Ch 1 - Establishing And Monitoring Contract Type

• 1.0 - Chapter Introduction
• 1.1 - Matching Contract Type to Contract Risk
• 1.2 - Utilizing Fixed-Price Economic Price Adjustment Contracts
  • 1.2.1 - Establishing Terms And Conditions For Economic Price Adjustment
  • 1.2.2 - Making an Economic Price Adjustment Using Cost Indexes
• 1.3 - Structuring And Applying Incentive Pricing Arrangements
  • 1.3.1 - Structuring A Cost Incentive Pricing Arrangement
  • 1.3.2 - Applying a Cost Incentive Pricing Arrangement
• 1.4 - Structuring and Applying Award-Fee Pricing Arrangements
  • 1.4.1 - Structuring an Award-Fee Pricing Arrangement
  • 1.4.2 - Applying an Award-Fee Pricing Arrangement
• 1.5 - Structuring a Fixed-Price Redeterminable Pricing Arrangement
• Appendix 1A - Performance Evaluation Criteria
• Appendix 1B - Contractor Performance Evaluation Report

1.0 Chapter Introduction

When used in this chapter, the terms "contract type" and "type of contract" refer to the contract compensation arrangement. The contract compensation arrangement is the method of determining the dollars due to the contractor under the contract. In this chapter, you will learn about the development and application of common compensation arrangements:

1.1 Matching Contract Type To Contract Risk

Points to Consider (FAR 16.103). Contract type selection is the principal method of allocating cost risk between the Government and the contractor. There is no single contract type that is right for every contracting situation. Selection must be made on a case-by-case basis considering contract risk, incentives for contractor performance, and other factors such as the adequacy of the contractor's accounting system. Your objective should be to select a contract type that will result in reasonable contractor risk with the greatest incentive for efficient and economical contract performance. Selecting the proper contract type will make the work more attractive to more potential offerors, thereby increasing competition.

As you match contract type to contract risk, consider the following:

• Identify available contract types;
• Consider acquisition method;
• Consider commerciality of the requirement;
• Consider cost risk associated with the contract action;
• Consider appropriate performance incentives;
• Consider the accounting system adequacy; and
• Document the selection decision.

Identify Available Contract Types. The table on the following pages compares the most common type of contract arrangements. Most of those arrangements fit into two general categories fixed-price and cost-reimbursement, but labor-hour and time-and-materials contracts have characteristics of both:

• Fixed-Price (FAR Subpart 16.2).Under a fixed-price contract, the contractor agrees to deliver the product or service required at a price not in excess of the agreed-to maximum. Fixed-price contracts should be used when the contract risk is relatively low, or defined within acceptable limits, and the contractor and the Government can reasonably agree on a maximum price. Contract types in this category include:
  • Firm fixed-price (FFP)
  • Fixed-price economic price adjustment (FPEPA)
  • Fixed-price award-fee (FPAF)
  • Fixed-price incentive firm (FPIF)
  • Fixed-price incentive with successive targets (FPIS)
  • Fixed-price contract with prospective price redetermination (FPRP)
  • Fixed-ceiling-price contract with retroactive price redetermination (FPRR)
  • Firm fixed-price level of effort term contract (FFPLOE)
• Cost-Reimbursement (FAR Subpart 16.3).Under a cost-reimbursement contract, the contractor agrees to provide its best effort to complete the required contract effort. Cost-reimbursement contracts provide for payment of allowable incurred costs, to the extent prescribed in the contract. These contracts include an estimate of total cost for the purpose of obligating funds and establishing a ceiling that the contractor cannot exceed (except at its own risk) without the approval of the contracting officer. Contract types in this category include:
  • Cost (CR)
  • Cost-sharing (CS)
  • Cost-plus-fixed-fee (CPFF)
  • Cost-plus-award-fee (CPAF)
  • Cost-plus-incentive-fee (CPIF)
• Labor-Hour and Time-and-Materials (FAR Subpart 16.6). There are two other types of contract compensation arrangements that do not completely fit the mold of either fixed-price or cost-reimbursement contracts. Labor-hour and time-and-materials contracts both include fixed labor rates but only estimates of the hours required to complete the contract. They are generally considered to most resemble cost-reimbursement contracts because they:
  • Do not require the contractor to complete the required contract effort within an agreed-to maximum price; and
  • Pay the contractor for actual hours worked.

¹ Goodwill is the value of the name, reputation, location, and intangible assets of the firm.

Consider Acquisition Method (FAR 14.104 and FAR 16.102,). The acquisition method selected for a particular acquisition may limit the available choice of contract type:

• Simplified Acquisition. When using simplified acquisition procedures purchase orders are normally firm fixed-price. You may use an unpriced order in certain situations when it is impossible to obtain firm pricing prior to issuing the purchase order. Whenever you use an unpriced order, the order must include a dollar limit on the Government's obligation and the contracting officer must follow-up to assure timely pricing.
• Sealed Bidding. When using sealed bidding procedures:
  • You will normally use a firm fixed-price contract.
  • You may use a fixed-price contract with economic price adjustment if the contracting officer determines (in writing) what type of contract is necessary to protect the contractor and the Government against significant fluctuations in labor or material costs or to provide for contract price adjustments in the event of changes in the contractor's established prices.
  • You must not use any other contract type.
• Negotiation. When using the negotiation procedures prescribed in FAR Part 15:
  • You may use any contract type or combination of contract types that will promote the best interests of the Government, as long as you meet the specific limitations in FAR Part 16.
  • You must not use any contract type not prescribed in the FAR unless authorized by agency regulation or a FAR deviation.

Consider Commerciality of the Requirement (FAR 12.207). When acquiring a commercial item:

• You normally should use a firm fixed-price contract.
• You may use a fixed-price contract with economic price adjustment if the contracting officer determines (in writing) what type of contract is necessary to protect the contractor and the Government against significant fluctuations in labor or material costs or to provide for contract price adjustments in the event of changes in the contractor's established prices.
• You must not use any other contract type in acquiring commercial items.

Consider Cost Risk . Encourage contractors to accept reasonable cost risks of contract performance. However, requiring contractors to accept unknown or uncontrollable cost risk can endanger contract performance, substantially reduce competition, and/or substantially increase contract price. To realistically choose the proper contract type to meet a specific contract situation, you must consider the proper allocation of cost risk.

Cost estimates, whether they are the offeror's proposed or the Government's recommended, are point estimates. In all contracts involving forward pricing, the point estimate is a projection of what the estimator believes is most likely to happen. Since things rarely happen exactly as predicted, there is usually some variation between projected and actual cost. The greater the potential variability between the projected and actual cost, the greater the cost risk.

Quantitative analysis techniques can provide invaluable information about the distribution of values around the most likely future cost. For example, consider the confidence interval when your estimate is based on sampling analysis and the prediction interval when your estimate is based on regression analysis. However, use this information wisely. If the variance is large, attempt to determine why the interval is so large and what can be done to narrow it, before you select a contract type to share the risk.

As a minimum, your appraisal of cost risk should consider two areas of particular concern, contract performance risk and market risk.

• Performance Risk. Most contract cost risk is related to contract requirements and the uncertainty surrounding contract performance. The lower the uncertainty the lower the risk. Therefore, your appraisal of cost risk should begin with an appraisal of performance risk. For larger more complex contracts, you will likely need assistance from other members of the Government Acquisition Team (e.g., representatives from the requiring activity, engineering staff, contracting, and program/project management).
  • Areas that you consider should include:
  • Stability and clarity of the contract specifications or statement of work;
  • Type and complexity of the item or service being purchased;
  • Availability of historical pricing data;
  • Prior experience in providing required supplies or services;
  • Urgency of the requirement;
  • Contractor technical capability and financial responsibility; and
  • Extent and nature of proposed subcontracting.
  • The figure below depicts what happens as the contract requirement becomes better defined.

• Performance risk should be reduced from a high to a relatively low level, as the requirement progresses from vague to well-defined and experience with the product increases.
  • Research and development contracts generally have a rather high performance risk. This is due to the factor of ill-defined requirements that arise from the necessity to deal beyond, or at least very near, the upper limits of current technology (i.e., "the state of the art").
  • Follow-on production contracts generally have a relatively low performance risk. Requirements are well known, there is a cost history to draw on, contractors have experience producing the product, etc.
• As performance risk changes, so should contract type. Note that cost-reimbursement, time & materials, or labor-hour contracts are generally associated with higher-risk requirements and fixed-price contracts are generally associated with lower-risk requirements.

S_CU = Contractor percentage share of cost rise

• Write the under-target share ratio in the form S_G/S_C.

Step 8. Calculate the over-target share ratio.

• Contractor share. Use the following formula to calculate the contractor's percentage share of cost risk:
  
  S_CO = (P_T - P_P) / (C_T - C_P) x (100)

Where:

S_CO = Contractor percentage share of cost risk (This will
be a negative number, indicating that profit/fee
will go up as costs go down.)

P_T = Target profit/fee

P_P = Profit/fee at pessimistic cost estimate

C_T = Target cost

C_P = Pessimistic cost estimate

• Government share. Calculate the Government share of cost risk by subtracting the contractor share from 100 percent:

S_GO = 100% - S_CO

Where:

S_GO = Government percentage share of cost risk

S_CO = Contractor percentage share of cost risk

• Write the over-target share ratio in the form S_GO/S_CO.

Example of Sharing Arrangement Formula Development. You have analyzed a contractor's proposal considering all available information. As a result of your analysis, you have completed Steps 1 through 6 of adjustment formula development and prepared the three positions presented in the table below. You must now use this information to calculate the under target and over-target share ratios.

Step 7. Calculate the under-target share ratio.

• Contractor share.
  
  S_CO = (P_T -P_P) / (C_T - C_P) x (-100)
  = ($100,000 - $150,000) / ($1,000,000 - $800,000) x (-100)
  = -$500,000 / $200,000 x (-100)
  = 25%

• Government share.
  
  S_GU = 100% - S_CU
  = 100% - 25%
  = 75%

• Write the under-target share ratio as 75/25.

Step 8. Calculate the over-target share ratio.

• Contractor share.
  
  S_CO = (P_T -P_P) / (C_T - C_P) x (-100)
  = ($100,000 - $10,000) / ($1,000,000 - $1,300,000) x (-100)
  = $90,000 / -$300,000 x (-100)
  = 30%
• Government share.
  
  S_GO = 100% - S_CO
  = 100% - 30%
  = 70%
• Write the over-target share ratio as 70/30. Note that the over-target share ratio and the under-target share ratio are not the same. That is not unusual.

Final Steps for Developing a CPIF Arrangement. As you learned above, the basic elements of the CPIF contract and the FPIF contract are quite similar. Both have a target cost. CPIF target fee and FPIF target profit are both developed using structured profit/fee analysis. Both have sharing arrangements for costs over and under target.

The differences between the CPIF and FPIF pricing arrangements occur when contract costs are substantially above or below target cost. The CPIF contract pricing arrangement must include a minimum fee and a maximum fee that define the contract range of incentive effectiveness (RIE). When costs are above or below the RIE, the Government assumes full cost risk for each additional dollar spent within the funding or cost limits established in the contract. Consider the following final steps when developing a CPIF pricing arrangement.

Step 9. Set the minimum fee. No matter what fee you calculate using the share ratio, the contractor's actual fee cannot be less than the minimum fee stated in the contract. In effect, you are telling the contractor that the Government will accept the risk of contract cost exceeding the cost at the point where minimum fee is reached.

• The pricing arrangement should be structured so that the minimum fee is reached at the pessimistic cost estimate.
• The minimum fee may be zero, but it should rarely be less than zero.

Step 10. Set the maximum fee. No matter what fee you calculate using the share ratio, the contractor's actual fee cannot be more than the maximum fee stated in the contract. Logically, the pricing arrangement should be structured so that the maximum fee is reached at the optimistic cost estimate.

Example of CPIF Arrangement Development. Use the proposal analysis in the following table to develop a contract pricing arrangement including: target cost, target fee, under-target share ratio, over-target share ratio, maximum fee, and minimum fee.

Steps 1-6 have been completed in the table above. Note that:

• Target cost should be the most likely cost -- $1,000,000
• Target fee -- the $70,000 in the "Most Likely Cost" column in above table -- was developed using structured fee analysis.

Step 7. Calculate the under-target share ratio.

• Contractor share.
  
  S_CU = (P_T -P_O) / (C_T - C_O) x (-100)
  = ($70,000 - $120,000) / ($1,000,000 - $800,000) x (-100)
  = $-50,000 / $200,000 x (-100)
  = 25%

• Government share.
  
  S_GU = 100% - S_CU
  = 100% - 25%
  = 75%

• Write the under-target share ratio as 75/25.

Step 8. Calculate the over-target share ratio.

• Contractor Share.
  
  S_CO = (P_T -P_P) / (C_T - C_P) x (-100)
  = ($70,000 - $20,000) / ($1,000,000 - $1,400,000) x (-100)
  = $50,000 / -$400,000 x (-100)
  = 12.5%

• Government Share.
  
  S_GO = 100% - S_CO
  = 100% - 12.5%
  = 87.5%

• Write the over-target share ratio as 87.5/12.5.

Step 9. Set the minimum fee. Minimum fee should be the fee at the pessimistic cost. That fee is $20,000.

Step 10. Set the maximum fee. Maximum fee should be the fee at the optimistic cost. That fee is $120,000.

CPIF Range of Incentive Effectiveness. Whenever you develop a CPIF pricing arrangement, assure that you know the range over which the cost incentives are effective. The range of incentive effectiveness (RIE) is the range over which CPIF incentives can be expected to motivate contractor performance.

The RIE is not identified in the contract, but it is defined by the share ratio(s), minimum fee, and maximum fee. The cost incentive will be effective in the range between the cost point where the maximum fee is reached and the cost point where the minimum fee is reached -- the range between the optimistic cost estimate and the pessimistic cost estimate. Beyond these points, the contractor has no contract incentive to control cost, because fee is fixed.

In the example above, we developed the following pricing arrangement.

The range of incentive effectiveness would be between the optimistic cost ($800,000) and the pessimistic cost ($1,400,000) as shown in the figure below:

CPIF Pricing Arrangement. Note that the optimistic cost estimate and pessimistic cost estimate used to develop the pricing arrangement are not given in the terms of the pricing arrangement. If a contractor had presented an offer which included the elements above, you could calculate the offer RIE by using the following formulas to calculate the optimistic cost and pessimistic cost:

Example of Calculating CPIF Range of Incentive Effectiveness. We can use the pricing arrangement above to calculate the optimistic and pessimistic costs used to develop the pricing arrangement.

Step 1. Calculate the optimistic cost that is consistent with the pricing arrangement.

C_O = C_T - (P_O - P_T) / S_CU

= $1,000,000 - ($120,000 - $70,000) / 25%
= $1,000,000 - $50,000 / 25%
= $1,000,000 - $200,000
= $800,000

$800,000 is the optimistic cost estimate. Note that is the number we used in developing the pricing arrangement.

Step 2. Calculate the pessimistic cost that is consistent with the pricing arrangement.

C_O = C_T - (P_O - P_T) / S_CU

= $1,000,000 + ($70,000 - $20,000) / 12.5%
= $1,000,000 + $50,000 / 12.5%
= $1,000,000 + $400,000
= $1,400,000

$1,400,000 is the pessimistic cost estimate (Note that is the number we used in developing the pricing arrangement.)

Step 3. Use the calculated optimistic cost and the pessimistic cost to describe the RIE. The RIE in this example would be $800,000 to $1,400,000. Outside that range, the proposed incentive arrangement would not incentivize the contractor to control costs.

Final Steps for Developing a FPIF Arrangement.The FPIF contract does not have a maximum profit, the share ratio remains in effect throughout the range of under-target costs. Instead of a minimum profit, the FPIF contract must include a ceiling price. If costs exceed the ceiling price, the contractor assumes full cost risk for each additional dollar spent. Accordingly, the final step in developing a FPIF pricing arrangement is:
Step 9. Set ceiling price. No matter what profit you calculate using the share ratio, the actual price cannot exceed the ceiling price stated in the contract. Logically, the pricing arrangement should be structured so that the ceiling price is reached when contract cost reaches the pessimistic cost estimate. Accordingly, the ceiling price is equal to the pessimistic cost estimate plus estimated profit at that cost.

Step 9. Set Ceiling Price. The ceiling price should be structured so that the ceiling price is reached when contract cost reaches the pessimistic cost estimate. Accordingly, the ceiling price is equal to the pessimistic cost estimate ($1,300,000) plus the estimated $25,000 profit at that cost. Accordingly, the ceiling price is $1,325,000.

FPIF Point of Total Assumption. Whenever you discuss a FPIF pricing arrangement, assure that you identify the point of total assumption (PTA). The PTA is the cost at which the contractor assumes total responsibility for each additional dollar of contract cost. This point is not identified in the contract, but it is defined by the target price, target cost, over-target share ratio, and ceiling price. The PTA can be found mathematically using the following formula:

PTA = K_C - K_T / S_G + C_T

Where:

PTA = Point of total assumption

K_C = Ceiling price

K_T = Target price

C_T = Target cost

S_G = Government percentage share of cost risk

For the example above, the calculations would be:

PTA = $1,325,000 - $1,100,000 / 75% + $1,000,000

= $225,000 / 75% + $1,000,000

= $300,000 + $1,000,000

= $1,300,000

Note that the PTA is equal to the cost at the pessimistic cost estimate. After the contract cost reaches $1,300,000, each additional dollar of cost comes from profit. When cost exceeds the $1,325,000 ceiling price, each additional dollar of cost increases the loss (negative profit) on the contract.

The figure below depicts the FPIF pricing arrangement developed above, including the PTA:

1.3.2 Applying A Cost Incentive Pricing Arrangement

Incentive Contracts and Final Pricing. With incentive contracts, contract pricing does not end with establishing the incentive pricing arrangement. This section will examine the application of the incentive pricing arrangement to calculate final contract price.

Final Steps for Developing a FPIF Arrangement. The FPIF contract does not have a maximum profit, the share ratio remains in effect throughout the range of under-target contractor's share of any costs over or under target as calculated in Step 3.

Steps for CPIF Contract Final Pricing (FAR 52.216-10(e)(4)). Cost-reimbursement contracts provide for payment of allowable incurred costs, to the extent prescribed in the contract. In a CPIF contract, final fee will depend on the allowable cost incurred.

Follow the steps below in calculating final contract price.

Step 1. Calculate final allowable contract cost. Base calculations on the contractor’s final vouchers, Government audit results, and other available information. Exclude all costs specifically identified as unallowable.

Step 2. Determine final cost for fee adjustment purposes. For the purposes of fee adjustment, do not include costs arising from:

• Any of the causes covered by the contract Excusable Delays clause to the extent that the costs are beyond the control and without the fault or negligence of the contractor or any subcontractor.
• The taking effect, after target cost negotiation, of a statute, court decision, written ruling, or regulation that results in the contractor’s being required to pay or bear the burden of any tax or duty or rate increase in a tax or duty;
• Any direct cost attributed to the contractor’s involvement in litigation as required by the contracting officer pursuant to contract requirements, including furnishing evidence and information requested pursuant to the contract Notice and Assistance Regarding Patent and Copyright Infringement clause;
• The purchase and maintenance of additional insurance not in the target cost and required by the contracting officer, or claims for reimbursement for liabilities to third persons pursuant to the contract Insurance Liability and Third Persons clause; Establishing And Monitoring Contract Type
• Any claim, loss, or damage resulting from a risk for which the contractor has been relieved of liability by the contract Government property clause;
• Any claim, loss, or damage resulting from a risk identified in the contract as unusually hazardous or as a nuclear risk and against which the Government has expressly agreed to indemnify the contractor; or
• Any other costs specifically excluded from fee calculations by the contract.

Step 3. Calculate the contractor’s share of any costs over or under target. Use the final contract cost calculated in Step 2, target cost, and the appropriate share ratio.'

P_A = S_C (C_T - C_F)

Where:

P_A = Fee Adjustment
S_C = Contractor percentage share of cost risk
C_T = Target cost
C_F = Final cost

Step 4. Adjust contract fee considering the contractor’s share of any costs over or under target as calculated in Step 3.

P_F = P_T + P_A

Where:

P_F = Final fee amount
P_T = Target fee
P_A = Fee adjustment (Remember that the fee adjustment may be positive or negative.)

Step 5. If the fee calculated in Step 4 is more than the maximum fee or less than the minimum fee, adjust it to the appropriate fee.

Step 6. Add the final fee to final cost to determine final contract price.

K_F = C_F + P_F

Where:

K_F = Final price
C_F = Final cost
P_F = Final fee amount

Step 7. Modify the contract, using a bilateral contract modification, to incorporate agreement on final cost and fee.

Example of CPIF Contract Final Pricing. You and the contractor agree that the final cost on a CPIF contract is $1,100,000. Contract target cost is $1,000,000; target fee is $70,000; minimum fee is $20,000; and the over-target share ratio is 87.5/12.5.

Step 1. Calculate final allowable contract cost. Final contract cost is $1,100,000

Step 2. Determine final cost for fee adjustment purposes. In this contract no costs are excluded from fee calculations, so the final cost for fee calculations is $1,100,000

Step 3. Calculate the contractor’s share of any costs over or under target. Calculate contractor’s share of the cost over-target.

P_A = S_C (C_T - C_F )

= 12.5%($1,000,000 - $1,100,000)
= 12.5%(-$100,000)
= - $12,500

Step 4. Adjust contract fee considering the contractor’s share of any costs over or under target as calculated in Step 3.

P_F = P_T + P_A
= $70,000 + (-$12,500)
= $57,500

Step 5. If the fee calculated in Step 4 is more than the maximum fee or less than the minimum fee, adjust it to the appropriate fee.

No adjustment is required.

Step 6. Add the final fee to final cost to determine final contract price.

K_F = C_F + P_F

= $1,100,000 + $57,500
= $1,157,500

Step 7. Modify the contract, using a bilateral contract modification, to incorporate agreement on final cost and fee.

The final contract price is $1,157,500.

Steps for FPIF Contract Final Pricing (FAR 52.216-16). Computation of the final price under an FPIF contract is very similar to computation of final price under a CPIF contract. The major differences are that there are no limits on profit and total price cannot exceed the contract ceiling price.

Follow the steps below in calculating final FPIF contract price.

Step 1. Review the contractor's final cost proposal to develop a position on final contract cost.

• Assure that the contractor's final cost proposal includes all data required by the contract.
• Develop a negotiation position based on Government audit recommendations and other available information

Step 2. Calculate the contractor's share of any costs over or under target. Use the final contract cost calculated in Step 1, target cost, and the appropriate share ratio.

P_A = S_C (C_T - C_F)

Where:

P_A = Profit Adjustment

S_C = Contractor percentage share of cost risk

C_T = Target cost

C_F = Final cost

Step 3. Adjust contract profit considering the contractor's share of any costs over or under target as calculated in Step 2.

P_F = P_T + P_A

Where:

P_F = Final Profit

P_T = Target Profit

P_A = Profit Adjustment (Remember that the profit
adjustment may be positive or negative.)

Step 4. Add the final profit to final cost to determine final contract price.

K_F = C_F + P_F

Where:

K_F = Final price

C_F = Final cost

P_F = Final profit

Step 5. If the price calculated in Step 4 exceeds the contract ceiling price, the final contract price will be the ceiling price.

Step 6. Negotiate final contract price.

• Use the results of Steps 1 through 5 as your objective in negotiating contract final cost. If the contractor provides additional support that leads you to modify your position on final cost, modify your position on final profit and price accordingly.
• When you reach a agreement on final contract price, modify the contract, using a bilateral contract modification, to incorporate agreement on final cost and profit.
• If you cannot reach a final price agreement, it may be necessary for you to issue a final decision under the contract Disputes clause

Step 7. Obtain a final invoice. Apply any deductions or withholdings and process the invoice for final payment.

Example of FPIF Contract Final Pricing. You and the contractor agree that the final cost on a FPIF contract is $1,310,000. Contract target cost is $1,000,000; target profit is $100,000; ceiling price is $1,325,000; and the over-target share ratio is 75/25.

Step 1. Review the contractor's final cost proposal to develop a position on final contract cost.

The contractor proposed a final contract cost of $1,310,000. Government review and your analysis did not identify any deficiencies.

Step 2. Calculate the contractor's share of any costs over or under target.

P_A = S_C (C_T - C_F)

= 25% ($1,000,000 - $1,310,000)
= 25% (-$310,000)
= -$77,500

Step 3. Adjust contract profit considering the contractor's share of any costs over or under target as calculated in Step 2.

P_F = P_T + P_A

= $100,000 - $77,500
= $22,500

Step 4. Add the final profit to final cost to determine final contract price.

K_F = C_F + P_F

= $1,310,000 + $22,500
= $1,332,500

Step 5. If the price calculated in Step 4 exceeds the contract ceiling price, the final contract price will be the ceiling price.

Since the price in Step 4 exceeds the contract ceiling price, the final contract price is the ceiling price $1,325,000

Step 6. Negotiate final contract price.

In this example, negotiation should result in acceptance of the contractor's proposed cost.

Step 7. Obtain a final invoice.

Obtain a final invoice and process it for final payment.

1.4 Structuring And Applying Award-Fee Pricing Arrangements

In this section, we examine factors to consider in structuring and applying award-fee pricing arrangements.

• 1.4.1 - Structuring An Award-Fee Pricing Arrangement
• 1.4.2 - Applying An Award-Fee Pricing Arrangement

Award-Fee Concept (FAR 16.405-2(a)). An award-fee contract is a form of incentive contract. Unlike the FPIF or CPIF contract, the award-fee contract does not include predetermined targets and automatic fee adjustment formulas. Contractor performance is motivated by fee adjustments based on a subjective evaluation of contractor performance in areas such as quality, timeliness, technical ingenuity, and cost-effective management.

CPAF Contract Features (FAR 16.405-2(a)). The most common award-fee contract is the cost-plus-award-fee (CPAF) contract.

• A CPAF contract provides for a fee consisting of:
  • A base fee that is fixed at the time of contract award, and
  • An award-fee that the contractor may earn in whole or in part during contract performance. The award-fee must be large enough to motivate the contractor to excel in such areas as quality, timeliness, technical ingenuity, and cost-effective management.
• At established points during contract performance, the Government Fee Determining Official will evaluate contractor performance and determine the amount of award-fee that the contractor will receive from the available award-fee pool in accordance with criteria established in the contract. The determination is made unilaterally by the Fee Determining Official.

Situations for CPAF Contract Use (FAR 16.405-2(b)(1)). Consider a CPAF contract when the following conditions exist:

• It is neither feasible nor effective to devise predetermined objective incentive targets applicable to cost, technical performance, or schedule.
• The likelihood of meeting acquisition objectives will be enhanced by using a contract that effectively motivates the contractor toward exceptional performance and provides the Government with the flexibility to evaluate both actual performance and the conditions under which it was achieved.
• Any additional administrative effort and cost required to monitor and evaluate performance are justified by the expected benefits.

Restrictions on CPAF Contract Use (FAR 16.405-2(c) and DFARS 216.405-2(c)). In addition to restrictions applicable to all cost-reimbursement contracts, FAR directs that CPAF contracts not be used unless the expected benefits are sufficient to warrant the additional administrative effort and cost involved.

Your agency may provide additional restrictions. For example, DoD personnel must not use a CPAF contract:

• To avoid establishing a CPFF contract when the criteria for a CPFF contract apply or developing objective targets so that a CPIF contract can be used.
• For either engineering development or operational development acquisitions which have specifications suitable for simultaneous research and development and production. However, you may use a CPAF contract for individual engineering development or operational system development acquisitions in support of the development of a major weapon system or equipment, where:
  • It is more advantageous to the Government, and
  • The purpose of the acquisition is clearly to determine or solve specific problems associated with the major weapon system or equipment.

Situations for FPAF Contract Use (FAR 16.404(a) and DFARS 216.470). You may use award-fee provisions in fixed-price contracts when the Government wishes to motivate a contractor and other incentives cannot be used because contractor performance cannot be measured objectively. Such contracts must:

• Establish a fixed price (including normal profit) for the effort. This price will be paid for satisfactory contract performance. Award fee earned (if any) will be paid in addition to that fixed price; and
• Provide for periodic evaluation of the contractor's performance against an award-fee plan.

Restrictions on FPAF Contract Use (FAR 16.404(b) and DFARS 216.470). Do not consider an FPAF unless the following conditions exist:

• The administrative costs of conducting award-fee evaluations are not expected to exceed the expected benefits;
• Procedures have been established for conducting the award-fee evaluation;
• The award-fee board has been established; and
• An individual above the level of the contracting officer approved the fixed-price-award-fee incentive.

1.4.1 Structuring An Award-Fee Pricing Arrangement

Base Fee Objective for CPAF Contracts (FAR 15.404-4(b)(1), DFARS 215.404-74, and DFARS 216.404-2(c)(2)(B)).

Most agencies (including the DoD) exempt CPAF contracts from the requirement for application of the agency's structured approach to fee analysis.

Accordingly, you must subjectively develop your base fee objective for each contract considering the following guidelines:

• The base fee must not exceed prescribed agency limits (e.g., three percent of contract cost for DoD contracts).
• The base fee should be large enough to provide the contractor with an adequate fee for rendering minimum acceptable performance, but small enough to provide an award-fee pool that will provide the contractor with an adequate incentive to improve performance above minimum requirements.

Award-Fee Objective. The award-fee pool is meant to provide the contractor with an incentive to provide more than the minimum level of performance required by the contract. Based on contract performance, the contractor may earn all, part, or none of the available award-fee pool.

As with base fee, you must subjectively develop your award-fee objective. The award-fee pool should be sufficient to motivate or reward the contractor at any level of performance above the minimum designated in the evaluation criteria. Normally, you should expect the sum of the base fee and the award-fee pool to exceed the fee objectives that would be provided under a CPFF contract.

Contract Award-Fee Clauses (FAR 16.406(e) and FAR 52.216-7).

FAR does not prescribe specific award-fee clauses, instead it requires you to insert an appropriate award-fee clause in solicitations and contracts when a CPAF contract is contemplated.

• FAR requires that the clause:
  • Be prescribed by or approved under agency acquisition regulations;
  • Be compatible with the Allowable Cost and Payment clause; and
  • Expressly exclude from the operation of the Disputes clause any disagreement by the contractor concerning the amount of the award fee. (However, this wording does not negate the authority of Courts and Boards to overturn a decision that is arbitrary or capricious (see Burnside-Ott Aviation Training Center v. John H. Dalton,
    Secretary of the Navy, US-CT-APP-FC, 41 CCF ¶77,043)).
• In preparing the clause, also consider the following:
  • Base Fee:
  • State the agreed-to amount.
  • State how the base fee will be paid (e.g., equal monthly installments).
  • Award-fee:
  • State the total agreed-to amount.
  • Include a provision for the prompt payment of contractor-earned award-fee after each determination.
  • Award-fee Determination Process:
  • The award-fee determination process need not be spelled out in the contract or in an appendix to the contract. Normally, it is preferable to delineate the award-fee determination process in a comprehensive Award-Fee Plan that is identified in the contract.
  • State that the Fee Determining Official has the unilateral right to change the Award-Fee Plan, except for conditions that otherwise require mutual agreement under the contract.
  • State that the contractor must receive notice of any change to the Plan by a specified number of work or calendar days prior to the beginning of the evaluation period to which the change will apply.
• Award-Fee Evaluations. Award-fee evaluations should be timed so that the contractor will be periodically informed about performance quality and the areas in which improvement is expected (FAR 16.405-2(b)(3)). Tie partial payment of fee to the evaluations.
  • If a program or project is involved, the award-fee evaluation points should be tied to key program decision points.
  • If the contract is for a continuing effort (e.g., facility operation and maintenance), the award-fee evaluation points should be established periodically throughout the contract.

Award-Fee Plan. The Award-Fee Plan should comprehensively delineate the award-fee determination process.

• Organizational Structure for Award-fee Determination. The plan should identify and define the responsibilities of personnel involved in the award-fee process. The structure should be tailored to fit the contract situation. However, a three-tier structure is common.
  • Fee Determining Official. The Fee Determining Official is responsible for:
  • Determining the award-fee earned and payable for each evaluation period.
  • Changing the matters covered by the Award-Fee Plan, as necessary.
  • Performance Evaluation Board. The Board is responsible for:
  • Conducting ongoing evaluations of contractor performance and making recommendations to the Fee Determining Official concerning award-fee.
  • Considering proposed changes in the Award-Fee Plan and recommending those that it determines are appropriate.
  • Performance Monitor. Assign a performance monitor to each performance area which will be evaluated as part of the Award-Fee Plan.
• Performance Evaluation Criteria (FAR 16.405-2(b)(2)). The plan should identify areas that will be evaluated and how they will be evaluated.
  • The number of evaluation criteria and requirements that they represent will differ widely among contracts.
  • The criteria and the rating plan should motivate the contractor to improve performance in the areas rated, but not at the expense of at least minimum acceptable performance in all other areas. Appendix A presents an example for a contract for shipyard support from DFARS Table 16-1, Performance Evaluation Criteria.
• Performance Evaluation Report Format. The plan should include a format for Performance Monitor evaluation of contractor performance. Appendix B presents an example for shipyard support from DFARS Table 16-2, Contractor Performance Evaluation Report.

1.4.2 Applying An Award-Fee Pricing Arrangement

Award-Fee Determination Process. The award-fee determination is a subjective process that requires effective communication between all the parties involved. The process begins with the Award-Fee Plan and the individual Performance Monitors and follows the general process described below. The overall flow should be modified as necessary to meet agency requirements and the needs of each contracting situation.

Step 1. Performance Monitor orientation.

• Each Performance Monitor should be provided with the following documents:
• A copy of the contract award-fee provisions.
• A copy of the Award-Fee Plan.
• A copy of specific instructions applicable to Performance Monitor assigned areas of evaluation cognizance.
• The Performance Evaluation Board Chairperson should conduct a discussion of the award-fee determination process in general and the Performance Monitor's responsibilities in particular.
• The Performance Evaluation Board Chairperson should consider scheduling periodic meetings with Performance Monitors to discuss ongoing contractor performance, general problems and solutions, and other contractual issues.

Step 2. Performance Monitors assess contractor performance throughout the performance period.

Step 3. At the end of each evaluation period, Performance Monitors submit Performance Management Reports to the Performance Evaluation Board. Each report should conform to the requirements of the Award-Fee Plan.

Step 4. The Performance Evaluation Board evaluates information obtained from the Performance Monitors and other available sources of information.

• The Board may request contractor input concerning the reports provided by the Performance Monitors.
• The Board may discuss any questions about the Performance Monitor Reports with the Performance Monitors. For example, a contractor's shortcoming identified in a Performance Monitor Report may have been occasioned by Government influences and decisions to which the contractor responded at the expense of certain aspects of otherwise prescribed contract work. Board members may be in a better position than the Performance Monitor to evaluate the contractor's response.

Step 5. The Board meets and summarizes preliminary findings and positions.

Step 6. After it reaches its preliminary decision, the Board meets with contractor top-management to provide a summary of its preliminary findings and position regarding the performance levels achieved in the areas evaluated.

Step 7. After the conference with the contractor, the Board should consider contractor input and, if appropriate, modify its preliminary findings and recommendations accordingly.

Step 8. The Board Chairperson submits the Performance Evaluation Board Report to the Fee Determining Official.

The Performance Evaluation Board Report should consider such matters as:

• Recommended range of dollars within which the award-fee should fall.
• Performance points assigned by the Board to each performance area and evaluation criterion, if applicable.
• Bases of the performance points assigned.
• Rationale for selecting the recommended award-fee range.

Step 9. The Fee Determining Official considers the recommendation of the Performance Evaluation Board and makes a decision regarding award-fee.

That decision may or may not be in accord with the Performance Evaluation Board recommendation. If it is not in accord with the Board recommendation, the Fee Determining Official must assure that reasons for any differences are fully documented.

Step 10. The Fee Determining Official sends the award-fee decision to the contractor.

1.5 Structuring Fixed-Price Redeterminable Pricing Arrangements

Redeterminable Contract Types (FAR 16.205 and FAR 16.206). There are two types of fixed-price contracts that provide for price redetermination without an incentive arrangement, the fixed-price contract with prospective price redetermination (FPRP) and the fixed-ceiling-price contract with retroactive price redetermination (FPRR).

FPRP Description (FAR 16.205-1). A FPRP contract provides for a firm fixed-price for an initial period of contract deliveries or performance and prospective price redetermination at a stated time or times during contract performance for subsequent periods. It can probably be best described as a series of firm fixed-price contracts negotiated at stated times during performance.

Situations for FPRP Contract Use (FAR 16.205-2). You should consider an FPRP contract for acquisitions of quantity production or services for which you can negotiate a fair and reasonable firm fixed-price for the initial period, but not for subsequent periods of contract performance. In the DoD, FPRP contracts are frequently used for aircraft engine acquisition, where the nature of manufacture and resulting methods of accounting for costs lend themselves to periodic, plant-wide pricing on a prospective basis.

FPRP Elements (FAR 16.205-2). The FPRP contracts have two key elements:

• Firm fixed-price for an initial period of contract deliveries or performance.
• Stated time or times for price redetermination.

They generally also have a third element, a ceiling price. In negotiating a ceiling price you should consider the uncertainties involved in contract performance and their cost impact. This ceiling should provide for assumption of a reasonable proportion of the risk by the contractor and, once established, may be adjusted only by operation of contract clauses providing for equitable price adjustment or other revision of the contract price under stated circumstances.

FPRP Negotiation and Administration (FAR 16.205-2, FAR 16.205-3(c), and FAR 52.216-5). Consider the following points when you negotiate and administer an FPRP contract.

• The initial period for which the price is fixed at the time of contract negotiation should be the longest period for which it is possible to establish a fair and reasonable firm fixed-price.
• The length of the prospective pricing periods will depend on the circumstances of each contract but generally should be at least 12 months.
• The prospective pricing period(s) should conform with the operation of the contractor's accounting system. They can be described in terms of units delivered, or as calendar periods, but generally are defined to end on the last day of a month. The first day of the succeeding period must be the effective date for the price redetermination.
• At a specified time before the end of each redetermination period prior to the last, the contractor is required to submit:
  • Proposed prices for supplies or services to be delivered during the next succeeding period, and:
  • An estimate and breakdown of the costs of these supplies or services in a format that meets the requirements of the law and applicable regulations.
  • Sufficient data to support the accuracy and reliability of this estimate, and
  • An explanation of the differences between this estimate and the original (or last preceding) estimate for the same supplies or services.
  • A statement of all contract costs incurred through the end of the first month (or second if necessary to achieve compatibility with the contractor's accounting system) before submission of the proposed prices.
  • The data must be sufficient to disclose unit cost and cost trends for:
    • Supplies delivered and services performed, and
    • Inventories of work in process and undelivered contract supplies on hand (estimated to the extent necessary).
  • The data format must meet the requirements of the contract, the law, and applicable regulations.
• The contractor must also submit (to the extent that it becomes available before negotiations on price redetermination are concluded):
  • Supplemental statements of costs incurred after proposal submission, and
  • Any other relevant data that you may reasonably require.
• If the contractor fails to submit the data required within the time periods specified, the contracting officer may suspend contract payments until the data are submitted. If it is later determined that the Government overpaid the contractor, the contractor must repay the Government immediately. Unless repaid within 30 days after the end of the data submittal period, the amount of the excess must bear interest - computed from the date the data were due to the date of repayment - at the rate established in accordance with the Interest clause of the contract.
• Upon receipt of the data required, negotiate to redetermine fair and reasonable prices for the supplies and services that may be delivered in the period following the effective date of the price redetermination.
• Formalize each price redetermination in a bilateral contract modification.
• Pending execution of the bilateral contract modification, the contractor will submit invoices or vouchers in accordance with the billing prices established in the contract.
  • If at any time it appears that the then-current billing prices will be substantially different than the estimated prices, negotiate an appropriate change in the billing price.
  • Any billing rate adjustment must be reflected in a contract modification, but it must not affect price redetermination.
  • After price redetermination, adjust the total amount paid or to be paid on all invoices or vouchers to the agreed-upon price. Assure that any required payments or refunds are made promptly.
• If you and the Contractor fail to agree on redetermined prices for any price redetermination period within 60 days (or within such other period as the parties agree) after the date on which the above data are to be submitted, the contracting officer must promptly issue a decision in accordance with the Disputes clause. If the contractor fails to appeal, this decision must be treated as an executed contract modification, unless modified by agreement with the contractor.
• Quarterly -- during periods for which prices have not been established, costs have been incurred, and adjusted billing prices exceed the existing contract price -- the contractor must submit cumulative data showing:
  • Total contract price for all supplies and services delivered and accepted by the Government for which final prices have been established.
  • Total costs (estimated to the extent necessary) for supplies and services delivered and accepted by the Government for which prices have not been established.
  • Interim profit for supplies and services delivered and accepted by the Government for which prices have not been established.
  • The total amount of all invoices or vouchers for supplies or services delivered and accepted by the Government.

FPRR Description (FAR 16.206-1). An FPRR contract provides for a fixed ceiling price and retroactive price redetermination within the ceiling price after contract completion.

Situations for FPRPR Contract Use (FAR 16.206-2 and FAR 16.206-3). A FPRR contract is appropriate for research and development contracts estimated at $100,000 or less when you establish at the outset that a fair and reasonable contract cannot be negotiated and that the amount involved and short performance period make the use of any other fixed-price contract impractical. Before use, obtain approval from the head of the contracting activity (or the higher level official designed by your agency).

FPRR Elements (FAR 16.206-2 and FAR 16.206-3). The FPRR contract has three key elements:

• Ceiling price negotiated for the contract at a level that reflects a reasonable sharing of risk by the contractor. The established ceiling price may be adjusted only if required by the operation of contract clauses providing for equitable price adjustment or other revision of the contract price under stated circumstances.
• Billing price that is fair and reasonable as circumstances permit. The billing price may be adjusted during contract performance if circumstances warrant. Any billing price adjustment must be reflected in a contract modification and must not be the final price redetermination.
• Agreement to promptly negotiate a fair and reasonable price after contract completion.

FPRR Negotiation and Administration (FAR 16.206-3(d) and FAR 52.216-6). Contract requirements are similar to those for an FPRP contract except that price is not redetermined until all items are delivered. However, you should consider two additional points as you negotiate and administer an FPRR contract.

When you negotiate the contract, you should emphasize the importance of management effectiveness and ingenuity in contract performance will be considered during final pricing. This emphasis is important because this contract type does not provide the contractor with a calculable incentive for effective cost control, aside from the cost ceiling.

• Within a specified number of days after delivery of supplies or services, the contractor is required to submit:
  • Proposed prices.
  • A statement of all costs incurred during contract performance. The data format must meet the requirements of the contract, the law, and applicable regulations.
  • Any other relevant data that you may reasonably require.
• When you negotiate the redetermined contract price, you should give weight to the management effectiveness and ingenuity exhibited by the contractor during performance.