Thursday, April 3, 2014

Performance Based Payments - DoD's "PBP Analysis Tool"

We've been discussing the new DFARS (DoD FAR Supplement) rule on performance-based payments for the past few days. This new rule provides for a structured approach for determining how PBPs are to be calculated and administered. Its not quite like it used to be. Previously, the Government and contractor established milestones and assigned values to those milestones. When the contractor met that milestone, it gets paid the agreed to amount. Under the new rule, the same applies except now there is a cap on what the Government will pay - no more than the costs incurred. So, if a milestone is worth $100 thousand but the contractor spent $80 thousand, it will only receive $80 thousand. Also, in order for a contractor to obtain PBPs, it must be willing to give up some of its negotiated profit.

The key to determining how much profit a contractor will forgo is calculated using DoD's "PBP Analysis Tool", a spreadsheet model. You can read more about the "tool" and download it here. We don't have any experience in working with this spreadsheet but we have looked at it. And, we can state that its not for the feint of heart. It will take a bit of work to fully understand, comprehend, and use the model. In fact, it the published comments to the draft of the new rule, commentators expressed similar sentiment. DoD, however, responded that the tool "...will be used by trained contracting officers who will be able to walk the contractor through the process, if required." So you can see that even DoD recognizes that this is not something you can pull off the shelf and use. It's going to require some training. The idea that a "trained" contracting officer is going to "walk the contractor through the process" doesn't give us much confidence either. When was the last time your contracting officer returned your phone call?

According to DoD, the benefit of improved cash flow is so significant from a contractor's perspective that a contract with considerably less profit (lwer price) with PBPs can be a better financial deal for the contractor than a higher price for the same contract with progress payments. They call this a "win-win" deal.

The DoD PBP Analysis Tool allows the contracting officer to identify a "win-win" solution for both the Government and the contractor. It does this by comparing the expected monthly cash flow to the contractor when using PBPs versus progress payments. The tool calculates the final cost to the Government and the financial value to the contractor under both scenarios. The final cost to the Government is calculated by adding the cost of borrowing the financing payments made to the contractor to the contract price. The financial value to the contractor is based on calculating the Internal Rate of Return (IRR) and Net Present Value (NPV) of the cash flows. The tool finds the solution that benefits both parties: Lower final cost to the Government and greater IRR and NPV for the contractor. The tool also allows the user to do "what-ifs" on PBP event timing to see the financial impact to the contract and Government of event slippage or acceleration. This permits the user to make a fact-based assessment of the financial risk and benefits of the PBP arrangement.

Whether PBPs is the way to go for all contractors remains to be seen. We would hesitate giving up a significant portion of our profit for improved cash-flow, especially if we were a company that wasn't experiencing cash-flow issues. If you have cash sitting around earning less than one percent interest, you don't want to use the tool and pretend that your money can get 4 or 5 or 6 percent interest (the IRR). If the model is built of faulty assumptions, contractors are going to suffer. It might be preferable to take the traditional progress payment route.

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