in selecting a contract type.

FIXED-PRICE CONTRACTS

Fixed-price contracts specify a firm price for work to be performed. These contracts may provide for adjustable prices under certain circumstances and/or provide ceiling prices. Fixed-price contracts providing for an adjustable price may include a ceiling price, a target price (including target cost), or both. Normally, the ceiling price or target price is subject to adjustment in the event of an equitable price adjustment. Firm-fixed-price or fixed-price with economic price adjustment contracts are used for acquiring commercial items. The fixed-price contract provides maximum incentive for a contractor to control costs and perform effectively because the contractor bears full responsibility for the resulting profit or loss.

The most frequently used fixed-price contract types are firm-fixed-price and fixed-price-incentive. Several other variations of the fixed-price contract are also available.

Firm-Fixed-Price Contract

Of all the various types of contracts, the firm-fixed-price (FFP) contract has the greatest potential for contractor financial reward and risk. Because the contract price is fixed at the date of award and the contractor is obligated to provide the product or service under contract, a highly efficient and cost-effective operation will generally result in greater contractor profits.

Obviously, the opposite is also true. A firm-fixed-price contract provides for a price that is not subject to any adjustment on the basis of the contractor’s cost experience in performing the contract. This contract type provides maximum incentive for the contractor to control costs and perform effectively, and imposes a minimum administrative burden on the contracting parties.

Fixed-Price-Incentive Contract

A fixed-price-incentive (FPI) contract provides for adjusting profit and establishing the final contract price by applying a formula based on the relationship of total allowable cost to target cost. The final price is subject to a price ceiling established upon award of the contract. An FPI contract is most appropriate when: (1) a firm-fixed-price contract is not suitable (i.e., the nature of the product is such that the costs to be incurred in producing the product cannot be accurately estimated); (2) the nature of the goods or services being acquired and the circumstances of the acquisition are such that the contractor’s assumption of a degree of cost responsibility will provide a positive profit incentive for effective cost control and performance; or (3) the contract also includes incentives on technical performance and/or delivery.

When predetermined formula-type incentives on technical performance or delivery are included, increases in profit or fee are provided only for achievement that surpasses the targets, and decreases are provided to the extent that such targets are not met. The incentive increases or decreases are applied to performance targets rather than minimum performance requirements. With an FPI contractual arrangement, a contractor has a high incentive to be cost-efficient and performance-effective. If successful in lowering contract costs below the target costs, a contractor can realize a higher profit through application of the incentive formula. Essentially, the contractor and the government become partners when the costs incurred are less than the costs estimated.

The five elements commonly negotiated into the terms of an FPI contract are: (1) target cost; (2) target profit; (3) target price (the sum of (1) plus (2)); (4) a fee adjustment formula target cost; and (5) a price ceiling (an amount in excess of the target price). The sharing ratio is a formula specifying how the government and the contractor will share any cost underrun or overrun.

Figures 2 through 4 depict how this contract type is applied. For each of these figures, the following basic assumptions are the same: (1) the target cost is $1,000,000; (2) the target profit is $85,000; (3) the target price is $1,085,000; (4) the government share of any cost over/underrun is 70 percent; and (5) the ceiling price is $1,160,000.

Figure 2 is a fixed-price-incentive contract where the actual cost of $900,000 is under the target price. This results in a $100,000 underrun. The contract price is computed by starting with the target price on line (i). The price is then reduced on line (j) by the government’s share of the cost underrun or $70,000, which is 70 percent of $100,000. This results in a contract price of $1,015,000 on line (k). The profit on this contract is $115,000, which is $1,015,000 minus $900,000.

Figure 3 is a fixed-price-incentive contract where the actual cost of $1,100,000 is over the target price. This results in a $100,000 overrun. The contract price is computed by starting with the target price on line (i). The price is then increased on line (j) by the government’s share of the cost overrun or $70,000, which is 70 percent of $100,000. This results in a contract price of $1,155,000 on line (k). The profit on this contract is $55,000, which is $1,155,000 minus $1,100,000.

Figure 4 is a fixed-price-incentive contract where the actual cost of $1,200,000 is over the target price and the ceiling price. This results in a $200,000 overrun. The contract price is computed by starting with the target price on line (i). The price is then increased on line (j) by the government’s share of the cost overrun or $140,000, which is 70 percent of $200,000. This results in a contract price of $1,255,000 on line (k). However, this exceeds the ceiling price of $1,160,000; thus, the ceiling price becomes the contract price. The loss on this contract is $40,000, which is $1,200,000 minus $1,160,000.

Figure 5 contains the spreadsheet formulas for the calculations in Figures 2 through 4.

Most incentive contracts include only cost incentives, which take the form of a profit or fee adjustment formula and are intended to motivate the contractor to manage costs effectively. No incentive contract may provide for other incentives without also providing a cost incentive. The FPI contract can be a profitable and lucrative endeavor for both the contractor and the government. The contractor must adhere closely to the federal regulations in estimating and accumulating contract costs, however, since these costs will be the basis for determining the eventual price to be paid by the government.

Incentives Contract

Performance incentives include such aspects as a missile’s range, an aircraft’s speed, an engine’s thrust, or a vehicle’s maneuverability. Both positive and negative performance incentives may be used with service contracts. Technical performance incentives are often used in development and in production for major weapon systems and may involve a variety of specific characteristics that contribute to the overall performance of the end item.

Delivery incentives are used when improvement from a required delivery schedule is an important government objective. Incentive arrangements on delivery should specify the application of the reward-penalty structure in the event of government-caused delays or other delays beyond the control—and without the fault or -negligence—of the contractor or subcontractor.

A fixed-price-incentive (firm target) contract specifies a: (1) target cost; (2) target profit; (3) price ceiling (but not a profit ceiling or floor); and (4) profit adjustment formula. These elements are all negotiated at the outset. The price ceiling is the maximum that may be paid to the contractor, except for any price adjustment under the contract terms. When the contract is completed, the parties negotiate the final cost, and the final price is established by applying the formula. If the final cost is less than the target cost, application of the formula results in a final profit greater than the target profit. Conversely, if the final cost is more than the target cost, application of the formula results in a final profit less than the target profit, or even a net loss. If the final negotiated cost exceeds the price ceiling, the contractor absorbs the difference as a loss.

Firm-Fixed-Price with Economic Adjustment Contract

A fixed-price contract with economic price adjustment provides for upward and downward revision of the contract price upon the occurrence of specified contingencies. A fixed-price contract with economic price adjustment is used when there is serious doubt concerning the stability of market or labor conditions that will exist during an extended period of contract performance. Price adjustments based on labor and material costs are generally limited to contingencies beyond the contractor’s control. Commonly, an economic adjustment provision adjusts the contract price only if the actual escalation exceeds or falls short of a stated percentage. Economic price adjustments are determined on one of three bases: (1) established prices; (2) actual costs of labor and/or materials; and (3) cost indexes for labor and/or materials.

Adjustments based on established prices are based on increases or decreases from an agreed-upon level in published or otherwise established prices of specific items or the contract end items. For example, a contract that requires a substantial amount of a special metal might provide for an annual price adjustment if the change in a published price of the metal exceeds a certain percent.

Adjustments based on actual costs of labor or materials are based on increases or decreases in specified costs of labor or materials that the contractor actually experiences during contract performance. For example, a contract that requires significant costs for an operating crew might provide for an annual price adjustment if the change in actual labor costs exceeds a certain percent. When this method is used, the contract terms must specifically identify the labor costs by category (e.g., type of personnel) and cost elements (e.g., labor rates, fringe benefits) to avoid subsequent disputes.

Adjustments based on cost indexes of labor or material are based on increases or decreases in labor or materials cost standards or indexes that are specifically identified in the contract. For example, a contract might provide for an annual price adjustment if the consumer price index changes by more than x percent.

Fixed-Price Redeterminable Contract

A fixed-price redeterminable (FPR) contract with retroactive price redetermination provides for a fixed ceiling price and retroactive price redetermination within the ceiling after completion of the contract. This contract type is used primarily for research and development contracts of $100,000 or less.

Firm-Fixed-Price Contract with Successive Targets

A fixed-price contract with prospective price redetermination provides for a firm fixed price for an initial period of contract deliveries or performance and prospective redetermination, at a stated time or times during performance, of the price for subsequent periods of performance. A fixed-price contract with prospective price redetermination is used in acquisitions of quantity production or services for which it is possible to establish a firm fixed price for an initial period, but not for subsequent periods of contract performance. The initial period is generally the longest period possible. Each subsequent pricing period should be at least 12 months. The contract may provide for a ceiling price and may be adjusted only by operation of contract clauses providing for equitable adjustment.

A fixed-price-incentive (successive targets) contract specifies the following elements, all of which are negotiated at the outset: (1) an initial target cost; (2) an initial target profit; (3) an initial profit adjustment formula to be used for establishing the firm target profit, including a ceiling and floor for the firm target profit; (4) a ceiling target profit; (5) a floor target profit; (6) a ceiling price that is the maximum that may be paid to the contractor, except for any equitable price adjustment; and (7) the production point at which the firm target cost and firm target profit will be negotiated.

When the production point specified in the contract is reached, the parties negotiate the firm target cost and the firm target profit. The firm target profit is established by an initially negotiated formula. At this point, the parties have two alternatives: (1) negotiate a firm fixed price, using the firm target cost plus the firm target profit as a guide; or (2) negotiate a formula for establishing the final price using the firm target cost and firm target profit (an FPIF contract).

A contractor’s accounting system must be adequate for providing data for negotiating firm targets and a realistic profit adjustment formula. It must also be adequate to establish a framework for later negotiation of final costs. Cost or pricing information adequate for establishing a reasonable firm target cost must be available at an early point in contract performance.

If the total firm target cost is more than the total initial target cost, the total initial target profit will be decreased. If the total firm target cost is less than the total initial target cost, the total initial target profit will be increased. The initial target profit will be increased or decreased by the contractually stated percentage of the difference between the total initial target cost and the total firm target cost. The resulting amount will be the total firm target profit, provided that in no event is the total firm target profit more or less than a contractually stated percentage of the total initial target cost.

Figures 6 through 10 show how this contract type works. The same basic data are assumed for five outcomes. The initial target cost, initial target profit, ceiling contract price, ceiling target profit percentage, and floor target profit percentage are negotiated at contract award. Also, a formula is negotiated for price adjustment purposes. The adjustment will be to the initial target profit. The formula will state that the initial target profit will be adjusted downward by x percent of the excess of the firm target cost over the initial target cost. Likewise, the formula will state that the initial target profit will be adjusted upward by y percent of the excess of the initial target cost over the firm target cost.

At a specified point in time (which is negotiated at the time the contract is awarded), a firm target cost is negotiated based on new cost data. The formula is applied to the initial target profit. The contract price can then be completed as either a firm-fixed-price (FFP) or a fixed-price-incentive fee (FPIF) contract. The examples include five scenarios for the firm target cost: (1) well under the initial target cost; (2) under the initial target cost; (3) over the initial target cost; (4) well over the initial target cost; and (5) extremely over the initial target cost. Assuming a firm fixed price rather than adding more complications for a FPIF contract, the expected profit or loss line is based on meeting the firm target cost.

Figure 6 is for the well under initial target price scenario, in which the ceiling target profit is attained. (The cost underrun is so great that the contracts maximum profit provision applies.) Figure 7 is for the under initial target price scenario. Figure 8 is for the over initial target price scenario. Figure 9 is for the well over initial target price scenario, in which the floor target profit is applied. (The cost overrun is so great that the contract’s minimum profit provision applies.) Figure 10 is for the extremely over initial target price scenario and the ceiling price is applied. Figure 11 contains the formulas for these scenarios. Figure 12 displays the relationship of the various components of this contract type.

Fixed-Price, Level-of-Effort Contract

A firm-fixed-price, level-of-effort (FP-LOE) term contract provides for a specified level of effort, over a stated period of time, on work that can be stated only in general terms. This contract type is suitable for investigation or study in a specific research and development area where the product is usually a report showing the results achieved through application of the required level of effort. However, payment is based on the effort expended rather than on the results achieved.

Some FP-LOE contracts contain price adjustment provisions that are based on the estimated versus actual labor provided. For example, the provision might require a price adjustment if more or less than 15 percent of the estimated hours is incurred. This provision could be on the total hours for the contract or on individual labor categories.

Fixed-Price, Award-Fee Contract

Award-fee provisions are used infrequently in a fixed-price contract. Such contracts establish a fixed price (including normal profit) for the effort. This price will be paid for satisfactory contract performance. Award fee earned (if any) will be paid in addition to that fixed price based on periodic formal evaluation of the contractor’s performance against an award-fee plan.