Performance-Based Payments No Longer Capped by the Amount of Incurred Costs

The Defense Department just issued a class deviation concerning performance-based payments and it marks a significant change from the existing DFARS (DoD FAR Supplement) regulations.

The current DFARS clause (DFARS 252.232-7012) states that "at no time shall cumulative performance-based payments exceed cumulative contract cost incurred under this contract. To ensure compliance with this requirement, the Contractor shall, in addition to providing the information required by FAR 52.232-32, submit supporting information for all payment requests using the following format:" The specified format is a schedule that, once you go through the calculations, limits performance-based payments to the cost incurred under the contract. 

The new clause removes that restriction. It does not limit performance-based payments to cost incurred although it still requires contractors to produce actual cost records upon request by the contracting officer. But it goes further:

An acceptable job order cost accounting system is not required for reporting of incurred costs under this clause. If the contractor's accounting system is not capable of tracking costs on a job order basis, the contractor shall provide a realistic approximation of the allocation of incurred costs attributable to this contract in accordance with Generally Accepted Accounting Principles (GAAP) and the contractor's accounting system. Contractors are not required to "certify" incurred costs.

The Government still needs some form of security for performance-based payments. Title to the property is the preferred security but the new clause also allows for (i) a paramount lien on assets, (ii) an irrevocable letter of credit from a federally insured financial institution, (iii) a performance bond, (iv) a guarantee of repayment from a person or corporation of demonstrated liquid net worth, connected by significant ownership interest to the contractor, or (v) title to identified contractor assets of adequate worth.

If the contractor fails to provide adequate security, no financing payment will be made. If the contracting officer determines that the security provided by the contractor is insufficient, the contractor must provide additional security. If the contractor fails to do that, the contracting officer may collect or liquidate such security that has been provided and suspend further payments.

In summary, performance-based payments on DoD contracts are no longer capped at the amount of incurred costs but contractors will need to provide some form of security in exchange for contract financing.

DoD's 'class deviation' letter and accompanying clauses can be accessed here.

Performance Based Payments - Proposal to Remove Limitation to Cost Incurred

The Defense Department is proposing changes to its rules on Performance-Based Payments. These changes are required to implement provisions in prior NDAAs (National Defense Authorization Act).

Performance-based payments are a method of contract financing that are based on the achievement of objective, quantifiably measurable events, results, or accomplishments that are defined and valued in the contract prior to performance. It is the preferred method of contracting as many believe that it reduces oversight and compliance costs to the Government. It also has benefits for contractors as it should help cash flow, reduce the cost of oversight and compliance, and allow management to focus on technical and schedule progress.

One of the inherent problems with performance based payments however has been that performance based payments are limited to amounts not greater than costs incurred up to the time of payments. This restriction then requires contractors to accumulate costs in such a way that such comparisons can be made. It kind of defeats some of the attractions of performance-based payments.

Under the proposed rule, those restrictions will be lifted. Contractors will no longer be limited by their costs incurred. Contractors will be able to bill based on the milestones stipulated in the contract.

The requirement for contractors to report costs incurred when requesting performance-based payments is retained, not for purposes of capping payment requests, but in order to have the data necessary for negotiation of performance-based payments on future contracts. So, contractors will still require a cost accounting system hat accumulates costs by contract.

You can access the full text of the proposed change, including instructions on where to send comments here.

Contract Financing - Performance-Based Payments - Generally

Performance-based payments (PBPs) for non-cost-reimbursable contracts are the Government's preferred financing method when the contracting officer finds them practical and the contractor agrees to their use (see FAR 32.1001(a)). The 2017 NDAA, as we discussed yesterday, removes the qualification "when the contracting officer finds them practical and the contractor agrees to their use" making PBPs the unquestionable preferred financing method. There's a lot to like with PBPs in lieu of Progress Payments based on costs. With PBPs, once contractors achieve a predetermined milestone, it gets paid. Progress payments on the other hand require considerable administrative effort including cost roll-ups, liquidation rates, subcontractor billings, loss ratio calculations and more.

Performance-based payments or PBPs can be based on

• performance measured by objective, quantifiable methods
• accomplishment of defined events, or
• other quantifiable measures of results.

The procedure for establishing PBPs is a two-part process. First, the Government and contractor must establish the performance bases (events or criteria) and second, the parties must assign payment amounts to each base. Almost any rational basis for associating payments to bases can be used. Examples include:

• engineering estimates of stages of completion, 
• engineering estimates of hours or other measures of effort to be expended in the performance of the event or achievement of a performance criterion, and 
• the estimated projected cost of performance of particular events 

Typically, the contractor proposes the PBP events and amounts but the contracting officer will review them to ensure that they result in equitable financing arrangements. The risk to the Government is paying too much up front where the amount of the financing is not commensurate with the milestone. Certainly the Government would not want to be in a position where it has paid half the cost of the contract at, say, ten percent completion.

The Government has developed a user's guide to facilitate the establishment of performance-based events. Although written for contracting officers, the guide can be very useful to contractors as well - especially establishing proposed performance-based events and assigning payment amounts to (or valuing) those events. That Guide can be downloaded here.

DCAA Gets Cut Off at the Pass - Again

We're beginning to think that Congress believes that the Defense Contract Audit Agency (DCAA) has become a stumbling block to efficient and effective Government contracting practices. Last week in discussing Sec. 820 of the 2017 NDAA (National Defense Authorization Act), we noted a provision that will effectively eliminate DCAA from auditing indirect costs in favor of privatization. DCAA can still audit the direct costs but will have no role in auditing indirect costs. We're not sure how that will work out in practice however. One cannot develop indirect expense rates without auditing both direct and indirect costs. Someone, either the independent public accountant or DCAA is going to have to marry up the two sides to come up with final rates. And, most likely, the two organizations will be on different auditing cycles which may be the undoing of the entire concept.

The 2017 NDAA has another provision that effectively prevents DCAA from sticking their noses into Performance Based Contract Payments. Sec 831 establishes a preference for performance-based payments to contractors as the preferred Government financing mechanism. The Senate version of the bill added the following:

1. Performance-based payments shall not be conditioned upon costs incurred in contract performance but on the achievement of performance outcomes.
2. The Secretary of Defense shall ensure that nontraditional defense contractors and other private sector companies are eligible for performance-based payments, consistent with best commercial practices.
3. In order to receive performance-based payments, a contractor's accounting system shall be in compliance with Generally Accepted Accounting Principles, and there shall be no requirement for a contractor to develop Government-unique accounting systems or practices as a prerequisite for agreeing to receive performance-based payments.

The House version of the NDAA did not contain a similar provision. During conference, the House agreed to the Senate provision with the added provision that reads as follows: "Nothing is this section shall be construed to grant the Defense Contract Audit Agency the authority to audit compliance with Generally Accepted Accounting Principles (GAAP).

How will a contracting officer determine that a contractor is GAAP compliant? If the contractor has "audited" or "reviewed" financial statements, there is independent assurance that the accounting system complies with GAAP. However, the majority of Government contractors will not have audited or reviewed financial statements so then it becomes problematic for the Government to ensure that a contractor's accounting system is GAAP compliant. Perhaps the Government can rely on self-certification as it now does with any number of contractual requirements. However GAAP compliance is to be determined however, don't expect that DCAA will have any role in the assessment.

Performance Based Payments - Cautions Before Using

This week we've been discussing the new DoD rule regarding performance-based payments (PBPs). We want to wrap up this series with a few miscellaneous comments and observations.

1. PBPs are limited to the lesser of values assigned to PBP events or total costs incurred to date (not to exceed 90 percent of the contract price). That means that PBPs can never include profit. Profit comes when contractors deliver the product.

2. Some contractors will not benefit from PBPs and should continue to use traditional progress payment forms of financing. Contractor efficiency will not be rewarded. Coming in under budget still nets a contractor only its incurred costs. Contractors that understate the value of an event, i.e. they overrun the cost associated with that event, are limited to reimbursement equal to the value of that event. Those contractors cannot recoup their actual costs.

3. The effort involved in establishing and agreeing to PBPs will be significant. The steps include:

• Identifying the PBP events
• Establishing completion criteria for each PBP event
• Obtain and evaluate the contractor's expenditure profile
• Establish PBP event values

4. From the PBP users guide, the Government's intention is to avoid any PBP scenario that would become equivalent to advance payments:

It is important to remember that the fundamental purpose of all contract financing is to assist the contractor in the paying the cost it incurs in the performance of the contract and, per FAR 32.1004(b)(2)(i), to do so “only to the extent actually needed for prompt and efficient performance.” Clearly the contractor can never have a “need” for more than its actual cost incurred at any point in time.

FAR 32.1004(b)(3)(ii) states that the contracting officer must ensure that PBPs “are not expected to result in an unreasonably low or negative level of contractor investment in the contract.” FAR does not define “unreasonably low” level of contractor investment, but it is clear that PBPs are not intended to result in the Government funding all contract costs as they are incurred throughout the contract. The prohibition against “negative level” of contractor investment means that PBPs must not be structured in such a way as to become equivalent to advance payments.

5. Contractors contemplating PBPs should be very careful to weight the potential advantages of higher levels of funding (100 percent vs 80 percent for progress payments) with the cost of foregoing some of their negotiated profit. The higher funding level is only a potential benefit and depends upon the accuracy of subjective elements. The lesser profit amount is certain.

6. Contractors contemplating PBPs should download and study the DoD User's Guide.

7. Contractors contemplating PBPs should not expect to encounter reduced Government oversight as compared to the use of progress payments. The adequacy of the accounting system is paramount under both types of financing arrangements. Under progress payments however, contractors have the added obligation to accurately estimate cost to complete.

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.

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"

Performance Based Payments - The Government will Extract Consideration from Contractors

The idea behind performance-based payments is to improve a contractor's cash flow - to provide contractors a mechanism to obtain more "interim" financing than that afforded by the traditional progress payment rules. In exchange for this "improved cash flow" however, the Government expects some consideration from the contractor. Usually this consideration means a reduction in the negotiated profit percentage. Whether that makes sense from a contractor's perspective will depend upon many factors including how badly the company needs cash. The Government thinks this can be a win-win situation - the Government gets a lower price and the contractor has to borrow less for its working capital needs. For contractors that have no debt, the attractiveness of performance-based payments loses some of its allure.

Historically, one of the attractive features of performance-based payments is that payments are not based on incurred cost but on established milestones. This created the ridiculous situation where contractors established milestones that did not reasonably correspond to the spend rate and some contractors were receiving most of the contract price well before anything was ready for delivery. That is changing. There is a requirement in the new regulations that prevent performance-based payments from exceeding incurred costs (that is why an adequate accounting system is necessary). In fact, with each performance-based payment request, the contractor must provide the following information.

• Negotiated value of all previously completed performance-based payment events
• Negotiated value of the current performance-based payment event
• Cumulative negotiated value of performance-based payment event completed to date
• Total costs incurred to date
• Cumulative amount of payments previously requested
• Payment amount requested for the current performance-based payment event (not to exceed total costs incurred to date).

Prior to using performance-based payments, the contracting officer must agree with the offeror on price using customary progress payments before negotiation begins on the use of performance-based payments. Then, the contracting officer must analyze the performance-based payment (PBP) schedule using the PBP analysis tool on DoD's website. We'll be saying more about this analysis tool later in this series but you can read about it and download it at this link.

To use the PBP analaysis tool, the contracting officer needs information from the contractor. The contracting officer will request the contractor to prepare a proposed PBP schedule that includes all performance-based payments events, completion criteria and event values along with the projected expenditure profile in order to negotiate the value of the performance events.

Then, the contracting officer must negotiate the consideration to be received by the Government if the performance-based payments payment schedule will be more favorable to the contractor than customary progress payments. The contracting officer is required to document in the contract file that the performance-based payment schedule provides a mutually beneficial settlement position that reflects adequate consideration to the Government for the improved contractor cash flow.

Performance Based Payments - Final Rule Published

DoD published a final rule in its FAR Supplement (DFARS) today that provides detailed guidance and instructions on the use of the performance-based payments analysis tool. Performance-based payments have been around for a long time but this new "tool" is a cash-flow analysis model for evaluating alternative financing arrangements. It is also required to be used by all contracting officers contemplating the use of performance-based payments on new fixed-price type contracts.

We're going to take a few days to look at this new rule in depth. Contractors who rely on contract financing through performance-based payments need to understand these new rules and to be able to position themselves to maximize their performance-based progress payment entitlements.

The very first thing to note is that an adequate accounting system is a paramont for obtaining performance-based payments. Contractors that do not have an adequate accounting system will not qualify. An inadequate accounting system is a show-stopper. DoD explains it this way:

FAR 32.1007(c) requires the contracting officer to determine the adequacy of controls established by the contractor for the administration of performance-based payments. Since the contractor will be required to report total cost incurred to date based on its existing accounting system, the contracting officer must consider the adequacy of the contractor's accounting system for providing reliable cost data. DFARS 232.1003-70, Criteria for use, is added to require contracting officers to consider the adequacy of an offeror's or contractor's accounting system prior to agreeing to use performance-based payments.

Contracting officers, before agreeing to any performance-based payments, will need to assure themselves that the contractor's (or offeror's) accounting system is adequate for providing reliable cost-data. They may use someone from their organization to do this or they might ask for assistance from DCMA (Defense Contract Management Agency) or DCAA (Defense Contract Audit Agency). Where possible, the Government will rely on information already in their files to make that assessment. But where no recent relevant oversight has been performed, contractors (offerors) can expect some level of inquiry and analysis of their accounting system.

To view the attributes that make up an adequate accounting system, see this posting.