A. Expected Advantage: Enhanced Technical and Schedule Focus
B. Expected Advantage: Reduced Cost of Oversight and Administration
C. Expected Advantage: Broadened Contractor Participation
D. Expected Advantage: Potentially Improved Cash Flow for the Contractor
E. Win-Win: Lower Price in Exchange for Better Cash Flow
F. The PBP Analysis Tool
When PBPs were first introduced a number of potential advantages were cited:
- enhanced technical and schedule focus,
- reduced cost of oversight,
- broadened contractor participation and
- potentially improved cash flow for the contractor.
Some of the advertised advantages have turned out to be overstated, unrealized or not measurable. Fortunately, the potential for improved cash flow has proven to be real and provides a unique opportunity for a financial Win-Win deal to be negotiated. Before discussing the Win-Win opportunity in detail, a discussion of the other expected advantages follows.
A. Expected Advantage: Enhanced Technical and Schedule Focus
The expectation was that PBPs would enhance the focus on technical and schedule performance because of the upfront effort needed to establish a PBP arrangement and the attention required to accomplish the PBP events during contract execution. When structured properly, PBPs can reinforce the contractor’s motivation to accomplish the entire effort in a prompt and efficient manner. However, if the PBP schedule is made up of less meaningful events, events have inadequate completion criteria, or the valuation of events is not reflective of their relative value to the successful performance of the contract, the PBP arrangement can unintentionally misdirect the contractor’s focus. The Department of Defense Inspector General's (DoDIG) Report No. DoDIG 25 June 2003 on the administration of PBPs cited numerous instances where the PBP arrangement contained these types of deficiencies.
B. Expected Advantage: Reduced Cost of Oversight and Administration
The expectation was that since PBP event values are established upfront, PBPs would not require the oversight of the contractor’s accounting system on the part of the Government. The expected benefits of this did not consider that oversight of a contractor’s accounting system is done on the system as a whole and is not contract specific. Therefore, unless a contractor had no other contracts which required an accounting system deemed adequate by the Government (such as cost type contracts or contracts that use progress payments), PBPs did not result in a reduction in the oversight of the accounting system. The vast majority of contractors who have been awarded contracts with PBP financing have contracts that continue to require oversight of their accounting system. Since PBPs require significant effort prior to award and validation of event completion during contract performance, expectations of reduced cost of administration may have been overstated.
C. Expected Advantage: Broadened Contractor Participation
The expectation was that the availability of PBP financing would attract contractors who, due to the lack of an adequate accounting system, would not otherwise seek Government contracts. There does not appear to have been a significant increase in the defense industrial base as a result of PBPs. This is understandable. Existing companies engaged in only non-Government work are generally providing commercial items or services. When the Government wants to acquire those items or services it can do so under FAR Part 12 and use commercial financing methods as described in FAR Part 32. When contemplating the use of PBPs with an existing defense contractor, this potential advantage is not applicable.
D. Expected Advantage: Potentially Improved Cash Flow for the Contractor
The one advantage that has been realized is the potential for improved contractor cash flow with PBPs versus progress payments. As noted above, total PBPs can equal as much as 90% of the contract price whereas progress payments are 80% of contract cost for large businesses. Previous guidance considered this to be an advantage only to the contractor and to a large extent only the contractor has reaped the benefits to date. However it is the improved cash flow which creates the potential for a true Win-Win financial arrangement for both sides to be negotiated when PBPs are structured properly. It is primarily this potential for a Win-Win financial arrangement that should make PBPs desirable to both sides as explained below.
E. Win-Win: Lower Price in Exchange for Better Cash Flow
The benefit of improved cash flow is so significant from a contractor’s perspective that a contract with considerably less profit (lower price) with PBPs can be a better financial deal for the contractor than a higher price for the same contract with progress payments.
The key to this opportunity for a Win-Win deal is in understanding the time-value of money in measuring the cost to the Government and benefit to the contractor of improved cash flow. If both sides had the exact same view of the time-value of money, a Win-Win associated with improved cash flow would not be possible. Fortunately, the time-value of money to the contractor is considerably greater than the time-value of money to the Government.
As stated in FAR 32.1004(b)(3), there is a cost to the treasury of providing contract financing to the contractor as the Government must obtain and provide the funds in advance of receiving the final goods or services. Similarly, absent Government financing, a contractor must use its own funds to pay the entire contract cost incurred prior to delivery and there is a cost to raising those funds. The Government’s cost of raising funds is based on what it costs the Government to borrow money. A contractor must also obtain the funds required to pay the costs incurred on a Government contract prior to final delivery and payment by the Government. This funding requirement is commonly referred to as working capital. The vast majority of Government fixed-price contract dollars are expended on contracts with publically held corporations. Although these corporations raise funds through both borrowing (debt) and selling stock (equity), the funds required for working capital needs are most often obtained through short-term borrowing. From a lender's perspective, corporations are considered to be a greater risk than the U.S. Government; therefore, the cost of short-term borrowing for corporations is greater than it is for the Government. Because a contractor's time value of money is higher than the Government's time value of money, accelerated funding provided by PBPs has greater financial benefit to the contractor than cost to the Government and sets the stage for the negotiation of a mutually beneficial and lower contract price.
The cost and benefits of a series of cash flows is not difficult to measure using the financial functions available in electronic spreadsheets. Therefore it is possible to compare the financial cost and benefits of PBP financing versus customary progress payments.
The progress payment scenario is used as the benchmark for determining a Win-Win arrangement for several reasons. First, it is the financing method most likely to be used if a PBP arrangement cannot be agreed to or is determined to be impractical. Second, it is the financing method most commonly used between the Government and Industry. And third, it is considered by industry to be a low-risk form of financing. For these reasons, the progress payment scenario is the right financial benchmark for a risk/reward analysis.
What is more difficult to evaluate is the potential risk associated with PBPs that is not present with progress payments. With PBPs a payment is only made when an event has been successfully accomplished. Therefore, a contractor would not be interested in a PBP contract price that is so much lower than the price would be with the less-risky progress payment method that the financial value of both is the same. The key then is to negotiate a price that is lower than it would be with progress payments, provides the contractor better financial value and recognizes the potential risk inherent in PBPs.
The DoD PBP Analysis Tool allows the contracting officer to identify that Win-Win solution. It does this by comparing the expected monthly cash flow to the contractor when using PBPs versus progress payments. The tool calculates the final cost to the Government and the financial value to the contractor under both scenarios. The final cost to the Government is calculated by adding the cost of borrowing the financing payments made to the contractor to the contract price. The financial value to the contractor is based on calculating the Internal Rate of Return (IRR) and Net Present Value (NPV) value of the cash flows. The tool finds the solution that benefits both parties.
Lower final cost to the Government and greater IRR and NPV for the contractor. More importantly, the tool allows the user to do “what-ifs” on PBP event timing to see the financial impact to the contractor and Government of event slippage or acceleration. This permits the user to make a fact-based assessment of the financial risk and benefits of the PBP arrangement.
