Understanding Federal Contract Vehicles: Fixed Price vs. Cost Reimbursable

1. Types of Contracts andContractual Vehicles inFederal (DOD) Procurements NCMA Boston Chapter March WorkshopBentley College16 March 2011 Jerome C. Burke (Jerry) BAE Systems Group Vice President, Contracts Electronics, Intelligence & Support 1

2. Course Objective • An overview of the various types of contract vehicles used in Federal (DoD) Procurement. • A basic Understanding of the differences in Fixed Price and Cost Reimbursable Contract arrangements. • An appreciation for the “Allocation of Risk” in the selection and application of contract type. • An understanding of the true nature of the concepts of “Fee” and “Profit” and how they differ. • An appreciation of the different “Behaviors” of Buyer and Seller in different contract types.

3. Flow-Charting the Contracting Process Buyer Fixed Price Environment PRODUCT Determination of Contracting Environment Motivation & Behaviors Allocation of Risk OUTCOME Cost Type Environment SALES & PROFIT Seller

4. Primary Contract Types The Procurement World Can be Divided Between Two Primary Contract Types • Fixed Price Arrangements • Cost Reimbursement Arrangements … And there are numerous variations of the themes. The “Variations” create what some texts Identify As a Third Primary Contract Type • The Incentive Arrangement

5. Contract Type and the Profit Factor... • Fixed Price Arrangements • Generally Involve Profit Discussions • Cost Reimbursable Arrangements • Generally Involve Fee Discussions

6. Definitions to Remember Profit: The difference between the cost of a product or service and the price charged for that product or service. The Seller of the product or service can impact his profit through positive or negative performance. Fee: A set sum certain to be paid by the Buyer to the Seller for providing a product or rendering a service. The fee as a real dollar amount is not impacted by fluctuations in performance.

7. Striking The Critical Balance Rewards Risk

8. Primary Contract Types Cost Reimbursable • Cost Sharing • Cost Plus Fixed Fee (CPFF) • Cost Plus Incentive Fee (CPIF) • Cost Plus Award Fee (CPAF) Fixed Price • Firm Fixed Price (FFP) • Fixed Price Incentive (FPI) • Firm Target (FPIF) • Successive Targets (FPIS) • Fixed Price Level of Effort (FP LOE) • Fixed Price Award Fee • Fixed Price w/ Redetermination • Economic Price Adjustment • Prospective Price Redetermination • Retroactive Price Redetermination

9. Primary Contract Types • Time & Material • Elements of both Fixed Price (Established Firm Labor Rate) & CR (only what is used) • Indefinite Delivery/Indefinite Quantity (ID/IQ) • Basic Ordering Agreements • Level of Effort and/or Term • Any Combination of the above, including the prior page… And worthy of mention, although not technically a “contract” … • Other Transactions Agreements (U.S.C. 2371, Section 845’s)

10. Federal Procurement Basis For Contract Types • 48 CFR Part 16 (CFR = Code of Federal Regulations) • FAR Part 16 (FAR = Federal Acquisition Regulations) Other Good Resources For Information on Contract Types • Formation of Government Contracts, John Cibinic & Ralph Nash, Government Contracts Program, George Washington University. • NASA Guide on Incentive Contracting • A Bunch of Websites • Your Favorite Local Contracts Professional!

11. Fundamental Principle • The selection of Contract Type is the Primary Factor in the Allocation of Risk and the Nature of the Profit Determination - or - conversely • The allocation of risk and the nature of profit determination are the primary factors in the selection of a contract type.

12. Selection of Contract Type….Straight From the Regs • Contract types vary according to: • The degree and timing of the responsibility assumed by the contractor for the costs of performance; and • The amount and nature of the profit incentive offered to the contractor for achieving or exceeding specified standards or goals.

13. Of Risk and Profit … Allocation of Risk: Who bears the financial risk of performance of the effort under contract between Buyer and Seller? Profit Determination: How variable is the margin potential to the seller of the effort under contract? • “Variable” is the Key Word.

14. Allocation of Risk Who bears the Financial Risk of performance of the effort under contract between buyer and seller • Fixed Price Arrangement - allocation of financial risk is solely on the Seller. • Addresses Financial Risk - There are other tangible risks but not discussed here. • Effort is performed for a pre-established, agreed, negotiated price. Seller will Provide “X” for set price “Y”

15. Allocation of Risk Who bears the Financial Risk of performance of the effort under contract between buyer and seller • Cost Reimbursable Arrangement - allocation of financial risk is primarily on the Buyer. • Cost of performance negotiated as an ESTIMATE (not a set price) • Buyer benefits or is injured by fluctuations from estimate versus actual costs • Profit dollars to seller is established as a “Fixed Fee” - does not change with fluctuations in estimated cost

16. Factors To Be Considered When Selecting A Contract Type • Price Competition - market pressures • Price Analysis - Comparison of products and price • Cost Analysis - when price comparison insufficient, a detailed analysis of cost elements • Type and complexity of the requirement • Urgency of the requirement • Period of Performance or Length of Production Run • Contractor’s Technical Capability and Financial Responsibility • Adequacy of the Contractor’s accounting system - important for CR Contracts • Concurrent Contracts • Extent and Nature of Proposed Subcontracting • Acquisition History - Risk decreases as item is repetitively ordered

17. The Important Difference Between Cost and Price • “Cost” and “Price” are not the same. • The consumer never (rarely?) pays the “Cost” of an item - they pay the price • “Profit” is the difference between a product’s “Cost” and it’s “Price”

18. The Important Difference Between Cost and Price • Cost: The actual costs incurred or realized in the manufacture of a product of the providing of a service. “Cost” is the actual amounts paid for the necessary elements of providing a good or service, such as labor, factory overheads, cost of materials, and other relevant support costs. • Price: Whatever a consumer of a Good or Service is willing to pay for that Good or Service - or…….conversely - whatever a provider of a Good or Service is able to charge a consumer for that Good or Service • Market conditions dictate

19. A Quick Comparative Illustration The U.S. Army wishes to procure a WIDGET from ECDC, Inc.. Firm Fixed Price Basis • ECDC charges $103,500 (Price) and the Army agrees to pay $103,500 Actual Performance Scenario 2 ECDC Estimate @ Proposal Scenario 3 Scenario 1 Total Cost Profit Price Profit as % of Cost = Profit as % of Price = Army Pays ECDC Makes (Looses) $ 90,000 13,500 $ 103,500 15% 13.1% $ 103,500 $ 13,500 85,000 18,500 $ 103,500 21.7% 17.87% $ 103,500 $ 18,500 $ 98,000 5,500 $ 103,500 5.6% 5.3% $ 103,500 $ 5,500 $ 118,000 (14,500) $ 103,500 (-12.2%) (-14.0%) $ 103,500 ($14,500)

20. The Contracting Environment and It’s Impact on Contract Type • Allocation of risk is all about when to use a specific contract type • What is the contracting environment? • Known, certain or almost certain, environment => Fixed Price • Uncertainties, unquantifiable elements of performance => CR

21. Now….Let’s Examine the Particulars of the Specific Contract Types

22. Firm Fixed Price (FFP)

23. Firm Fixed Price (FFP) Defined: • Provides for a price that is not subject to any adjustment on the basis of the contractor’s cost experience in performing the contract. • Places on Contractor maximum risk and full responsibility for all costs and resulting profit or loss. • Maximum incentive on Contractor to control costs and perform effectively • Minimum administrative burden on parties • No detailed cost reports to customer

24. A Quick Comparative Illustration Same Widget, Cost Reimbursable Basis • ECDC has an Estimated Cost Plus Fixed Fee of $100,000 Actual Performance Scenario 2 ECDC Estimate @ Proposal Scenario 3 Scenario 1 Estimated Cost FCCM Fixed Fee Total CPFF (Price) Profit as % of Cost = Profit as % of Price = Army Pays ECDC Makes (Looses) $ 90,000 1,000 9,000 $ 100,000 10% 9% $ 100,000 $ 9,000 85,000 900 9,000 $ 94,900 10.59% 9.53% $ 94,900 $ 9,000 $ 98,000 1,100 9,000 $ 108,100 9.1% 8.32% $ 108,100 $ 9,000 $ 118,000 1,300 9,000 $ 128,300 7.6% 7.0% $ 128,300 $9,000 Although the Cost of Performance (Price) Increases, Fee Remains the same (Fixed), as Cost of Performance Increases, Fee as Margin Decreases

25. Firm Fixed Price (FFP) Application: • Used to procure standard and commercial items • When reasonably definite functional or detailed specification exists • When adequate price competition exists • When reasonable price comparisons with prior or similar purchases can be made

26. Elements of a Firm Fixed Price (FFP)Contract Price

27. Elements of a Firm Fixed Price (FFP)Contract (Continued) • In DoD Procurements, regulations require insight into the separate elements • FFP has the most basic elements: • Cost • Profit • Total FFP • Sometimes the separate elements are separately negotiated, sometimes negotiations are at the “bottom line” • FFP is the simplest contract type from the stand point of both Buyer and Seller.

28. Firm Fixed Price (FFP) • Over-riding element: Is Price • Bind the contractor to complete the work at a fixed amount (price) of compensation regardless of the costs of performance. • Best Utilizes the basic profit motive of business • “If I perform efficiently (or increase my efficiency), I make more money” • “If I perform inefficiently, I make less or even lose money” • Used when risk involved is minimal or can be predicted with an acceptable degree of certainty. • Requires reasonable basis for Firm Prices.

29. FFP and The Allocation of Risk ... • Allocation of financial risk is on the Contractor • Because of the allocation of risk, must have a clear, thorough definition of the work scope • Clear, precise, unambiguous specifications • Clear, precise, unambiguous Statement of Work • Need firm delivery and end date • Need clear, unambiguous sell-off criteria (“Definition of ‘Done’”) • FFP contract type assumes minimal Government intervention during performance. Leave as little to interpretation as possible

30. FFP and Contracting Party Behaviors • Contractor is reluctant to accept even minor changes or interference. • This is why “contract scope” needs to be precisely defined • All “uncompensated” changes impact bottom line • All changes subject to Equitable Adjustment (“Send Money”) • Buyer often tries to get more than he bargained for • Stretches scope of work interpretations • “Just Do It” • Threats to follow-on work

31. Fixed Price Incentive (FPI)

32. Fixed Price Incentive Defined: • Provides for adjusting profit and establishing the final contract price by a formula based on the relationship of final negotiated total cost to the target cost • Final Price is subject to a price ceiling (negotiated up front) • Two (2) Types • Fixed Price Incentive, Firm • Fixed Price Incentive, Successive Target When Applied: • When a straight FFP contract is not suitable • Contractors assumption of a degree of cost responsibility will provide a positive profit incentive for cost control and performance • When other incentives (technical performance or delivery) are being used.

33. Elements of a FPI Contract • Involves a pre-negotiated formula for sharing cost over-runs and under-runs • Target Cost • Target Profit • Ceiling Price • Share Ratio

34. Elements of a FPI Contract Defined Target Cost • Represents a reasonable estimate that both parties are willing to accept of the anticipated total cost of performance • “Represents the most likely outcome to be attained through efficient performance of the work” • Establish prior to performance Target Profit • A reasonable return on the anticipated cost of performance as agreed by the parties prior to performance • Is not (necessarily) the final profit

35. Elements of a FPI Contract Defined (Cont’d) Ceiling Price • The maximum dollar value the buyer is willing and obligated to pay for the goods or services • Unique to fixed price incentive contracts • Most critical element of an FPI contract • Represents the point at which financial responsibility is 100% on the contractor (Well, not really ... But bare with me ... It’s the PTA) • Final price never exceeds ceiling (what the Buyer will pay)

36. Elements of a FPI Contract Defined (Cont’d) • Share Ratio (Sometimes expressed simply as “Contractor’s Share”) - • Represents the percentage of sharing above and below the target cost to determine the profit and price. • When two percentages expressed, first percentage always refers to the Government (Buyer) and the second percentage to Contractor (Seller) 75% / 25% Share Ratio Government (75%)/Contractor (25%) Example:

37. ... And Unique to FPI Contracts is.... The Point of Total Cost Assumption • Defined • Identifies the mathematical point at which the contractor’s risk changes from the negotiated incentive sharing to a fixed price risk - 100% responsibility for cost incurred. • PTA = The point at which for every dollar you spend, you lose a dollar of profit. • PTA is the mathematical point at which Government sharing has maximized, and Government sharing ends.

38. The Point of Total Cost Assumption • Expressed as a formula Ceiling Price - Target Price Government Share + Target Cost PTA =

39. FPI Example - Actual Performance (Under-run) NegotiatedScenario 1Comment (Target) Cost $ 10,000,000 $ 9,000,000 $1M Under-run (Target) Profit 1,500,0001,500,000 Original Profit Target (Target) Price $ 11,500,000 $10,500,000 Unadjusted Price Ceiling Price $12,500,000 $12,500,000 Absolute $$ value not to be exceeded Share Ratio 75/25 $250,000 25% share of $1M under-run Actual Profit TBD $1,750,000 Actual profit increases by share of under-run Final Price TBD $10,750,000 Final price is $750K less than target 75% is Government share of $1M under-run

40. FPI Example - Actual Performance (Over-run) NegotiatedScenario 2Comment (Target) Cost $ 10,000,000 $ 11,000,000 $1M cost overrun (Target) Profit 1,500,0001,500,000 Original Profit - to be decremented (Target) Price $ 11,500,000 $12,500,000 Unadjusted Price Ceiling Price $12,500,000 $12,500,000 Absolute $ value not to be exceeded Share Ratio 75/25 ($250,000) 25% share of $1M over-run - Reduces fee to $1.25M Actual Profit TBD $1,250,000 Reduced Target Profit by Share Final Price TBD $12,250,000 Actual cost plus final profit

41. FPI Example - Actual Performance (Over-run) NegotiatedScenario 2Comment (Target) Cost $ 10,000,000 $ 11,000,000 $1M cost overrun (Target) Profit 1,500,0001,500,000 Original Profit - to be decremented (Target) Price $ 11,500,000 $12,500,000 Unadjusted Price Ceiling Price $12,500,000 $12,500,000 Absolute $ value not to be exceeded Share Ratio 75/25 ($250,000) 25% share of $1M over-run - Reduces fee to $1.25M Actual Profit TBD $1,250,000 Reduced Target Profit by Share Final Price TBD $12,250,000 Actual cost plus final profit

42. FPI Example - Actual Performance (Over-run) NegotiatedScenario 2Comment (Target) Cost $ 10,000,000 $ 12,250,000 $2.25M cost overrun (Target) Profit 1,500,0001,500,000 Original Profit - to be decremented (Target) Price $ 11,500,000 $13,750,000 Unadjusted Price Ceiling Price $12,500,000 $12,500,000 Absolute $ value not to be exceeded Share Ratio 75/25 ($562,500) 25% share of $2.25M over-run - reduces fee to $937.5K Actual Profit TBD $250,000* Additional fee decrement of $687.5K necessary to stay within ceiling Final Price TBD $12,500,000

43. 2 Variations of Fixed Price Incentive • Fixed Price Incentive, Firm (FPIF) • Don’t say “Fixed Price Incentive Fee” - WRONG!!!!! • Simply means a firm incentive target has been established at the outset • Fixed Price Incentive, Successive Targets (FPIS) • Same “initial” elements as a FPIF - cost elements termed as “initial” targets • Identifies a point in contract performance where “initial targets” are converted to “firm” targets • Often a production point where some performance experience has been collected • Can have multiple future points (successive targets)

44. FPI and The Impact on Behavior • Same basic motivations and behaviors exist as in FFP • Buyer may be slightly more flexible to changes given sharing and ceiling .... Nonetheless.... • Must protect profit position through cost control

45. Fixed Price Contracts w/Economic Price Adjustment (EPA) • A type of Fixed Price contract that allows a price redetermination based on circumstances largely outside of the control of either contracting party • Adjustment can be either upward or downward • Three (3) General Types of EPA • Adjustments based on established prices • Market conditions • Ex: Cost of Silicon rises, driving the chip market up - impacts many products • Adjustments based on actual costs of labor and material • Market conditions - public indexes • Adjustments based on cost indexes of labor or material • Ex: Producer Price Index for a commodity • Application: When there is serious doubt concerning the stability of market or labor conditions that will exist during the extended period of contract performance. • Limitations: Only used when necessary to protect Contractor, Government, or both, from significant cost fluctuations.

46. Fixed Price Award FeeFAR 16.404 • A Fixed Price Arrangement that provides for an element of Profit (Fee) to be earned through an Award Fee Process • Provides additional incentive to encourage optimum performance • Buyer and Seller may be slightly more flexible to changes given Award Fee potential • Award Fee Element is SUBJECTIVE • (vs. Incentive Fee Objective)

47. Cost Reimbursable Types

48. Cost Plus Fixed Fee (CPFF)

49. Cost Plus Fixed Fee (CPFF) • A cost reimbursement contract that provides for payment to the contractor of all allocable and allowable costs incurred PLUS a negotiated fee that is fixed at definitization • Fixed Fee does not vary with the actual costs of performance • Assuming no changes to initial baseline • Fee may be increased as a result of changes to the workscope that are outside of the original contract requirements • Considered a “fee bearing” equitable adjustment • Fee may be decreased as a result of changes to the workscope that remove effort that was part of the contract

50. Cost Plus Fixed Fee (CPFF) • Common vehicle for R&D efforts, prototypes, preliminary exploration, and concept formation phases of programs • Sometimes used for Proof of Concept and LRIP phases • Used when level of effort required cannot be easily (and fairly) determined • Used when Spec’s and SOWs are “Open” - Requirements not able to be defined with certainty • Contractor must have an acceptable accounting systems to collect and report costs • Used when a CPIF contract is not practical