Contract Types and

Appropriate Incentives

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Jo CunninghamDistinguished Member of Laboratory Staff

Sandia National Laboratories

Session #3, 1:00pm - 1:30pm ET

NCMA’s 1st Performance-Based Service Acquisition Community of Practice - Virtual Conference

Wednesday, March 31, 2010 12:00pm - 4:00pm ET

Contract Types & Appropriate Incentives

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Basic Decisions:

• Selecting the contract pricing arrangement is THE most important decision you will ever make!

• The Second most important decision is how to motivate the contractor.

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What’s Really in it For Me?

Describe how you saved

us

$10 Million AND

reduced our risks!

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Contract Types

• Two Basic Contract Types:

– Fixed Price• FFP, FFP/EPA, FP+AF, FP+I, FF Rate, Cost-

Share

– Cost Reimbursement• CNF, CPFF, CPIF, CPAW, Cost-Share• T&M, LH

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Contractor Performance Considerations

• Firm Fixed Price: Failure is not an option

• Time & Materials: We can’t fail as long as we show up for work.

• Cost Reimbursable: We will give it our best try, but failure may be an option

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Cost Risk & Contract Type

Cost Risk:High >>>>>>>>>>>>>>>>>>>>>>>> Low

Requirement

Definition Vague >>>>>>>>>>>>>>>>>>>>>>>>> Well Defined

Production Concept Exploratory Test/ Full scale Full

Stages Studies, & Development Demo DevelopmentProduction

Basic Research

Contract Varied CPFF CPIF, CPIF, FPIF, FFP, FPIF,

Type FPIF or FFP or FPEPA

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Firm Fixed Price

Principal Risks: None, Contractor assumes all cost risk

Use When: The requirement is well-defined.

Contractors are experienced in meeting the fixed price.

Market conditions are stable.

Financial risks are otherwise insignificant

Typical Application: Commercial supplies and services, Generally NOT appropriate for R&D.

Contractor is required to: Provide acceptable deliverable at the time, place and price specified in the contract

Contractor Incentive: Generally realizes an additional dollar of profit for every dollar that costs are reduced

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Fixed Price Economic Price Adjustment

Principal Risks: Unstable market prices for labor or material over life of contract.

Use When: Market prices at risk are severable and significant. Risks stem from industry-wide contingencies beyond contractor's control. Dollars at risk outweigh administrative burdens of an FPEPA.

Typical Application: Long-term contracts for commercial supplies during a period of high inflation.

Contractor is required to: Provide acceptable deliverable at the time and place specified in the contract at the adjusted price.

Contractor Incentive: Generally realizes an additional dollar of profit for every dollar that costs are reduced

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Fixed Price Incentive Fee

Principal Risks: Moderately uncertain contract labor or material requirements

Use When: Ceiling price can be established that covers most probable risks inherent in nature of work. Proposed profit sharing formula would motivate contractor to control costs to & meet other objectives

Typical Application: Production of a major system based on a prototype.

Contractor is required to: Provide acceptable deliverable at time & place specified in contract, at or below ceiling price.

Contractor Incentive: Realizes a higher profit by completing work below ceiling price and/or by meeting objective performance targets

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Fixed Price Award Fee

Principal Risks: Risk that the user will not be fully satisfied because of judgmental acceptance criteria.

Use When: Judgmental standards can be fairly applied by Award-fee panel. The potential fee is large enough to both: (1) Provide meaningful incentive; (2) Justify related administrative burdens.

Typical Application: Performance-based service contracts.

Contractor is required to: Perform at time, place, and price fixed in contract.

Contractor Incentive: Generally realizes an additional dollar of profit for every dollar that costs are reduced; earns an additional fee for satisfying performance standards

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Fixed Price Prospective Redetermination

Principal Risks: Costs of performance after the first year because they cannot be estimated with confidence.

Use When: Buyer needs a firm commitment from contractor to deliver supplies /services during subsequent years. Dollars at risk outweigh administrative burdens of FPRP.

Typical Application: Long-term production of spare parts for a

major system.

Contractor is required to: Provide acceptable deliverables at time & place specified in contract at price established for each period.

Contractor Incentive: For the period of performance, realizes an additional dollar of profit for every dollar that costs are reduced.

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Cost Plus Incentive Fee

Principal Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other) necessary to perform contract. Buyer assumes risks; benefiting if actual cost is lower than expected cost; losing if work can’t be completed within expected cost of performance.

Use When: Objective relationship can be established between fee & such measures of performance as actual costs, delivery dates, performance benchmarks, etc.

Typical Application: Research and development of prototype for major system.

Contractor is required to: Make good faith effort to meet Buyer's needs within estimated cost in the Schedule.

Contractor Incentive: Realizes a higher fee by completing work at lower cost and/or by meeting other objective performance targets

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Cost Plus Award Fee

Principal Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance.

Use When: Objective incentive targets are not feasible for critical aspects of performance. Judgmental standards can be fairly applied. Potential fee would provide a meaningful incentive.

Typical Application: Large scale research study.

Contractor is required to: Make good faith effort to meet Buyer's needs within estimated cost in the Schedule.

Contractor Incentive: Realizes a higher fee by meeting judgmental performance standards.

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Cost Plus Fixed Fee

Principal Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance.

Use When: Relating fee to performance (e.g., to actual costs) would be unworkable or of marginal utility.

Typical Application: Research studies.

Contractor is required to: Make good faith effort to meet Buyer's needs within estimated cost in the Schedule.

Contractor Incentive: Realizes a higher rate of return (i.e., fee divided by total cost) as total cost decreases.

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Cost Sharing

Principal Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance.

Use When: The contractor expects substantial compensating benefits for absorbing part of the costs and/or foregoing fee.

Typical Application: Joint research where Contractor expects to derive long term benefits to his company.

Contractor is required to: Make good faith effort to meet Buyer's needs within estimated cost in the Schedule.

Contractor Incentive: Shares in the cost of providing a deliverable of mutual benefit..

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Cost No Fee

Principal Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance.

Use When: The supplier is a not-for-profit entity.

Typical Application: Joint research with an educational institutions or other not-for-profit entities.

Contractor is required to: Make good faith effort to meet Buyer's needs within estimated cost in the Schedule.

Contractor Incentive: Providing a deliverable with benefits to both parties; Contractor expects to derive long term benefits to his firm; Enhanced reputation.

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Time and Materials

Principal Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance.

Use When: No other type of contract is suitable (e.g., labor & materials can’t be reliably estimated due to inherent uncertainties, and contractor does not have accounting system to support a job cost accounting system).

Typical Application: Emergency repairs to heating plants and aircraft engines; hazardous waste removal; Contractor support for field exercises.

Contractor is required to: Make good faith effort to meet Buyer's needs within ceiling price.

Contractor Incentive: None, other than enhanced reputation.

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Firm Fixed Rate

Principal Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance. Limit risk by ceiling price of $100,000 or less.

Use When: No other type of contract is suitable (e.g., because costs are too low to justify an audit of the contractor's indirect expenses).

Typical Application: Emergency repairs to facilities and equipment; Contractor support for small efforts <$100,000.

Contractor is required to: Make good faith effort to meet Buyer's needs within ceiling price.

Contractor Incentive: None, other than enhanced reputation.

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Summary

• Initial steps to remember:• Discuss requirements with the customer & compare to the SOW,

revising as necessary• Review the pricing types, and consider the pros & cons of each.

• Pitfalls:• Avoid cost-type and T&M/LH if contractor has unsophisticated

accounting system.• Avoid setting up Contractor for failure (e.g. using FFP when not

appropriate)• Award / Incentive Fees = High Admin costs

• Remember: Choosing Wisely Reduces Risks and may save you potentially significant costs!