Contract Types and Appropriate Incentives

1 Jo Cunningham Distinguished Member of Laboratory Staff Sandia National Laboratories Session #3, 1:00pm - 1:30pm ET NCMA’s 1 st Performance-Based Service Acquisition Community of Practice - Virtual Conference Wednesday, March 31, :00pm - 4:00pm ET Contract Types & Appropriate Incentives

2 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.

3 What’s Really in it For Me? Describe how you saved us $10 Million AND reduced our risks!

4 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

5 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

6 Cost Risk & Contract Type Cost Risk:High >>>>>>>>>>>>>>>>>>>>>>>> Low Requirement DefinitionVague >>>>>>>>>>>>>>>>>>>>>>>>> Well Defined Production Concept ExploratoryTest/Full scaleFull Stages Studies, & Development DemoDevelopmentProduction Basic Research Contract Varied CPFFCPIF,CPIF, FPIF,FFP, FPIF, Type FPIFor FFPor FPEPA

7 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

8 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

9 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

10 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

11 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.

12 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

13 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.

14 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.

15 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..

16 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.

17 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.

18 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.

19 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!