Seminar: Contract Types & Contract Financing

1. Seminar: Contract Types& Contract Financing Program Management Office Course PMT 352B Version 2.9, 2-25-14

2. FIXED PRICE TYPES Firm Fixed Price Fixed Price Award Fee Fixed Price Incentive (Firm Targetor Successive Target) Fixed Price (Level of Effort) Fixed Price with Economic Price Adjustment Fixed Price with Price Redetermination COST REIMBURSEMENT TYPES Cost Plus Fixed Fee Cost Plus Incentive Fee Cost Plus Award Fee Cost Cost Sharing Contract Types

3. Contract Family Characteristics

4. Factors in Selecting Contract Type • Contractor’s • technical capability • financial responsibility • Adequacy of the contractor’s accounting system • Concurrent contracts • Extent and future of subcontracting • Acquisition history • Price Competition • Price Analysis • Cost Analysis • Complexity of the requirement • Urgency of the requirement • Period of Performance or, • Length of the production run

5. General Differences Cost Plus Fixed Fee Firm Fixed Price Cost Cost + Fee + Profit Price Price

6. Cost Risk and Contract Type Greatest Risk to the Contractor Greatest Risk to the Government CPFF CPIF CPAF FPI (F) FPAF FFP Technical Risk Vague technical requirements; labor and material costs uncertain Technical requirements defined; fair & reasonable prices determinable

7. Cost Plus Fixed Fee (CPFF) Fee Contractor gets 100% of fee regardless of cost Fixed Fee Cost Negotiated and established at contract award: - Estimated Cost - Fixed Fee • Fee shall not exceed: • 15% of estimated contract cost (excluding fee) for R&D contracts • 6% of estimated contract cost (excluding fee) for architectural & engineering contracts • 10% of estimated contract cost (excluding fee) for other contract types

8. CostPlus Incentive Fee (CPIF) Fee Maximum Fee Gov’t/Ktr Share Ratio(s) Range of Incentive Effectiveness Target Fee Minimum Fee Cost Target Cost Established at Contract Award: • Fee Adjustment Formula: • TC - Actual Cost (AC) = over/underrun • Over/underrun x Ktr’s SR = Fee adjustment • TF +/- Fee adjustment = Adjusted Fee (AF) • (If AF > than MaxF or < than MinF, then use MaxF or • MinF, as appropriate, for AF below to determine Final • Contact Price) • Final Contract Price = AC + AF - Target Cost (TC) - Target Fee (TF) - Maximum Fee (MaxF) - Minimum Fee (MinF) - Share Ratio(s) (SR)

9. CPIF Final Contract Price: Two Examples Established at Contract Award: Target Cost = $1000 Target Fee = $110 Maximum Fee = $130 Minimum Fee = $80 Share Ratio = 75/25 If actual cost is $1300, what is final contract price (FCP)? (1) $1000 - $1300 = ($300) (2) ($300) x .25 = ($75) (3) $110 - $75 = $35 BUT $35 is < than Min Fee, so use Min Fee ($80) to determine FCP (4) FCP = $1300 + $80 = $1380 • If actual cost is $800, what is final contract price (FCP)? • (1) $1000 - $800 = $200 • (2) $200 x .25 = $50 • (3) $110 + $50 = $160 • BUT $160 is > Max Fee, so use Max Fee ($130) to determine FCP • Final Contact Price = • $800 + $130 = $930

10. Cost Plus Award Fee (CPAF) Government pays all allowable costs Established at contract award: Estimated Cost Base Fee (0 – 3%) Award Fee Pool Criteria Base Fee • End of each award fee period: • Contractor performance evaluated • against award fee pool criteria for • that period • Contractor paid for applicable portion • of base fee + amount of award fee • pool earned for period Award Fee Pool 2 3 4 5 1 6 Award Fee Periods Shall not be used in lieu of CPFF or CPIF when objective measurement is feasible

11. Cost Plus Award Fee (CPAF) (2) • Advantages to the Government: • Subjective/Discretionary decision making • Control and flexibility of criteria • Unilateral modification to add award fee for period • Disadvantages • Very people and time intensive • Contractor may dispute whether Government followed its award fee plan; not whether it earned “correct” fee

12. Firm Fixed Price (FFP) Profit Contractor must deliver quality product; paid negotiated price regardless of cost • C o s t • Price is negotiated and established at contract award

13. Award Fee Pool 1 2 3 4 6 5 Profit Fixed Price Award Fee (FPAF) • Negotiated and established • at contract award • Fixed Price Paid for satisfactory performance • Award Fee evaluation criteria • C o s t • Award Fee paid in addition to fixed price • Based on performance during award fee periods in accordance with Award Fee plan Award Fee Periods

14. Fixed Price Incentive (Firm Target) (FPI(F)) Profit Target Price (TPr) = TC + TP (TC,TP) Gov’t/Ktr Share Ratio(s) Point of Total Assumption (PTA) = cost at which the contractor assumes all cost risk (0/100 share ratio from PTA to CP and beyond) • Target Profit (0,TP) • (PTA, $Y) • C o s t Target Cost (TC,0) Ceiling Price (CP) (CP,0) Established at Contract Award • Profit Adjustment Formula: • TC- Actual Cost (AC) = over/underrun • Over/underrun x Ktr’s SR = Profit adjustment • TP +/- Profit adjustment = Adjusted Profit (AP) • AC + AP = Final Contract Price (if < CP) • If >= CP, then Final Contract Price = CP - Target Cost (TC) - Target Profit (TP) - Ceiling Price (CP) - Share Ratio (SR)

15. FPI(F) Final Contract Price: Two Examples (Along 60/40 Share Line) Established at Contract Award: Target Cost (TC) = $1000 Target Profit (TP) = $140 Ceiling Price (CP) = $1290 Share Ratio (SR) = 60/40 PTA (derived) = $1250 PTA = ((CP-TPr)/Gov’t Share) + TC = ((1290-1140)/.6)+1000 = $1250 • If actual cost is $1200, what is Final Contact Price (FCP)? • (1) 1000 - $1200 = (-$200) • (2) -$200 x. 4 = (-$80) Profit adjustment • (3) Adjusted profit = $140 -$80 = $60 • $1200 (actual cost) + $60 (adjusted profit) = $1260 • Since $1260 is below the Ceiling Price ($1290), FCP = $1260 • If Actual Cost is $800, what is Final Contract Price (FCP)? • $1000 - $800 = $200 (positive) • $200 x .4 = $80 • $140 + $80 = $220 • $800 (actual cost) + $220 (adjusted profit) = $1020 • Since $1020 is below the Ceiling Price • ($1290) , FCP = $1020

16. FPI(F) Final Contract Price: Additional Examples (From PTA to CP and beyond) Established at Contract Award: Target Cost (TC) = $1000 Target Profit (TP) = $140 Ceiling Price (CP) = $1290 Share Ratio (SR) = 60/40 PTA (derived) = $1250 • The Final Contract Price at every point on the line between PTA and CP and beyond will equal the CP!........ Why? • - Every additional dollar of cost reduces profit by a dollar (constant slope of -1) • The Final Contract Price at any point = Actual Cost + Profit (AC, Profit), thus, when • Actual Cost = 1250, then Profit = 40; FCP = 1290 • Actual Cost = 1260, then Profit = 30; FCP = 1290 • Actual Cost = 1270, then Profit = 20; FCP = 1290 • Actual Cost = 1280, then Profit = 10; FCP = 1290 • Actual Cost = 1290, then Profit = 0; FCP = 1290 • Actual Cost = 1400, then Profit = -110, FCP = 1290 • See display of results (“points”) on next chart If actual cost is $1250 (the PTA), what is the final contact price (FCP)? (1) $1000 - $1250 = ($250) (2) $250 x. 4 = ($100) (3) Adjusted profit = $140 -$100 = $40 (4) $1250 (actual cost) + $40 (adjusted profit) = $1290 Since $1290 is the Ceiling Price, FCP = $1290 = CP (not a coincidence!!).

17. FPI(F) Final Contract Price: Display of Examples As noted previously, in this case, 1250 is traditionally called the PTA even though the PTA is actually a “point” in the plane, that is (1250,40) Profit • • (0,220) FCP2 = 1020 (800,220) • TP = 140 (0,140) TPr = 1140 (1000,140) • FCP1 = 1260 (1200,60) (0,60) • • • • (0,40) FCP at PTA = 1290 (1250,40) • FCP = 1290 (1260,30) • FCP = 1290 (1270,20) • FCP = 1290 (1280,10) • • • • • Cost (0,0) TC = 1000 (1000,0) (1250,0) CP = 1290 (1290,0) (800,0) • (1200,0) FCP = 1290 (1400,-110) (loss)

18. Types of Contract Financing • Commercial • Advance payments • Interim payments • Non-commercial • Advance payments • Loan guarantees • Progress payments • Based on Costs • Performance based payments

19. Progress Payments (DFAR 232.102) • A form of Government financing in recognition of the need for working capital, for long lead items, and work in-process expenditures • Based on Costs or • a percentage or stage of completion (for construction or ship building/conversion/alteration/repair) • The customary progress payment rates for DoD contracts, • including contracts that contain foreign military sales • (FMS) requirements, are: • 80 % for large business concerns • 90 % for small business concerns, and • 95 % for small disadvantaged business concerns.

20. Performance Based Payments (PBPs) • The Government’s preferred method of contract financing for fixed price contracts. • Payment is based on the achievement of specific events that are defined and valued in advance by the parties to the contract. • PBPs focus on performance rather than on incurred costs.

21. PBP Elements • Three pieces to defining PBP terms. 1) The Payment Event or Criteria, 2) The Definition of Successful completion 3) The Value of the event. • All three pieces need to be considered together to ensure : • Adequate cash flow to the contractor, • Appropriate motivation for the contractor, and • that achieving the payment events will lead to the successful completion of the contract.

22. Establishing PBP Events • Each event or performance criterion that will trigger a financing payment must: • Be an integral and necessary part of contract performance and • Be identified in the contract, and • Include a description of what constitutes successful performance of the event or attainment of the performance criterion.  

23. Payment Events • The following are a sample of payment events: • Receipt of material • Receipt of major subcontracted items • Product leaving a machining / tooling phase • Completion of first article testing • Machining, forging, fabricating parts • The best method of selecting events…. • Diagram the process flow of the product and select the key events that lead to completing the product.

24. Minimizing Risk • Contract financing is a risky proposition for the Government since we are providing payments to a contractor prior to full delivery. • In both commercial and non-commercial financing we must actively mitigate the risk associated with contract financing. • When we finance commercial contracts we require that the contractor provide some form of security or collateral in the event they fail perform. • With non-commercial contracts the approach is a bit different, but the bottom line is the same: PROTECT the TAXPAYER'S INTEREST!

25. Cost Reimbursement Fixed Price 1975: DoDD 5000.1 Initial preference for CR Dev K’s noted 1989 - 2007: Title 10/FAR preference emphasized for almost 20 yrs ~1983 to 1989 2007 to ? (FY 2007 Authorization Act) Research & DevelopmentWhat Contract Type Now? • FY 07 Authorization Act & Interim 5000.02 (Enclosure 1. Tables 1 & 6) • MDA shall select contract type at M/S B for MDAP • May select fixed-price (including FPI) or cost type • Cost type requires written determination that: • Program risk due to complexity and technical challenges too great for fixed price type • Complexity and technical challenges not result of failure to meet certification requirements established in section 2366a of title 10, United States Code

26. Thoughts on Contracting Strategy • Selecting the appropriate contract type, incentive package, and financing plan are part of acquisition strategy planning • Contracting Officer must work with Program Manager to recommend appropriate contract type to MDA for MDAP • A fixed price development contract may be too risky, if so: • MDA documents basis for contract type • Explanation of the level of program risk • If level of risk is high, steps taken to reduce risk • Reasons for proceeding with M/S B approval despite high risk Remember A-12 fiasco

27. Additional Thoughts on Contracting Strategy • Selecting contract type, incentive package, and financing plan are part of risk mitigation planning • Contracting strategy for program asa whole must be thought through “up front and early” • Work hand-in-hand with your contracting officer throughout the entire process