CHAPTER 2
Types of Government Contracts

A flexible selection of contract types is available to the government for acquiring the variety and volume of goods and services it requires. 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.

Two factors are significant in the government’s selection of contract type: (1) the government’s ability to state precisely a quantity of goods or services; and (2) the government’s ability to define precisely the work to be performed. When uncertainties are limited, the contracting arrangement will be precise with respect to price and performance. When uncertainties are great, the contractual arrangement will have much more flexibility.

The government uses two major categories of contract type: fixed-price and cost-reimbursement. Numerous variations exist within each of these two categories. Specific contract types range from firm-fixed-price, in which the contractor has full responsibility for the performance costs and the resulting profit or loss, to cost-plus-fixed-fee, in which the contractor has minimal responsibility for the performance costs, and the negotiated fee or profit is fixed. For a fixed-price contract, the contractor is obligated to provide an end product or service at an established price. Thus, the profit or loss on the contract will be directly affected by any difference between the estimated cost and the actual cost of performance.

By comparison, in a cost-reimbursement contract, the contractor is responsible only for whatever product or service evolves as a result of the effort, up to the estimated costs established in the contract. The contractor’s fee or profit is fixed by the contract and, thus, the contractor’s interest in cost performance factors is not as significant as in a fixed-price contract. In between the firm-fixed-price contract and the cost-plus-fixed-fee contract are various incentive contracts, in which the contractor’s responsibility for the performance costs and the profit or fee incentives offered are tailored to the uncertainties involved in contract performance.

The government’s concern in monitoring contractor costs is greatest under cost-reimbursement contracts. The government imposes strict regulations on contractors regarding the accumulation, allowability, and allocation of costs. In addition, the government takes steps to ensure that the accounting systems of contractors with cost-reimbursement contracts are adequate to establish actual costs. The same regulations apply to the negotiation of fixed-price contracts; however, the emphasis on cost monitoring is not as rigid.

Negotiated contracts may be of any contract type that promotes the government’s interest. Contract types not described in the FAR are not to be used without a formal deviation. The cost-plus-a-percentage-of-cost system of contracting is prohibited by legislation. Prime contracts other than firm-fixed-price contracts must prohibit cost-plus-a-percentage-of-cost subcontracts.

During the federal government’s early years, the use of firm-fixed-price contracts was essentially exclusive. Purchased goods and services were rather simple—horses, guns, cannons, etc. World War I temporarily popularized the cost-reimbursement contract type. Because of the contractor risks involved in designing, developing, and producing new items, this contract type was necessary for equitable contracting arrangements. World War II expanded the use of cost-reimbursement contracts, which became institutionalized in regulations shortly thereafter.

The development of cost allowability rules parallels the expanded usage of cost-reimbursement contracts. From World War II through about the 1960s, contracts were either firm-fixed-price or a variation of cost-reimbursement. The next additions to contract types were the variations on the fixed-price contract. These variations permitted more risk to be shifted to a contractor than under a cost-reimbursement contract. However, both fixed-price incentive and cost-reimbursement contracts depended on the determination of actual costs in establishing a final contract price.

In the mid-1990s, a new trend developed to minimize administrative requirements by using other than cost-based pricing of contracts. The definition of commercial items was expanded to allow more purchases under fixed-price contracts without prices being cost-based. The government began to use “other transaction” authority instead of traditional contracting to obtain goods and services. This approach greatly limited the amount of audited cost-based pricing. Initiatives were directed at eliminating or reducing the extent of cost-based pricing throughout the government procurement process.

GOVERNMENT SELECTION OF CONTRACT TYPES

The government generally determines the contract type to be used. However, contract type is theoretically a matter for negotiation. The contract type and the contract price are closely related and are usually considered together. The government’s overall objective is to establish a contract type and price that will result in reasonable contractor risk and provide a contractor with the greatest incentive for efficient and economical performance. Generally, a firm-fixed-price contract, which makes best use of the inherent profit motive, is used when the contractor risk involved is minimal or can be predicted with an acceptable degree of certainty. When a reasonable basis for firm pricing does not exist, other contract types are used.

For major acquisition programs, a series of contracts may result in a different contract type in later periods than that used at the start of the program. Contracting officers are discouraged from protracted use of a cost-reimbursement or time-and-materials contract if experience provides a basis for firmer pricing. Fixed-price contracts have been found unacceptable for research and development work. Under these contracts, a contractor may be required to research and/or develop an item at a fixed price, which may be impractical. The use of fixed-price contracts for research and development has proven to be disastrous. Contractors cannot afford the risks under these conditions, and when failure occurs the outcome is not good—default, lawsuits, etc. A contractor invariably loses money and the government may not get the work expected.

The government considers many factors in selecting the contract type. Effective price competition results in realistic pricing and thus a fixed-price contract is usually appropriate. Price analysis with or without actual price competition may also provide a basis for selecting the contract type. The government also considers the degree to which price analysis can provide a realistic pricing standard.

In the absence of effective price competition and if price analysis is not sufficient, the cost estimates of the offeror and the government may provide the basis for negotiating contract pricing arrangements. The uncertainties involved in performance and the possible impact on costs are evaluated, so that a contract type that places a reasonable degree of cost responsibility on the contractor can be negotiated.

A firm-fixed-price contract is suitable for acquiring commercial items or for acquiring other supplies or services on the basis of reasonably definite functional or detailed specifications when the contracting officer can establish fair and reasonable prices at the outset. This occurs when: (1) price competition is adequate; (2) price comparisons with prior purchases of the same or similar supplies or services made on a competitive basis or supported by valid cost or pricing data are reasonable; (3) available cost or pricing information permits realistic estimates of the probable costs of performance; or (4) performance uncertainties can be identified and reasonable estimates of their cost impact can be made.

If urgency is a primary factor, the government may choose to assume a greater proportion of risk or it may offer incentives to ensure timely contract performance. In times of economic uncertainty, contracts extending over a relatively long period may require economic price adjustment terms. Before a contract type other than firm-fixed-price is used, a contractor’s accounting system must permit development of all necessary cost data required by the proposed contract type. This factor may be critical when a contractor is being considered for a cost-reimbursement contract. If performance under a proposed contract involves concurrent operations under existing contracts, the impact of those contracts should be considered in selecting a contract type.

FIXED-PRICE CONTRACTS

Fixed-price contracts specify a firm price for work to be performed. These contracts may provide for adjustable prices under certain circumstances and/or provide ceiling prices. Fixed-price contracts providing for an adjustable price may include a ceiling price, a target price (including target cost), or both. Normally, the ceiling price or target price is subject to adjustment in the event of an equitable price adjustment. Firm-fixed-price or fixed-price with economic price adjustment contracts are used for acquiring commercial items. The fixed-price contract provides maximum incentive for a contractor to control costs and perform effectively because the contractor bears full responsibility for the resulting profit or loss.

The most frequently used fixed-price contract types are firm-fixed-price and fixed-price-incentive. Several other variations of the fixed-price contract are also available.

Firm-Fixed-Price Contract

Of all the various types of contracts, the firm-fixed-price (FFP) contract has the greatest potential for contractor financial reward and risk. Because the contract price is fixed at the date of award and the contractor is obligated to provide the product or service under contract, a highly efficient and cost-effective operation will generally result in greater contractor profits.

Obviously, the opposite is also true. A firm-fixed-price contract provides for a price that is not subject to any adjustment on the basis of the contractor’s cost experience in performing the contract. This contract type provides maximum incentive for the contractor to control costs and perform effectively, and imposes a minimum administrative burden on the contracting parties.

Fixed-Price-Incentive Contract

A fixed-price-incentive (FPI) contract provides for adjusting profit and establishing the final contract price by applying a formula based on the relationship of total allowable cost to target cost. The final price is subject to a price ceiling established upon award of the contract. An FPI contract is most appropriate when: (1) a firm-fixed-price contract is not suitable (i.e., the nature of the product is such that the costs to be incurred in producing the product cannot be accurately estimated); (2) the nature of the goods or services being acquired and the circumstances of the acquisition are such that the contractor’s assumption of a degree of cost responsibility will provide a positive profit incentive for effective cost control and performance; or (3) the contract also includes incentives on technical performance and/or delivery.

When predetermined formula-type incentives on technical performance or delivery are included, increases in profit or fee are provided only for achievement that surpasses the targets, and decreases are provided to the extent that such targets are not met. The incentive increases or decreases are applied to performance targets rather than minimum performance requirements. With an FPI contractual arrangement, a contractor has a high incentive to be cost-efficient and performance-effective. If successful in lowering contract costs below the target costs, a contractor can realize a higher profit through application of the incentive formula. Essentially, the contractor and the government become partners when the costs incurred are less than the costs estimated.

The five elements commonly negotiated into the terms of an FPI contract are: (1) target cost; (2) target profit; (3) target price (the sum of (1) plus (2)); (4) a fee adjustment formula target cost; and (5) a price ceiling (an amount in excess of the target price). The sharing ratio is a formula specifying how the government and the contractor will share any cost underrun or overrun.

Figures 2 through 4 depict how this contract type is applied. For each of these figures, the following basic assumptions are the same: (1) the target cost is $1,000,000; (2) the target profit is $85,000; (3) the target price is $1,085,000; (4) the government share of any cost over/underrun is 70 percent; and (5) the ceiling price is $1,160,000.

Figure 2 is a fixed-price-incentive contract where the actual cost of $900,000 is under the target price. This results in a $100,000 underrun. The contract price is computed by starting with the target price on line (i). The price is then reduced on line (j) by the government’s share of the cost underrun or $70,000, which is 70 percent of $100,000. This results in a contract price of $1,015,000 on line (k). The profit on this contract is $115,000, which is $1,015,000 minus $900,000.

Figure 3 is a fixed-price-incentive contract where the actual cost of $1,100,000 is over the target price. This results in a $100,000 overrun. The contract price is computed by starting with the target price on line (i). The price is then increased on line (j) by the government’s share of the cost overrun or $70,000, which is 70 percent of $100,000. This results in a contract price of $1,155,000 on line (k). The profit on this contract is $55,000, which is $1,155,000 minus $1,100,000.

Figure 4 is a fixed-price-incentive contract where the actual cost of $1,200,000 is over the target price and the ceiling price. This results in a $200,000 overrun. The contract price is computed by starting with the target price on line (i). The price is then increased on line (j) by the government’s share of the cost overrun or $140,000, which is 70 percent of $200,000. This results in a contract price of $1,255,000 on line (k). However, this exceeds the ceiling price of $1,160,000; thus, the ceiling price becomes the contract price. The loss on this contract is $40,000, which is $1,200,000 minus $1,160,000.

Figure 2
FIXED-PRICE-INCENTIVE CONTRACT
Under Target Price

Figure 3
FIXED-PRICE-INCENTIVE CONTRACT
Over Target Price

Figure 4
FIXED-PRICE-INCENTIVE CONTRACT
Over Ceiling Price

Figure 5 contains the spreadsheet formulas for the calculations in Figures 2 through 4.

Most incentive contracts include only cost incentives, which take the form of a profit or fee adjustment formula and are intended to motivate the contractor to manage costs effectively. No incentive contract may provide for other incentives without also providing a cost incentive. The FPI contract can be a profitable and lucrative endeavor for both the contractor and the government. The contractor must adhere closely to the federal regulations in estimating and accumulating contract costs, however, since these costs will be the basis for determining the eventual price to be paid by the government.

Incentives Contract

Performance incentives include such aspects as a missile’s range, an aircraft’s speed, an engine’s thrust, or a vehicle’s maneuverability. Both positive and negative performance incentives may be used with service contracts. Technical performance incentives are often used in development and in production for major weapon systems and may involve a variety of specific characteristics that contribute to the overall performance of the end item.

Delivery incentives are used when improvement from a required delivery schedule is an important government objective. Incentive arrangements on delivery should specify the application of the reward-penalty structure in the event of government-caused delays or other delays beyond the control—and without the fault or -negligence—of the contractor or subcontractor.

A fixed-price-incentive (firm target) contract specifies a: (1) target cost; (2) target profit; (3) price ceiling (but not a profit ceiling or floor); and (4) profit adjustment formula. These elements are all negotiated at the outset. The price ceiling is the maximum that may be paid to the contractor, except for any price adjustment under the contract terms. When the contract is completed, the parties negotiate the final cost, and the final price is established by applying the formula. If the final cost is less than the target cost, application of the formula results in a final profit greater than the target profit. Conversely, if the final cost is more than the target cost, application of the formula results in a final profit less than the target profit, or even a net loss. If the final negotiated cost exceeds the price ceiling, the contractor absorbs the difference as a loss.

Figure 5
SPREADSHEET FORMULAS FOR FIXED-PRICE-INCENTIVE CONTRACT

Firm-Fixed-Price with Economic Adjustment Contract

A fixed-price contract with economic price adjustment provides for upward and downward revision of the contract price upon the occurrence of specified contingencies. A fixed-price contract with economic price adjustment is used when there is serious doubt concerning the stability of market or labor conditions that will exist during an extended period of contract performance. Price adjustments based on labor and material costs are generally limited to contingencies beyond the contractor’s control. Commonly, an economic adjustment provision adjusts the contract price only if the actual escalation exceeds or falls short of a stated percentage. Economic price adjustments are determined on one of three bases: (1) established prices; (2) actual costs of labor and/or materials; and (3) cost indexes for labor and/or materials.

Adjustments based on established prices are based on increases or decreases from an agreed-upon level in published or otherwise established prices of specific items or the contract end items. For example, a contract that requires a substantial amount of a special metal might provide for an annual price adjustment if the change in a published price of the metal exceeds a certain percent.

Adjustments based on actual costs of labor or materials are based on increases or decreases in specified costs of labor or materials that the contractor actually experiences during contract performance. For example, a contract that requires significant costs for an operating crew might provide for an annual price adjustment if the change in actual labor costs exceeds a certain percent. When this method is used, the contract terms must specifically identify the labor costs by category (e.g., type of personnel) and cost elements (e.g., labor rates, fringe benefits) to avoid subsequent disputes.

Adjustments based on cost indexes of labor or material are based on increases or decreases in labor or materials cost standards or indexes that are specifically identified in the contract. For example, a contract might provide for an annual price adjustment if the consumer price index changes by more than x percent.

Fixed-Price Redeterminable Contract

A fixed-price redeterminable (FPR) contract with retroactive price redetermination provides for a fixed ceiling price and retroactive price redetermination within the ceiling after completion of the contract. This contract type is used primarily for research and development contracts of $100,000 or less.

Firm-Fixed-Price Contract with Successive Targets

A fixed-price contract with prospective price redetermination provides for a firm fixed price for an initial period of contract deliveries or performance and prospective redetermination, at a stated time or times during performance, of the price for subsequent periods of performance. A fixed-price contract with prospective price redetermination is used in acquisitions of quantity production or services for which it is possible to establish a firm fixed price for an initial period, but not for subsequent periods of contract performance. The initial period is generally the longest period possible. Each subsequent pricing period should be at least 12 months. The contract may provide for a ceiling price and may be adjusted only by operation of contract clauses providing for equitable adjustment.

A fixed-price-incentive (successive targets) contract specifies the following elements, all of which are negotiated at the outset: (1) an initial target cost; (2) an initial target profit; (3) an initial profit adjustment formula to be used for establishing the firm target profit, including a ceiling and floor for the firm target profit; (4) a ceiling target profit; (5) a floor target profit; (6) a ceiling price that is the maximum that may be paid to the contractor, except for any equitable price adjustment; and (7) the production point at which the firm target cost and firm target profit will be negotiated.

When the production point specified in the contract is reached, the parties negotiate the firm target cost and the firm target profit. The firm target profit is established by an initially negotiated formula. At this point, the parties have two alternatives: (1) negotiate a firm fixed price, using the firm target cost plus the firm target profit as a guide; or (2) negotiate a formula for establishing the final price using the firm target cost and firm target profit (an FPIF contract).

A contractor’s accounting system must be adequate for providing data for negotiating firm targets and a realistic profit adjustment formula. It must also be adequate to establish a framework for later negotiation of final costs. Cost or pricing information adequate for establishing a reasonable firm target cost must be available at an early point in contract performance.

If the total firm target cost is more than the total initial target cost, the total initial target profit will be decreased. If the total firm target cost is less than the total initial target cost, the total initial target profit will be increased. The initial target profit will be increased or decreased by the contractually stated percentage of the difference between the total initial target cost and the total firm target cost. The resulting amount will be the total firm target profit, provided that in no event is the total firm target profit more or less than a contractually stated percentage of the total initial target cost.

Figures 6 through 10 show how this contract type works. The same basic data are assumed for five outcomes. The initial target cost, initial target profit, ceiling contract price, ceiling target profit percentage, and floor target profit percentage are negotiated at contract award. Also, a formula is negotiated for price adjustment purposes. The adjustment will be to the initial target profit. The formula will state that the initial target profit will be adjusted downward by x percent of the excess of the firm target cost over the initial target cost. Likewise, the formula will state that the initial target profit will be adjusted upward by y percent of the excess of the initial target cost over the firm target cost.

At a specified point in time (which is negotiated at the time the contract is awarded), a firm target cost is negotiated based on new cost data. The formula is applied to the initial target profit. The contract price can then be completed as either a firm-fixed-price (FFP) or a fixed-price-incentive fee (FPIF) contract. The examples include five scenarios for the firm target cost: (1) well under the initial target cost; (2) under the initial target cost; (3) over the initial target cost; (4) well over the initial target cost; and (5) extremely over the initial target cost. Assuming a firm fixed price rather than adding more complications for a FPIF contract, the expected profit or loss line is based on meeting the firm target cost.

Figure 6
FIXED-PRICE-INCENTIVE SUCCESSIVE TARGET CONTRACT Well
Under Initial Target Price

Figure 7
FIXED-PRICE-INCENTIVE SUCCESSIVE TARGET CONTRACT
Under Initial Target Price

Figure 6 is for the well under initial target price scenario, in which the ceiling target profit is attained. (The cost underrun is so great that the contracts maximum profit provision applies.) Figure 7 is for the under initial target price scenario. Figure 8 is for the over initial target price scenario. Figure 9 is for the well over initial target price scenario, in which the floor target profit is applied. (The cost overrun is so great that the contract’s minimum profit provision applies.) Figure 10 is for the extremely over initial target price scenario and the ceiling price is applied. Figure 11 contains the formulas for these scenarios. Figure 12 displays the relationship of the various components of this contract type.

Fixed-Price, Level-of-Effort Contract

A firm-fixed-price, level-of-effort (FP-LOE) term contract provides for a specified level of effort, over a stated period of time, on work that can be stated only in general terms. This contract type is suitable for investigation or study in a specific research and development area where the product is usually a report showing the results achieved through application of the required level of effort. However, payment is based on the effort expended rather than on the results achieved.

Figure 8
FIXED-PRICE-INCENTIVE SUCCESSIVE TARGET CONTRACT
Over Initial Target Price

Some FP-LOE contracts contain price adjustment provisions that are based on the estimated versus actual labor provided. For example, the provision might require a price adjustment if more or less than 15 percent of the estimated hours is incurred. This provision could be on the total hours for the contract or on individual labor categories.

Fixed-Price, Award-Fee Contract

Award-fee provisions are used infrequently in a fixed-price contract. Such contracts 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 based on periodic formal evaluation of the contractor’s performance against an award-fee plan.

COST-REIMBURSEMENT CONTRACTS

Cost-reimbursement contracts provide for payment of actual allowable costs, as governed by Part 31 of the FAR. Cost-reimbursement contracts establish estimates of total cost for the purpose of obligating funds. If a contractor exceeds the funds without contracting officer approval, such costs are incurred at the contractor’s risk.

Figure 9
FIXED-PRICE-INCENTIVE SUCCESSIVE TARGET CONTRACT
Well Over Initial Target Price

A cost-reimbursement contract is used when the uncertainties of performance do not permit costs to be estimated with enough accuracy to use a fixed-price contract. Cost-reimbursement contracts entail minimal contractor financial responsibility. Under these contracts, the contractor is reimbursed for actual allowable costs up to the contract ceiling, plus the established fee. The contractor usually is not allowed to invoice for more than 85 percent of the fee until the contract is completed. The remaining 15 percent is held by the government as a reserve for contractual problems and/or final indirect rate adjustments.

Once awarded a cost-reimbursement contract, a contractor is subject to numerous federal regulations and contract clauses. One of the more troublesome clauses, the limitation of cost clause (LOCC), is found in FAR 52.232-20. This clause requires a contractor to notify the contracting officer in writing whenever he has reason to believe that: (1) the costs he expects to incur under the contract in the next 60 days (or an alternative number of days ranging from 30 to 90) when added to costs previously incurred, will exceed 75 percent (or an alternative percentage ranging from 75 to 85) of the estimated costs specified in the contract; or (2) the total cost for the performance of the contract, exclusive of any fee, will be either greater or substantially less than estimated.

Figure 10
FIXED-PRICE-INCENTIVE SUCCESSIVE TARGET CONTRACT
Extremely Over Initial Target Price

The primary purpose of the LOCC is to protect the government from unauthorized and unexpected cost overruns. Once the contractor notifies the government of a potential overrun, the government must decide whether or not to extend the work and grant additional funding, or to revise the contract scope of work.

Several decisions by the Board of Contract Appeals (BCA) construed a pre-1966 LOCC liberally, allowing contractors to recover for cost overruns in a variety of situations. Since then a revised LOCC, adopted in October 1966, has made it extremely difficult for a contractor to be reimbursed for a cost overrun. If a contractor with an adequate accounting system can show that he could not reasonably foresee a cost overrun, he can be excepted from the requirement. In establishing this exception to the no-reimbursement for overrun rule, the Court of Claims has stated that it is an abuse of discretion for the contracting officer to refuse to fund the cost overrun because of the contractor’s failure to give notice when it was impossible to do so.

The best example of when a contractor may not be aware of a potential overrun is a contractor who had submitted indirect cost billing rates for audit. The government auditor challenged certain pension costs and reduced the billing rate substantially. The contract funds were substantially expended using this lower billing rate. When the government auditor performed the final indirect cost audit several years later, the auditor changed his mind and did not disallow any pension costs.

Figure 11
SPREADSHEET FORMULAS FOR FIXED-PRICE-INCENTIVE SUCCESSIVE TARGET CONTRACT

Another practical danger is the government’s unilateral removal of funds from a contract before final audited rates have been established. In some cases, funds expire after three or five years. In other cases, funds may simply not be available to cover increases because final indirect cost rates are more than the interim billing rates.

Types of cost-reimbursement contracts available include cost-sharing, cost-reimbursement-only, cost-plus-fixed-fee, cost-plus-incentive-fee, and cost-plus-award-fee.

Cost-Sharing Contract

A cost-sharing contract is one in which the contractor receives no fee and is reimbursed only for an agreed-upon percentage (e.g., 80 percent) of allowable costs. A cost-sharing contract is used when a contractor agrees to absorb a portion of the costs, in the expectation of substantial compensating benefits. For example, a contractor might agree to share in the development costs of a weapon systems in anticipation of being awarded any resulting production contract. This contract type is more widely used for educational institutions and nonprofit entities than commercial organizations.

Figure 12
RELATIONSHIP OF PROFIT TO DIFFERENCES BETWEEN INITIAL TARGET COST AND FIRM TARGET COST

Cost-Reimbursement-Only Contract

A cost-reimbursement-only contract is one in which the contractor receives no fee. This contract type is more appropriate for research and development work, particularly with nonprofit educational institutions or other nonprofits.

Cost-Plus-Fixed-Fee Contract

A cost-plus-fixed-fee (CPFF) contract provides for payment to the contractor of a negotiated fee that is fixed at the inception of the contract. This contract type permits contracting for efforts that might otherwise present too great a risk to contractors, but it provides the contractor only a minimum incentive to control costs.

A cost-plus-fixed-fee contract may take one of two basic forms—completion or term. The completion form describes the scope of work by stating a definite goal or target and specifying an end product. This form of contract normally requires the contractor to complete and deliver the specified end product (e.g., a final report of research accomplishing the goal or target) within the estimated cost, if possible, as a condition for payment of the entire fixed fee. However, in the event that the work cannot be completed within the estimated cost, the government may require completion of the work without increase in fee, provided that the government increases the estimated cost. Additional fee under these circumstances depends on whether the “cost overrun” is due simply to more cost than anticipated or to increased scope of work. Simple cost overruns for the scope of work contemplated in the contract do not warrant additional fee. Cost increases due to change in the scope of work and contract risk do warrant additional fee (or less fee if the government believes a reduced scope of work has occurred).

The term form describes the scope of work in general terms and obligates the contractor to devote a specified level of effort for a stated time period. Under this form, if the government considers performance to be satisfactory, the fixed fee is payable at the expiration of the agreed-upon period—upon contractor statement that the level of effort specified in the contract has been expended in performing the contract work. Renewal for further periods of performance is a new acquisition that involves new cost and fee arrangements.

Because of the differences in obligation assumed by the contractor, the completion form is preferred over the term form whenever the work, or specific milestones for the work, can be defined well enough to permit development of estimates within which the contractor can be expected to complete the work. The term form should not be used unless the contractor is obligated by the contract to provide a specific level of effort within a definite time period.

Cost-Plus-Incentive-Fee Contract

The cost-plus-incentive-fee (CPIF) contract is a cost-reimbursement contract that provides for the initially negotiated fee to be adjusted later by a formula based on the relationship of total allowable costs to total target costs. This contract type specifies: (1) a target cost; (2) a target fee; (3) a minimum fee; (4) a maximum fee; and (5) a fee adjustment formula. The formula provides, within limits, for increases in fee above the target fee when total allowable costs are less than target costs, and decreases in fee below the target fee when total allowable costs exceed target costs. When total allowable costs are greater or less than the range of costs within which the fee-adjustment formula operates, the contractor is paid total allowable costs, plus the minimum or maximum fee.

Figures 13 through 16 describe how this contract type is applied. For each of these figures, the following basic assumptions are the same: (1) the estimated cost is $1,000,000; (2) the stated fee is $85,000; (3) the minimum fee is $60,000; (4) the maximum fee is $110,000; and (5) the contractor share of any cost over/underrun is 30 percent.

Figure 13 is a cost-plus-incentive-fee contract where the actual cost of $900,000 is well under the estimated cost. This results in a $100,000 underrun. The contract price is computed by starting with the actual cost on line (i). The fee calculation begins with the stated fee, $85,000, on line (j). The fee is then increased on line (k) by the contractor’s share of the cost underrun or $30,000, which is 30 percent of $100,000. This results in a calculated fee of $115,000 on line (l). However, this fee exceeds the maximum fee, so the allowable fee amount is the maximum or $110,000. The price on the contract is then $1,010,000, which is the sum of the actual cost and the allowable fee. The profit on this contract is $110,000, which is $1,010,000 minus $900,000.

Figure 14 is a cost-plus-incentive-fee contract where the actual cost of $950,000 is slightly under the estimated cost. This results in a $50,000 underrun. The contract price is computed by starting with the actual cost on line (i). The fee calculation begins with the stated fee, $85,000, on line (j). The fee is then increased on line (k) by the contractor’s share of the cost underrun or $15,000, which is 30 percent of $50,000. This results in a calculated fee of $100,000 on line (l). The price on the contract is then $1,050,000, which is the sum of the actual cost and the allowable fee. The profit on this contract is $100,000, which is $1,050,000 minus $950,000.

Figure 15 is a cost-plus-incentive-fee contract where the actual cost of $1,050,000 is slightly over the estimated cost. This results in a $50,000 overrun. The contract price is computed by starting with the actual cost on line (i). The fee calculation begins with the stated fee, $85,000, on line (j). The fee is then decreased on line (k) by the contractor’s share of the cost overrun or $15,000, which is 30 percent of $50,000. This results in a calculated fee of $70,000 on line (l). The price on the contract is then $1,120,000, which is the sum of the actual cost and the allowable fee. The profit on this contract is 70,000, which is $1,120,000 minus $1,050,000.

Figure 16 is a cost-plus-incentive-fee contract where the actual cost of $1,150,000 is well over the estimated cost. This results in a $100,000 overrun. The contract price is computed by starting with the actual cost on line (i). The fee calculation begins with the stated fee, $85,000, on line (j). The fee is then decreased on line (k) by the contractor’s share of the cost overrun or $45,000, which is 30 percent of $150,000. This results in a calculated fee of $40,000 on line (l). However, this fee is less than the minimum fee so the allowable fee amount is the minimum, or $60,000. The price on the contract is then $1,210,000, which is the sum of the actual cost and the allowable fee. The profit on this contract is 60,000, which is $1,210,000 minus $1,150,000.

Figure 17 contains the spreadsheet formulas for the calculations in Figures 13 through 16.

Cost-Plus-Award-Fee Contract

A cost-plus-award-fee (CPAF) contract is a cost-reimbursement contract that provides for a fee consisting of: (1) a base amount fixed at inception of the contract (which may be zero); and (2) an award amount that the contractor may earn in whole or in part during performance. The amount of the award fee to be paid is determined by the government’s judgmental evaluation of the contractor’s performance in terms of the criteria stated in the contract.

Figure 13
COST-PLUS-INCENTIVE-FEE CONTRACT
Well Under Estimated Cost

OTHER CONTRACT TYPES

Other contract types include time-and-materials, labor-hour, indefinite-delivery, letter, basic agreement, and basic ordering agreement.

Time-and-Materials Contract

A time-and-materials (T&M) contract provides for acquiring supplies or services on the basis of: (1) direct labor hours at specified fixed hourly rates that include wages, overhead, general and administrative (G&A) expenses, and profit; and (2) materials at cost, including, if appropriate, material handling costs. A time-and-materials contract provides little positive profit incentive to the contractor for cost control or labor efficiency. T&M rates are sometimes referred to as “wrap-rates” because all costs are included in the price per labor hour.

Materials and other direct costs are paid on a cost-reimbursement basis without a fee. All appropriate indirect costs allocated to direct materials in accordance with the contractor’s usual accounting procedures consistent with Part 31 are permitted. This includes G&A expenses and indirect material handling costs—only if the contractor has an established material handling cost pool.

Figure 14
COST-PLUS-INCENTIVE-FEE CONTRACT
Slightly Under Estimated Cost

T&M contracts have been popular for inspect-and-repair-as-needed (IRAN) contracts. Under these contracts, the contractor is paid a fixed hourly rate for labor and related costs, and actual costs for materials identified as needed for repairs. The purpose of the contract not allowing a profit on materials is to avoid an incentive for a contractor to identify repairs that might be of questionable need.

Whether a T&M contract is a fixed-price type contract or a cost-type contract is an ongoing disagreement between the government and some nongovernment people. The government considers these contracts to be cost-type because the ultimate price is based on the quantity of goods or services delivered, which the government views as being at the discretion of a contractor rather than determined by the government buyer. The opposing view is that a T&M contract is both fixed-price and cost-type. The time portion is a fixed unit cost per item delivered. The materials portion is cost-reimbursement.

In the late 2000s it became necessary to segregate T&M contracts into two categories, commercial and non-commercial, for purposes of establishing whether subcontracted work should be invoiced as time or materials under a prime contract. The ramifications of this distinction are clear: A prime contractor receives no profit or fee on work performed by a subcontractor if the work is treated as a subcontract. For commercial T&M contracts, the labor for the prime contractor, subcontractors, and affiliates of the prime contractor may be invoiced to the government based on the labor rate specified in the prime contract. For T&M contracts awarded based on adequate price competition for other than the Department of Defense, the labor may also be invoiced in this manner. For the Department of Defense, such contracts must be invoiced as non-commercial items would be invoiced. For non-commercial items the labor of subcontractors and affiliates is invoiced based on actual cost, i.e., as the materials portion of the T&M contract.

Figure 15
COST-PLUS-INCENTIVE-FEE CONTRACT
Slightly Over Estimated Cost

Labor-Hour Contract

A labor-hour contract is a variation of a time-and-materials contract, differing only in that no materials are to be supplied by the contractor.

Indefinite-Delivery Contract

The indefinite delivery (ID) contract type relates to multiple awards of indefinite-quantity contracts. The two categories of ID contracts are: (1) a delivery-order contract, which does not procure or specify a firm quantity of supplies (other than a minimum or maximum quantity) and which provides for the issuance of orders for the delivery of supplies during the period of the contract; and (2) a task-order contract, which does not procure or specify a firm quantity of services (other than a minimum or maximum quantity) and which provides for the issuance of orders for the performance of tasks during the period of the contract.

There are three types of indefinite-delivery contracts: (1) definite-quantity contracts; (2) requirements contracts; and (3) indefinite-quantity contracts. Indefinite-quantity contracts and requirements contracts permit flexibility in both quantities and in delivery scheduling and ordering of supplies or services after requirements materialize. Indefinite-quantity contracts limit the government’s obligation to the minimum quantity specified in the contract. Requirements contracts may permit faster deliveries when production lead time is involved, because contractors are usually willing to maintain limited stocks when the government will obtain all of its actual purchase requirements from the contractor.

Figure 16
COST-PLUS-INCENTIVE-FEE CONTRACT
Well Over Estimated Cost

Definite-Quantity Contract

A definite-quantity contract provides for delivery of a definite quantity of specific supplies or services for a fixed period, with deliveries or performance to be scheduled at designated locations upon order. A definite-quantity contract is often used when it can be determined in advance that a definite quantity of supplies or services will be required during the contract period, and the supplies or services are regularly available or will be available after a short lead time.

Requirements Contract

A requirements contract provides for filling all actual purchase requirements of designated government activities for supplies or services during a specified contract period, with deliveries or performance to be scheduled by placing orders with the contractor. The solicitation and resulting contract state that an estimated quantity will be required or ordered, or that conditions affecting requirements will be stable or normal. The contract may also specify maximum or minimum quantities that the government may order under each individual order and the maximum that it may order during a specified period of time.

Figure 17
SPREADSHEET FORMULAS FOR COST-PLUS-INCENTIVE-FEE CONTRACT

Indefinite-Quantity Contract

An indefinite-delivery, indefinite-quantity (IDIQ) contract provides for an indefinite quantity, within stated limits, of supplies or services to be furnished during a fixed period, with deliveries or performance to be scheduled by placing orders with the contractor.

The contract requires the government to order and the contractor to furnish at least a stated minimum quantity of supplies or services, and requires the contractor to furnish any additional quantities ordered, not to exceed a stated maximum. To ensure that the contract is binding, the minimum quantity must be more than a nominal quantity, but it should not exceed the amount that the government is fairly certain to order. The contract may also specify maximum or minimum quantities that the government may order under each task or delivery order and the maximum that it may order during a specific period of time.

There are two types of IDIQ contracts—single awardee and multiple awardee. For a single awardee contract, only one contractor is selected for award and the contract operates as described. A multiple-awardee contract results in several awardees being selected as eligible to bid on delivery orders or task orders issued subsequent to contract award. For orders issued under multiple-delivery order contracts or multiple-task order contracts, each awardee is to be provided a fair opportunity to be considered for each order in excess of $2,500. Winning a multiple-award contract is similar to “winning air.” There is no guarantee of any work unless the awardee is successful in the individual order competition stage. In most instances, a contractor may not protest an agency award of an individual order.

Letter Contract

A letter contract is a written contractual instrument that authorizes the contractor to begin immediately manufacturing supplies or performing services. A letter contract may be used when the government’s interests demand that the contractor be given a binding commitment so that work can start immediately and negotiating a definitive contract is not possible in sufficient time to meet the requirement. However, a letter contract should be as complete and definite as feasible under the circumstances. When a letter contract is awarded, the contracting officer will include an overall price ceiling in the letter contract.

Each letter contract must specify a definite schedule, including: (1) dates for submission of the contractor’s price proposal, required cost or pricing data, and, if required, make-or-buy and subcontracting plans; (2) a date for the start of negotiations; and (3) a target date for definitization, which is to be the earliest practicable date. The schedule will provide for definitization of the contract within 180 days after the date of the letter contract or before completion of 40 percent of the work to be performed, whichever occurs first.

However, the contracting officer may, in extreme cases and according to agency procedures, authorize an additional period. In practice, many definitizations take much longer than 180 days. Generally, this delay is more advantageous to the government than the contractor because the letter contract contains a not-to-exceed (NTE) or ceiling price. Thus, if the cost estimate decreases, the price will likely be negotiated downward, but if the cost estimate increases, the price may not be negotiated in excess of the ceiling. Contractors are advised to avoid letter contracts.

Basic Agreement

A basic agreement is a written instrument of understanding, negotiated between the government and a contractor, that: (1) contains contract clauses applying to future contracts between the parties during its term; and (2) contemplates separate future contracts that will incorporate by reference or attachment the required and applicable clauses agreed upon in the basic agreement. Importantly, a basic agreement is not a contract. A basic agreement is used when a substantial number of separate contracts may be awarded to a contractor during a particular period. Basic agreements are used with negotiated fixed-price or cost-reimbursement contracts.

Basic agreements provide for discontinuing their future applicability upon 30 days’ written notice by either party. A basic agreement will not obligate funds, state or imply any agreement by the government to place future contracts or orders with the contractor, or be used in any manner to restrict competition. Each contract incorporating a basic agreement includes a scope of work and price, delivery, and other appropriate terms that apply to the particular contract.

Basic Ordering Agreement

A basic ordering agreement (BOA) is a written instrument of understanding, negotiated between an agency, contracting activity, or contracting office and a contractor, that contains: (1) terms and clauses applying to future contracts (orders) between the parties during its term; (2) a description, as specific as practicable, of supplies or services to be provided; and (3) methods for pricing, issuing, and delivering future orders. Importantly, a basic ordering agreement is not a contract.

A basic ordering agreement is used to expedite contracting for uncertain requirements for supplies or services when specific items, quantities, and prices are not known at the time the agreement is executed, but a substantial number of supplies or services covered by the agreement is anticipated to be purchased from the contractor. The use of these procedures can result in economies in ordering parts for equipment support by reducing administrative lead-time, inventory investment, and inventory obsolescence resulting from design changes.

A basic ordering agreement does not state or imply any agreement by the government to place future contracts or orders with the contractor or be used in any manner to restrict competition. Each basic ordering agreement describes the method for determining prices to be paid to the contractor for the supplies or services. Common application is for ordering spare parts. The agreement may provide a formula for pricing spare parts based on agreed-upon direct labor rates and indirect cost rates plus other factors.

UNAUTHORIZED CONTRACT TYPES AND VARIATIONS

The FAR very specifically states that contract types other than those authorized by the regulations are not permitted. However, approved and unapproved variations occasionally exist. For example, a major weapon system contract was converted to a “cost-plus-fixed-loss” contract as part of an agreement to ensure delivery when the contractor had a significant financial problem. This contractual arrangement had to be approved at the highest level of the agency.

Other unauthorized variations typically attempt to provide downward-only adjustments to fixed-price contracts. For example, some contracting officers seek a downward-only adjustment clause in T&M contracts. In other words, the price will be the lower of the negotiated fixed hourly rate and the actual hourly rate determined on an after-the-fact basis. This is an inequitable contract type and is not authorized. Any “maverick” provision that violates the sanctity of a fixed-price contract should be rejected.

OTHER TRANSACTIONS

Beginning in the early 1990s, the government expanded the use of arrangements other than contracts to obtain certain goods and services. A transaction other than a contract does not require most of the contract clauses that are mandatory for government contracting. The most notable of these are the clauses for compliance with cost accounting standards (CAS), cost allowability rules, and government audit rights. The initial usage of this vehicle was under the Small Business Innovative Research Program.

The goal of the other-transaction (OT) approach was to entice commercial organizations into providing goods and services to the government. Often strictly commercial organizations refuse to accept government contracts because of the excessive administrative and government oversight that accompanies contracts. The use of other transactions has expanded from research to prototype development and beyond. This approach is beneficial to the government because it attracts sellers that would not otherwise deal with the government, and is beneficial to the sellers because it avoids the most negative aspects of contracting with the government.

CONTRACT TYPE AND POTENTIAL FINANCIAL REWARD

The fixed-price contract offers the greatest opportunity for profit or loss and the cost-plus-fixed-fee contract offers the least potential variability in profit. The term “profit” is used here in terms of the difference between the contract price and allowable costs. Potential profit must be further reduced by any unallowable costs, including federal income taxes.

Figure 18 displays the relative profit at various levels of cost incurrence for: (1) firm-fixed-price contracts; (2) fixed-price-incentive contracts; (3) cost-plus-incentive-fee contracts; and (4) cost-plus-fixed-fee contracts. The vertical scale is profit or loss, with the breakeven point noted. The horizontal scale is the allowable cost. As allowable costs increase, the profit decreases in all instances. However, the pattern is different for each contract type. The figure incorporates the differences in profit levels associated with the various contract types as well as the relationship to allowable cost.

The firm-fixed-price contract profit has a constant relationship to allowable costs, i.e., a dollar for dollar correlation. The fixed-price-incentive contract involves a 30 percent sharing of any allowable cost variance from the estimate up to a maximum price. The cost-plus-incentive-fee contract provides for a similar sharing; however, both a minimum and maximum profit are established. The cost-plus-fixed-fee contract maintains a constant profit regardless of allowable costs.

Figure 18
COMPARISON OF ALLOWABLE COST TO PROFIT ON VARIOUS CONTRACT TYPES