Pricing Arrangements: Choose Your
Contract Type Wisely & Reduce Your
Risks!
Breakout Session # 304
Jo Cunningham
April 7, 2009
2:30 PM
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Selecting the contract pricing
arrangement is THE most
important decision you will
ever make!
AVOID
Cost Plus
Percentage
of Cost
2
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 Pricing Arrangements:
– Fixed Price
• FFP, FFP/EPA, FP+AF, FP+I, FF Rate, CostShare
– Cost Reimbursement
• CNF, CPFF, CPIF, CPAW, Cost-Share
• T&M, LH
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Failure is NOT an Option!
• 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
5
Statement of Work Is Crucial
• The SOW:
– First and most important basis for pricing
arrangement selection.
– The pricing arrangement must be
consistent with the SOW in its final form.
6
Cost Risk & Contract Type
Cost Risk:
High
>>>>>>>>>>>>>>>>>>>>>>>>
Low
Vague
>>>>>>>>>>>>>>>>>>>>>>>>>
Well Defined
Requirement
Definition
Production
Stages
Concept
Studies, &
Exploratory
Test/
Full scale
Full
Development
Demo
Development
Production
CPFF
CPIF,
CPIF, FPIF,
FFP, FPIF,
FPIF
or FFP
or FPEPA
Basic Research
Contract
Type
Varied
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Comparison of Major Contract Types
• Fixed Price
– Principle 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.
– Elements: A firm fixed-price for each line item or one or more
groupings of line items.
– Contractor is required to: Provide acceptable deliverable at
the time, place and price specified in the contract.
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Comparison of Major Contract Types
• Fixed Price
– Contractor Incentive: Generally realizes an additional
dollar of profit for every dollar that costs are reduced
– Typical Application: Commercial supplies and services.
– Primary Limitations: Generally NOT appropriate for
R&D.
– Variants: Firm Fixed-price Level of Effort.
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Comparison of Major Contract Types
• Fixed Price Economic Price Adjustment
- Principle 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.
- Elements: Fixed-price, ceiling on upward adjustment, & a formula
for adjusting prices up or down based on established prices, actual
labor or material costs, labor or material indices.
- Contractor is required to: Provide acceptable deliverable at
the time and place specified in the contract at the adjusted price.
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Comparison of Major Contract Types
• Fixed Price Economic Price Adjustment
– Contractor Incentive: Generally realizes an additional
dollar of profit for every dollar that costs are reduced.
– Typical Application: Long-term contracts for commercial
supplies during a period of high inflation.
– Primary Limitations: Must be justified.
– Variants: None.
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Comparison of Major Contract Types
• Fixed Price Incentive Fee
– Principle 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.
– Elements: Ceiling price; Target cost; Target profit; Delivery,
quality, other performance targets; Profit sharing formula.
– Contractor is required to: Provide acceptable deliverable
at time & place specified in contract, at or below ceiling price.
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Comparison of Major Contract Types
• Fixed Price Incentive Fee
– Contractor Incentive: Realizes a higher profit by
completing work below ceiling price and/or by meeting
objective performance targets.
– Typical Application: Production of a major system based
on a prototype.
– Primary Limitations: Must be justified. Must be
negotiated. Contractor must have an adequate
accounting system. Cost data must support targets.
– Variants: Successive Targets.
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Comparison of Major Contract Types
• Fixed Price Award Fee
– Principle 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.
– Elements: Firm fixed-price; Standards for evaluating
performance; Procedures for calculating fee based on performance
against standards.
– Contractor is required to: Perform at time, place, and price
fixed in contract.
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Comparison of Major Contract Types
• Fixed Price Award Fee
– Contractor Incentive: Generally realizes an additional
dollar of profit for every dollar that costs are reduced; earns
an additional fee for satisfying performance standards.
– Typical Application: Performance-based service
contracts.
– Primary Limitations: Must be negotiated.
– Variants: None.
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Comparison of Major Contract Types
• Fixed Price Prospective Redetermination
– Principle 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.
– Elements: Fixed price for first period; Proposed subsequent
periods (12 months apart); Timetable for pricing next period(s).
– Contractor is required to: Provide acceptable deliverables at
time & place specified in contract at price established for each
period.
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Comparison of Major Contract Types
• Fixed Price Prospective Redetermination
– Contractor Incentive: For the period of performance,
realizes an additional dollar of profit for every dollar that costs
are reduced.
– Typical Application: Long-term production of spare parts
for a major system.
– Primary Limitations: MUST be negotiated. Contractor
must have an adequate accounting system that supports the
pricing periods. Prompt redeterminations.
– Variants: Retroactive Redetermination
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Comparison of Major Contract Types
• Cost Plus Incentive Fee
– Principle Risks: Highly uncertain & speculative labor hours, labor
mix, material requirements (and other things) 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.
– Elements: Target cost; Performance targets; Minimum, maximum &
target fee; Formula for adjusting fee based on actual costs and/or
performance.
– Contractor is required to: Make good faith effort to meet Buyer's
needs within estimated cost in the Schedule.
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Comparison of Major Contract Types
• Cost Plus Incentive Fee
– Contractor Incentive: Realizes a higher fee by completing work
at lower cost and/or by meeting other objective performance targets.
– Typical Application: Research and development of prototype for
major system.
– Primary Limitations: Contractor must have adequate accounting
system. Buyer must exercise surveillance during performance to
ensure use of efficient methods & cost controls. Must be negotiated.
Must be justified. Statutory & regulatory limits on fees that may be
negotiated. Must include applicable Limitation of Cost clause at
FAR 52.232-20 through 23.
– Variants: None.
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Comparison of Major Contract Types
• Cost Plus Award Fee
– Principle 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.
– Elements: Target cost; Standards for evaluating performance; Base
& maximum fee; Procedures for adjusting fee, based on performance
against standards.
– Contractor is required to: Make good faith effort to meet Buyer's
needs within estimated cost in the Schedule.
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Comparison of Major Contract Types
• Cost Plus Award Fee
– Contractor Incentive: Realizes a higher fee by meeting
judgmental performance standards.
– Typical Application: Large scale research study.
– Primary Limitations: Contractor must have adequate
accounting system. Buyer must exercise surveillance during
performance to ensure use of efficient methods & cost controls.
Must be negotiated. Must be justified. Statutory & regulatory limits
on fees that may be negotiated. Must include applicable Limitation
of Cost clause at FAR 52.232-20 through 23.
– Variants: None.
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Comparison of Major Contract Types
• Cost Plus Fixed Fee
– Principle 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.
– Elements: Target cost; Fixed fee.
– Contractor is required to: Make good faith effort to meet
Buyer's needs within estimated cost in the Schedule.
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Comparison of Major Contract Types
• Cost Plus Fixed Fee
– Contractor Incentive: Realizes a higher rate of return (i.e., fee
divided by total cost) as total cost decreases.
– Typical Application: Research study.
– Primary Limitations: Contractor must have adequate
accounting system. Buyer must exercise surveillance during
performance to ensure use of efficient methods & cost controls.
Must be negotiated. Must be justified. Statutory & regulatory limits
on fees that may be negotiated. Must include applicable Limitation
of Cost clause at FAR 52.232-20 through 23.
– Variants: Completion or term contract.
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Comparison of Major Contract Types
• Cost-Sharing
– Principle 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.
– Elements: Target cost; Agreement on Buyer’s share of cost.
– Contractor is required to: Make good faith effort to meet
Buyer's needs within estimated cost in the Schedule.
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Comparison of Major Contract Types
• Cost-Sharing
– Contractor Incentive: Shares in the cost of providing a
deliverable of mutual benefit.
– Typical Application: Joint research where Contractor expects to
derive long term benefits to his company.
– Primary Limitations: Contractor must have adequate
accounting system. Buyer must exercise surveillance during
performance to ensure use of efficient methods & cost controls.
Must be negotiated. Must be justified. Must include applicable
Limitation of Cost clause at FAR 52.232-20 through 23.
– Variants: Firm fixed price, where Contractor pays all costs over
contract price.
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Comparison of Major Contract Types
• Cost No Fee
– Principle 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.
– Elements: Target cost; No fee.
– Contractor is required to: Make good faith effort to meet
Buyer's needs within estimated cost in the Schedule.
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Comparison of Major Contract Types
• Cost-No-Fee
– Contractor Incentive: Providing a deliverable with benefits to
both parties; Contractor expects to derive long term benefits to his
firm; Enhanced reputation.
– Typical Application: Joint research with an educational
institutions or other not-for-profit entities.
– Primary Limitations: Contractor must have adequate
accounting system. Buyer must exercise surveillance during
performance to ensure use of efficient methods & cost controls.
Must be negotiated. Must be justified. Statutory & regulatory limits
on fees that may be negotiated. Must include applicable Limitation
of Cost clause at FAR 52.232-20 through 23.
– Variants: None.
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Comparison of Major Contract Types
• Time and Materials
– Principle 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., because
costs are too low to justify an audit of the contractor's indirect
expenses).
– Elements: Ceiling price; Per-hour labor rate includes overhead &
profit; Provisions for reimbursing direct material costs.
– Contractor is required to: Make good faith effort to meet
Buyer's needs within ceiling price.
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Comparison of Major Contract Types
• Time and Materials
– Contractor Incentive: None.
– Typical Application: Emergency repairs to heating plants
and aircraft engines; Contractor support for field exercises.
– Primary Limitations: Labor rates must be negotiated.
MUST be justified. The Buyer MUST exercise appropriate
surveillance to ensure efficient performance.
– Variants: Labor Hour (LH)
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Steps to Selecting Contract Type
1. Customers Requirements – Talk with them!
– Need What? By When??!!??
– Project Management Requirements?
– Funding Availability? Limitations of Obligation?
Phases?
– Complexities and Possible Complications?
– Risks? Who should carry the burden of risks?
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Steps to Selecting Contract Type
2. Contractor Selection Influences Choices
– Not for Profit?
– Educational Institution?
– Small Businesses? Unsophisticated accounting
system?
– Does the contractor have a job-cost accounting
system?
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Steps to Selecting Contract Type
3. Consider revising the SOW to reduce risks
4. Request your Audit Department to perform
and accounting survey if you are considering
a Cost-type or T&M contract, where the
contractor has no history of performing such
contracts for you.
5. Select the most appropriate pricing
arrangement for your contract.
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The Logic Tree!
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Three Statements of Work –
What Pricing Type Shall We Choose?
• Fish & Bad-Boy Finders LLC
• Desert Rat Communications, Inc.
• Z-Pinchie Consolidated
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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.
(using FFP when not appropriate)
• Award / Incentive Fees = High Admin costs
• Remember: Choosing Wisely Reduces Risks
and may save you potentially significant costs!
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Summary
• Practical approaches are in the briefing on the website,
including the Logic Tree, and the Comparison of Major
Contract Types (a.k.a. Eye Chart), courtesy of Defense
Procurement & Acquisition Policy-Contract Pricing
Reference Guide.
• Questions?
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