Pricing Arrangements: Choose Your Contract Type Wisely & Reduce Your Risks!

2. Pricing Arrangements: Choose Your Contract Type Wisely & Reduce Your Risks! Breakout Session # 304 Jo Cunningham April 7, 2009 2:30 PM

3. Selecting the contract pricing arrangement is THE most important decision you will ever make! AVOID Cost Plus Percentage of Cost 2

4. What’s Really in it For Me? Describe how you saved us $10 MillionAND reduced our risks!

5. Contract Types • Two Basic Pricing Arrangements: • Fixed Price • FFP, FFP/EPA, FP+AF, FP+I, FF Rate, Cost-Share • Cost Reimbursement • CNF, CPFF, CPIF, CPAW, Cost-Share • T&M, LH 4

6. Failure is NOT an Option! • Firm Fixed Price: Failure is not an option • Time & Materials: We can’t fail as long as we show up for work. • Cost Reimbursable: We will give it our best try, but failure may be an option 5

7. Statement of Work Is Crucial • The SOW: • First and most important basis for pricing arrangement selection. • The pricing arrangement must be consistent with the SOW in its final form. 6

8. Cost Risk & Contract Type Cost Risk: High >>>>>>>>>>>>>>>>>>>>>>>> Low Requirement Definition Vague >>>>>>>>>>>>>>>>>>>>>>>>> Well Defined Production Concept Exploratory Test/ Full scale Full Stages Studies, & Development Demo Development Production Basic Research Contract Varied CPFF CPIF, CPIF, FPIF, FFP, FPIF, Type FPIF or FFP or FPEPA 7

9. Comparison of Major Contract Types • Fixed Price • Principle Risks: None, Contractor assumes all cost risk. • Use When: The requirement is well-defined. • Contractors are experienced in meeting the fixed price. • Market conditions are stable. • Financial risks are otherwise insignificant. • Elements: A firm fixed-price for each line item or one or more groupings of line items. • Contractor is required to: Provide acceptable deliverable at the time, place and price specified in the contract. 8

10. Comparison of Major Contract Types • Fixed Price • Contractor Incentive: Generally realizes an additional dollar of profit for every dollar that costs are reduced • Typical Application: Commercial supplies and services. • Primary Limitations: Generally NOT appropriate for R&D. • Variants: Firm Fixed-price Level of Effort. 9

11. Comparison of Major Contract Types • Fixed Price Economic Price Adjustment • - Principle Risks: Unstable market prices for labor or material over life of contract. • - Use When: Market prices at risk are severable and significant. Risks stem from industry-wide contingencies beyond contractor's control. Dollars at risk outweigh administrative burdens of an FPEPA. • - Elements: Fixed-price, ceiling on upward adjustment, & a formula for adjusting prices up or down based on established prices, actual labor or material costs, labor or material indices. • - Contractor is required to: Provide acceptable deliverable at the time and place specified in the contract at the adjusted price. 10

12. Comparison of Major Contract Types • Fixed Price Economic Price Adjustment • Contractor Incentive: Generally realizes an additional dollar of profit for every dollar that costs are reduced. • Typical Application: Long-term contracts for commercial supplies during a period of high inflation. • Primary Limitations: Must be justified. • Variants: None. 11

13. Comparison of Major Contract Types • Fixed Price Incentive Fee • Principle Risks: Moderately uncertain contract labor or material requirements. • Use When: Ceiling price can be established that covers most probable risks inherent in nature of work. Proposed profit sharing formula would motivate contractor to control costs to & meet other objectives. • Elements: Ceiling price; Target cost; Target profit; Delivery, quality, other performance targets; Profit sharing formula. • Contractor is required to: Provide acceptable deliverable at time & place specified in contract, at or below ceiling price. 12

14. Comparison of Major Contract Types • Fixed Price Incentive Fee • Contractor Incentive: Realizes a higher profit by completing work below ceiling price and/or by meeting objective performance targets. • Typical Application: Production of a major system based on a prototype. • Primary Limitations: Must be justified. Must be negotiated. Contractor must have an adequate accounting system. Cost data must support targets. • Variants: Successive Targets. 13

15. Comparison of Major Contract Types • Fixed Price Award Fee • Principle Risks: Risk that the user will not be fully satisfied because of judgmental acceptance criteria. • Use When: Judgmental standards can be fairly applied by Award-fee panel. The potential fee is large enough to both: (1) Provide meaningful incentive; (2) Justify related administrative burdens. • Elements: Firm fixed-price; Standards for evaluating performance; Procedures for calculating fee based on performance against standards. • Contractor is required to: Perform at time, place, and price fixed in contract. 14

16. Comparison of Major Contract Types • Fixed Price Award Fee • Contractor Incentive: Generally realizes an additional dollar of profit for every dollar that costs are reduced; earns an additional fee for satisfying performance standards. • Typical Application: Performance-based service contracts. • Primary Limitations: Must be negotiated. • Variants: None. 15

17. Comparison of Major Contract Types • Fixed Price Prospective Redetermination • Principle Risks: Costs of performance after the first year because they cannot be estimated with confidence. • Use When: Buyer needs a firm commitment from contractor to deliver supplies /services during subsequent years. Dollars at risk outweigh administrative burdens of FPRP. • Elements: Fixed price for first period; Proposed subsequent periods (12 months apart); Timetable for pricing next period(s). • Contractor is required to: Provide acceptable deliverables at time & place specified in contract at price established for each period. 16

18. Comparison of Major Contract Types • Fixed Price Prospective Redetermination • Contractor Incentive: For the period of performance, realizes an additional dollar of profit for every dollar that costs are reduced. • Typical Application: Long-term production of spare parts for a major system. • Primary Limitations: MUST be negotiated. Contractor must have an adequate accounting system that supports the pricing periods. Prompt redeterminations. • Variants: Retroactive Redetermination 17

19. Comparison of Major Contract Types • Cost Plus Incentive Fee • Principle Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks; benefiting if actual cost is lower than expected cost; losing if work can’t be completed within expected cost of performance. • Use When:Objective relationship can be established between fee & such measures of performance as actual costs, delivery dates, performance benchmarks, etc. • Elements:Target cost; Performance targets; Minimum, maximum & target fee; Formula for adjusting fee based on actual costs and/or performance. • Contractor is required to:Make good faith effort to meet Buyer's needs within estimated cost in the Schedule. 18

20. Comparison of Major Contract Types • Cost Plus Incentive Fee • Contractor Incentive: Realizes a higher fee by completing work at lower cost and/or by meeting other objective performance targets. • Typical Application: Research and development of prototype for major system. • Primary Limitations: Contractor must have adequate accounting system. Buyer must exercise surveillance during performance to ensure use of efficient methods & cost controls. Must be negotiated. Must be justified. Statutory & regulatory limits on fees that may be negotiated. Must include applicable Limitation of Cost clause at FAR 52.232-20 through 23. • Variants: None. 19

21. Comparison of Major Contract Types • Cost Plus Award Fee • Principle Risks:Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance. • Use When:Objective incentive targets are not feasible for critical aspects of performance. Judgmental standards can be fairly applied. Potential fee would provide a meaningful incentive. • Elements:Target cost; Standards for evaluating performance; Base & maximum fee; Procedures for adjusting fee, based on performance against standards. • Contractor is required to:Make good faith effort to meet Buyer's needs within estimated cost in the Schedule. 20

22. Comparison of Major Contract Types • Cost Plus Award Fee • Contractor Incentive: Realizes a higher fee by meeting judgmental performance standards. • Typical Application: Large scale research study. • Primary Limitations: Contractor must have adequate accounting system. Buyer must exercise surveillance during performance to ensure use of efficient methods & cost controls. Must be negotiated. Must be justified. Statutory & regulatory limits on fees that may be negotiated. Must include applicable Limitation of Cost clause at FAR 52.232-20 through 23. • Variants: None. 21

23. Comparison of Major Contract Types • Cost Plus Fixed Fee • Principle Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance. • Use When: Relating fee to performance (e.g., to actual costs) would be unworkable or of marginal utility. • Elements: Target cost; Fixed fee. • Contractor is required to: Make good faith effort to meet Buyer's needs within estimated cost in the Schedule. 22

24. Comparison of Major Contract Types • Cost Plus Fixed Fee • Contractor Incentive: Realizes a higher rate of return (i.e., fee divided by total cost) as total cost decreases. • Typical Application: Research study. • Primary Limitations: Contractor must have adequate accounting system. Buyer must exercise surveillance during performance to ensure use of efficient methods & cost controls. Must be negotiated. Must be justified. Statutory & regulatory limits on fees that may be negotiated. Must include applicable Limitation of Cost clause at FAR 52.232-20 through 23. • Variants: Completion or term contract. 23

25. Comparison of Major Contract Types • Cost-Sharing • Principle Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance. • Use When: The contractor expects substantial compensating benefits for absorbing part of the costs and/or foregoing fee. • Elements: Target cost; Agreement on Buyer’s share of cost. • Contractor is required to: Make good faith effort to meet Buyer's needs within estimated cost in the Schedule. 24

26. Comparison of Major Contract Types • Cost-Sharing • Contractor Incentive: Shares in the cost of providing a deliverable of mutual benefit. • Typical Application: Joint research where Contractor expects to derive long term benefits to his company. • Primary Limitations: Contractor must have adequate accounting system. Buyer must exercise surveillance during performance to ensure use of efficient methods & cost controls. Must be negotiated. Must be justified. Must include applicable Limitation of Cost clause at FAR 52.232-20 through 23. • Variants: Firm fixed price, where Contractor pays all costs over contract price. 25

27. Comparison of Major Contract Types • Cost No Fee • Principle Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance. • Use When: The supplier is a not-for-profit entity. • Elements: Target cost; No fee. • Contractor is required to: Make good faith effort to meet Buyer's needs within estimated cost in the Schedule. 26

28. Comparison of Major Contract Types • Cost-No-Fee • Contractor Incentive: Providing a deliverable with benefits to both parties; Contractor expects to derive long term benefits to his firm; Enhanced reputation. • Typical Application: Joint research with an educational institutions or other not-for-profit entities. • Primary Limitations: Contractor must have adequate accounting system. Buyer must exercise surveillance during performance to ensure use of efficient methods & cost controls. Must be negotiated. Must be justified. Statutory & regulatory limits on fees that may be negotiated. Must include applicable Limitation of Cost clause at FAR 52.232-20 through 23. • Variants: None. 27

29. Comparison of Major Contract Types • Time and Materials • Principle Risks: Highly uncertain & speculative labor hours, labor mix, material requirements (and other things) necessary to perform contract. Buyer assumes risks inherent in contract; benefiting if actual cost is lower than expected cost; losing if work cannot be completed within expected cost of performance. • Use When: No other type of contract is suitable (e.g., because costs are too low to justify an audit of the contractor's indirect expenses). • Elements: Ceiling price; Per-hour labor rate includes overhead & profit; Provisions for reimbursing direct material costs. • Contractor is required to: Make good faith effort to meet Buyer's needs within ceiling price. 28

30. Comparison of Major Contract Types • Time and Materials • Contractor Incentive: None. • Typical Application: Emergency repairs to heating plants and aircraft engines; Contractor support for field exercises. • Primary Limitations: Labor rates must be negotiated. MUST be justified. The Buyer MUST exercise appropriate surveillance to ensure efficient performance. • Variants: Labor Hour (LH) 29

31. Steps to Selecting Contract Type • Customers Requirements – Talk with them! • Need What? By When??!!?? • Project Management Requirements? • Funding Availability? Limitations of Obligation? Phases? • Complexities and Possible Complications? • Risks? Who should carry the burden of risks? 30

32. Steps to Selecting Contract Type • 2. Contractor Selection Influences Choices • Not for Profit? • Educational Institution? • Small Businesses? Unsophisticated accounting system? • Does the contractor have a job-cost accounting system? 31

33. Steps to Selecting Contract Type • Consider revising the SOW to reduce risks • Request your Audit Department to perform and accounting survey if you are considering a Cost-type or T&M contract, where the contractor has no history of performing such contracts for you. • Select the most appropriate pricing arrangement for your contract. 32

34. The Logic Tree! 33

35. Three Statements of Work – What Pricing Type Shall We Choose? • Fish & Bad-Boy Finders LLC • Desert Rat Communications, Inc. • Z-Pinchie Consolidated 34

36. Summary • Initial steps to remember: • Discuss requirements with the customer & compare to the SOW, revising as necessary • Review the pricing types, and consider the pros & cons of each. • Pitfalls: • Avoid cost-type and T&M/LH if contractor has unsophisticated accounting system. • Avoid setting up Contractor for failure. • (using FFP when not appropriate) • Award / Incentive Fees = High Admin costs • Remember: Choosing Wisely Reduces Risks • and may save you potentially significant costs! 35

37. Summary • Practical approaches are in the briefing on the website, including the Logic Tree, and the Comparison of Major Contract Types (a.k.a. Eye Chart), courtesy of Defense Procurement & Acquisition Policy-Contract Pricing Reference Guide. • Questions? 36