McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 15

Methods of Compensation

15-2

Key Concepts

• Introduction to compensation agreements

• Contract cost risk appraisal

» Technical risk

» Contract schedule risk

• General types of contract compensation agreements

» Fixed price contracts

» Incentive contracts

» Cost-type contracts

15-3

Key Concepts• Specific types of compensation agreements

» Firm fixed price contracts

» Fixed price with economic adjustment contracts

» Fixed price redetermination contracts

» Incentive arrangements

» Cost plus incentive fee arrangements

» Cost plus fixed fee arrangements

» Cost plus award fee

» Cost without fee

» Cost sharing

» Time and materials

» Letter contracts and letters of intent

• Considerations when selecting contract types15-4

Introduction to Compensation Agreements

• The compensation arrangement determines:

» Degree and timing of the cost responsibility assumed by the supplier

» Amount of profit or fee available to the supplier

» Motivational implications of the fee portion of the compensation arrangements

15-5

Example 1: Low Level of Uncertainty

PotentialOutcomes Seller’s Cost Seller’s Price

Seller’s ProfitLow $950,000 $1,100,000

$150,000Most Likely 1,000,000 1,100,000

100,000High 1,050,000 1,100,000

50,000

Firm Fixed Price Contract

15-6

Example 2: High Level of Uncertainty

PotentialOutcomes Seller’s Cost Seller’s Price

Seller’s ProfitLow $500,000 $1,100,000

$600,000Most Likely 1,000,000 1,100,000

100,000High 1,500,000 1,100,000

(-400,000)

Same FFP Contract as 19-1

15-7

Example 2: Continued• Most sellers are unwilling to large risks

» The supplier will not want to offer the contract at $1,100,000 due to this additional uncertainty

• In this case, the seller studies the distribution of likely cost outcomes and concludes that, 9 times out of 10, the actual cost will be $1,400,000 or less

• Based on the risk aversion, the seller may demand a firm fixed price of $1,540,000» $1,400,000 plus $140,000 (10 percent profit on

this cost)

» The supplier will not lose money on the contract

15-8

Example 2: Continued

PotentialOutcomes Seller’s Cost Seller’s Price

Seller’s ProfitLow $500,000 $1,540,000

$1,040,000Most Likely 1,000,000 1,540,000

540,00090% Level 1,400,000 1,540,000

140,000High 1,500,000 1,540,000

40,000

Firm Fixed Price Contract

15-9

Example 2: Continued

PotentialOutcomes Seller’s Cost Seller’s Price

Seller’s ProfitLow $500,000 $550,000

$50,000Most Likely 1,000,000 1,050,000

50,00090% Level 1,400,000 1,450,000

50,000High 1,500,000 1,550,000

50,000

Cost Plus $50,000 Fixed Fee

15-10

Example 2: Continued

PotentialOutcomes Seller’s Cost Seller’s Price

Seller’s ProfitLow $500,000 $550,000

$50,000Most Likely 1,000,000 1,100,000

100,00090% Level 1,400,000 1,540,000

140,000High 1,500,000 1,650,000

150,000

Cost Plus Fixed 10% Fee

15-11

Contract Cost Risk Appraisal

• Technical Risk

» Risk associated with the nature of the item

» Technical risk appraisal:

– Type and complexity of the item or service

– Stability of design specifications or statement of work

– Availability of historical pricing data

– Prior production experience

• Contract Schedule Risk» Anticipate material and labor cost increases

– Forward pricing is common

» Anticipate possible schedule slippages15-12

General Types of Contract Compensation Arrangements

• Fixed Price Contracts

• Incentive Contracts

• Cost-Type Contracts

Buyer Risk

Supplier Risk

Low

High

High

Low

FixedPrice

Contracts

CostType

ContractsIncentive Contracts

15-13

Firm Fixed Price Contracts

• A firm fixed price (FFP) contract is an agreement to pay a specified price when the items (services) specified by the contract have been delivered (completed) and accepted

• Common types:

» Firm fixed price

» Fixed price with economic price adjustment

» Fixed price redetermination

15-14

When to Use FFP

• Specifications are well defined

• Cost risk is low

• Schedule risk is low

• Technical risk is low

• Competition has established pricing

15-15

Firm Fixed Price Contract ExampleFigure 19-3Figure 19-3

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Reasons Why Firm Fixed Price Contracts Do Not Always Remained Fixed

• A supplier losing money may request relief if:

» Customer contributed to the loss

» Customer badly needs the items

– Assumes other suppliers are not available

» Supplier has unique facilities and time is short

» Customers representatives do not employ sound supply management practices

15-17

Fixed Price and EconomicPrice Adjustment Contracts (FPEPA)

• (FPEPA) contracts are used to recognize economic contingencies, such as unstable labor or market conditions

• FPEPA is an FFP contract that includes economic price adjustment clauses

» Escalator clauses are for price increases

» De-escalator clauses are for price decreases

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Rules for Selecting Indexes for Price Adjustment Clauses

• Select from the appropriate Bureau of Labor Statistics category

• Avoid broad indexes; use the lowest-level classification

• Develop a weighted index for materials in a product

• Select labor rate indexes by type and location

• Define energy indexes by fuel type and location

• Analyze the past history of each index versus actual price change of the item being indexed

15-19

Fixed Price Redetermination Contracts (FPR)• A FFP is set for an initial contract period

• A redetermination (upward or downward) occurs at a stated time during the contract

• FPR prospective» Occurs at a stated time during the contract

» Used where a fair and reasonable price can be developed for initial periods but not subsequent periods

• FPR retroactive» Occurs at the end of the contract

» Used when uncertainty exists as in the prospective, but the amount of the contract is small and/or the performance period is short

15-20

Incentive Arrangements

• Used to motivate the supplier to:

» Control costs

» Encourage good supplier performance

• Contract price will usually be higher

• Ceiling price is usually fixed during negotiations

• Cost responsibility is shared

• Two primary types:

» Fixed price incentive

» Cost plus incentive fee15-21

Elements of a Simplified Incentive Contract

• Target cost

» Cost outcome both buyer and supplier feel is the most likely outcome

• Target profit

» Amount considered fair and reasonable

• Allocating costs above or below target

» Recognizes the target most likely will not be met

» A sharing arrangement is agreed upon that reflects the sharing of the cost responsibility

15-22

Fixed Price Incentive Fee Example

15-23

Cost Plus Incentive Fee Arrangements

• Combine the incentive arrangement and the cost plus fixed fee arrangement

• Under a CPIF arrangement, an incentive applies over part of the range of cost outcomes

• The fee structure resembles a cost plus fixed fee contract at both the low-cost and high-cost ends of the range

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Cost Plus Incentive Fee Example

• Target cost = $1,000,000

• Target profit = $70,000

• Optimistic cost = $800,000

• Optimistic and maximum profit = $120,000

• Pessimistic cost = $1,400,000

• Pessimistic and minimum profit = $20,000

• Sharing below target (customer/supplier) = 75/25

• Sharing above target (cust./supplier) = 87.5/12.5

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CPIF Contract Example Continued• Target cost = $1,000,000

• Target profit = $70,000

• Maximum fee = $120,000

• Minimum fee = $20,000

• Cost savings = target cost - final cost» $300,000 = $1,000,000 - $700,000

• Supplier’s savings = cost savings × supplier share» 75,000 = $300,000 × 0.25

• Computed fee = savings fee + target fee» $145,000 = $75,000 + $70,000

• Final price = final cost + maximum fee» $820,000 = $700,000 + $120,000

15-26

Cost Plus Incentive Fee Arrangements

• Cost savings = target cost - final cost

• Supplier’s share of cost savings = cost savings × supplier share

• Computed fee = savings fee + target fee

• Final price = final cost + maximum fee

15-27

Cost Plus Incentive Fee Example

15-28

Cost-type Arrangements• Used when:

» Research and development increases technical risk

» Project completion is in doubt

» Product specifications are incomplete

» High-dollar, highly uncertain procurements are involved

• Common types are:

» Cost reimbursement

» Cost plus fixed fee

» Cost plus award fee

» Cost without fee

» Cost sharing

» Time and materials

15-29

Cost Plus Fixed Fee Arrangements (CPFF)

• Buying firm pays a fixed fee and all costs beyond fee

• Fee is for specified scope of work

• Supplier has no incentive to control costs

• Characterized by low supplier profit

• A total liability limit is usually established

Optimistic Most likely Pessimistic

Final cost $800 $1,000 $1,200

Fixed fee 50 50 50

Price $850 $1,050 $1,250

CPFF Example(not in text)

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Cost Plus Award Fee (CPAF)

• The award fee is a pool of money established by the buyer to reward the supplier in meeting the buyer’s stated needs

• Receipt of the fee is based on the buying firm’s subjective evaluation

• CPAF works as a flexible tool

15-31

Cost Without Fee

• Used primarily by nonprofit institutions

• Used for research work without the objective of making a profit

• Institutions recover all overhead costs

• In recent years, high-technology firms have increased their use of this contract type

15-32

Cost Sharing

• In some situations, a firm doing research under a cost type of contract stands to benefit if the product developed can be used in its own product line

• Under such circumstances, the buyer and the seller agree on what they consider to be a fair basis to share the costs (most often it is 50-50)

• The electronics industry has found this type of contract especially useful

15-33

Considerations When Selecting Contract Types• Unstable labor conditions

• Unstable market conditions

• Improvement in production is required

• Complexity of product or service

• Product or service requires development

• Design is not completed or may change

• Learning must take place

• Short time to prepare for a bid or negotiation

• Short delivery period

» Which may require additional resources to meet deadlines

15-34

Concluding Remarks

• Sound application of the compensation methods presented will significantly reduce expenditures when cost risk is present

• Compensation agreements must result in a reasonable allocation of the cost risk

• Agreements should also provide adequate motivation to the supplier to assure effective performance

15-35