Wednesday, April 2, 2014

Performance Based Payments - What are the Alternatives?

According to the Federal Acquisition Regulations (FAR), the first preference for financing a contract is for the contractor to obtain private financing without Government guarantee (see FAR 32.106(a)). Of course, interest is unallowable - its not going to be allowed in the pricing of that contract (or any other Government contract) - so most contractors will opt for the second preference, customary contract financing. Any why not? Why not get the free Government financing as opposed to going out and paying interest for private financing.

There are two kinds of Government financing. There is the traditional progress payment and there is performance-based payments (PBPs). Between the two, FAR prefers the use of PBP (see FAR 32.1001(a)) when the contracting officer finds them to be practical and the contractor agrees to their use. Under customary progress payments, financing cannot exceed 80 percent of costs incurred (or, 85 percent for small businesses). Under PBPs, contractors have the opportunity to receive payments up to 100 percent of costs incurred, so long as they are less than 90 percent of the contract price. So one can readily see that PBPs will generate more cash flow to the contractor than will traditional progress payments.

As we mentioned a couple of days ago, PBPs are linked to certain contract milestones but also to costs incurred. The purpose of all contract financing is to assist the contractor in paying the contract cost incurred during contract performance. According to FAR (see FAR 32.104(a)), contract financing is intended to be provided only to the extent actually needed for prompt and efficient performance. The reason that DoD has linked PBP with cost incurred is to ensure that financing is not provided to a greater extent than intended by FAR.

When a contractor accepts Government-provided financing payments, it must accept some form of requirement for the oversight of business systems that substantiate the incurrence of the costs to support the financing payments and to protect the Government's interests. That's true for both traditional progress payments as well as PBPs. No contractor is under obligation to accept performance-based payments or any other type of contract financing, and thus, avoid any additional economic consequence of the rule for an adequate accounting system. If a contractor doesn't want the Government in its knickers, then it should not expect to receive Government financing.

PBPs, when properly structured, can provide benefits to both the Government and the contractor. The key benefit to the contractor is improved cash flow. However, there is a cost to the Government of providing improved contract financing to the contractor. The time-value of money works both ways. The contractor benefits but the Government pays. That is why the Government will expect some kind of consideration in exchange for granting PBPs. Usually, perhaps always, the PBP analysis tool will calculates a lower profit to ensure that the use of PBPs provides a mutually beneficial financial arrangement for both parties.

Tomorrow we will look at DoD's "PBP Analysis Tool"

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