Thursday, March 3, 2011

Government to Increase its use of Fixed Price Incentive Contracts

The Department of Defense is proposing changes to its procurement regulations to encourage contracting officers to increase the use fixed price incentive (FPI) contracts in the hope of reducing contract costs. DoD uses the phrase " incentivize productivity and innovation in industry"). Under FPI contracts, the price is not truly fixed. Instead, a target price is negotiated and this target price consists of a target cost and a target fee. If the final negotiated cost of the contract is above or below the target cost, then the contractor's profit will be adjusted downward or upward using a negotiated share ratio. The final price consists of the final negotiated cost plus the profit computed at that final cost using the share ratio. However, there's also a ceiling price above which the contractor will not be paid.

Under an FPI contract, profit is inversely related to cost; as costs go down, profit goes up (and vice versa). Therefore, it is believed that this contract type provides a positive incentive to the contractor to control costs. The necessary elements for a FPI contract are:
  • Target Cost - best estimate of expected cost
  • Target Profit - fair profit at target cost
  • Share Ratio(s) - to adjust profit after actual costs are documented (defaults to 50/50)
  • Ceiling Price - to limit the maximum the government may pay (defaults to 120%)

There is a significant downside to FPI contracts from a contractor's perspective. These contracts have to be tracked like cost-reimbursable contracts and included in contractors annual incurred cost submissions. Given that DCAA is hopelessly delinquent in auditing contractor incurred costs, the probability of negotiating a final contract price for purposes of calculating the final profit amount, in a reasonable amount of time, is slim. By comparison, contractors do not need to wait for a final audit before receiving final payment for fixed-price contracts.

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