incentive contracts
DESCRIPTION
INCENTIVE CONTRACTS David Dudley (ESC Pricing Chief) Paul Hovsepian (Raytheon VP, Contracts). Incentive Contracts. Changing Environment Incentivizing Acquisition Outcomes Understanding CPIF & FPIF Incentive Structures in Negotiations. Changing Environment. December 2005, GAO Report - PowerPoint PPT PresentationTRANSCRIPT
INCENTIVE CONTRACTS
David Dudley (ESC Pricing Chief) Paul Hovsepian (Raytheon VP, Contracts)
Incentive Contracts
Changing Environment
Incentivizing Acquisition Outcomes
Understanding CPIF & FPIF
Incentive Structures in Negotiations
Changing Environment
December 2005, GAO Report• “DOD Has Paid Billions in Award and Incentive Fees
Regardless of Acquisition Outcomes”
2007 National Defense Authorization Act (Sec 814)• “…award fees link such fees to acquisition outcomes (which
shall be defined in terms of program cost, schedule, and performance)”
• “…no award fee may be paid for contractor performance that is judged to be below satisfactory performance or performance that does not meet the basic requirements of the contract”
Changing Environment
April 2007, OSD AT&L Memo• “It is the policy of the Department that objective criteria will be
utilized, whenever possible, to measure contract performance”
2009 National Defense Authorization Act (Sec 867)• Substantially similar language as 2007 NDAA
Changing Environment
Award fee contracts (CPAF) became a popular contract type for efforts where Firm Fixed Price (FFP) was not suitable. CPAF provided a mechanism to incentivize many areas of performance – subjective and objective.
Traditional incentive contracts (CPIF / FPIF) have been used infrequently for many years.
Transitioning to IF Contracts
The transition from CPAF to CPIF and FPIF has been difficult for many.
How can the Government incentivize acquisition outcomes previously incentivized through the use of Award Fees?
Incentivizing Acquisition Outcomes
Gov’t program teams must decide on the behaviors they wish to motivate and incentivize contractors accordingly.
• Cost, Schedule, Technical Performance, etc.
These should be clearly defined, objective criteria (i.e. easy to evaluate) that meet or exceed the requirement.
Motivating Contractors
A contractor wants to put a quality product in the warfighter’s hands at a fair and reasonable price.
A contractor wants to satisfy their customer.• The acquisition office
Good past performance ratings are important Ability to meet schedule is critical
Contract Types
The contractor’s goal is to meet the requirements as efficiently and quickly as possible.
Cost and schedule often have a direct correlation• Programs that finish ahead of schedule are often under
budget and vice versa
Multiple IncentivesProceed with Caution
Competing incentives and contractor behavior
• Competing incentives often force trade-offs to maximize incentive $ earned
• The contractor and the Government may not agree on the priority/importance of incentives
“All or Nothing” Incentives
“All or Nothing” incentives are powerful but can also have unintended consequences. If incentive becomes unattainable, all motivation for contractor is lost.
Instead consider a tiered/scaled approach.
“All or Nothing” Incentives
“All or Nothing” never makes sense for a cost incentive.
Example: Contractor earns $1,000,000 incentive if he completes effort at or
below a certain cost The best financial outcome for the Govt is if the contractor misses
the incentive by 1 dollar. (Govt pays $999,999 less)
Govt should never establish an incentive where it is not in Govt’s best interest for contractor to earn the entire incentive (i.e. rooting against the contractor)
Incentives
How does CPIF and FPIF work?
How and when are contractor’s are motivated in the IF environment?
Why do contractor’s like IF contracts?
Cost Incentive Graphs
Graphing Cost Incentives is critical in understanding how they work.
Graph becomes very important when comparing alternatives and offers and provide insight into the contractor’s thought process.
CPIFReview
Target Cost: The anticipated cost of the effort Target Fee: The fee earned if the final cost equals the
Target Cost Share Ratio: The share of each dollar of overrun or
underrun borne by the Gov’t/Contractor ratio Min/Max Fee: The min or max fee the contractor
receives regardless of the amount of cost overrun (min fee) or underrun (max fee)
Range of Incentive Effectiveness: Area under the curve where the contractor is most incentivized
Target Cost $100.00
Target Fee 9.00 (9.0%)
Target Cost & Fee $109.00
Minimum Fee $ 4.00
Maximum Fee $ 14.00
Share Ratio:
Over 80 /20
Under 80 / 20 Target C
ost
Target Fee 80 / 20 (over)
80 / 20 (under)
Max Fee
Min Fee
100 / 0
100 / 0
Target Cost $100.00
Target Fee 9.00 (9.0%)
Target Cost & Fee $109.00
Minimum Fee $ 4.00
Maximum Fee $ 14.00
Share Ratio:
Over 80 /20
Under 80 / 20
80 / 20 (over)
80 / 20 (under)
Max Fee
Min Fee
100 / 0
100 / 0
Target Cost $100.00
Target Fee 9.00 (9.0%)
Target Cost & Fee $109.00
Minimum Fee $ 4.00
Maximum Fee $ 14.00
Share Ratio:
Over 80 /20
Under 80 / 20
80 / 20 (over)
80 / 20 (under)
Max Fee
Min Fee
100 / 0
100 / 0
FPIFReview
Target Cost: The anticipated cost of the effort Target Profit: The profit earned if the final cost
equals the Target Cost Ceiling Price: The max amount the Gov’t is obligated
to pay the contractor Share Ratio: Same as CPIF Point of Total Assumption: The point on the cost
overrun share line where cost plus profit equals Ceiling Price – share line becomes 0/100
Target Cost $100.00
Target Profit 12.00 (12.0%)
Target Price $112.00
Ceiling Price $130.00 (130%)
Share Ratio:
Over 70 / 30
Under 70 / 30
Target C
ost
Target Profit
PTA
0/100
70 / 30 (under)
70 / 30 (over)
Cost Incentive Geometry
Cost Incentives are not one-size-fits-all• Each element of cost incentive structure is important• Don’t just focus on Target Cost & Target Fee or Profit
The geometry (Share Lines, Min & Max Fees, Ceiling Price) is what creates the incentive
The geometry can be a powerful tool in the reaching settlement
Incentive Geometry FPIF
A B C
Target Cost $100.0M $94.0M $112.0M
Target Profit 12.0M 12.0% 13.8M 16.7% 8.4M 7.5%
Target Price $112.0M $107.8M $120.4M
Ceiling Price $130.0M 130% $130.0M 138% $130.0M 116%
Share Ratio
Over 70 / 30 70 / 30 70 / 30
Under 70 / 30 70 / 30 70 / 30
Financially, which offer is the best for the Govt?
FPIF GRAPHAlternative Offer Analysis
0
2
4
6
8
10
12
14
16
18
20
22
24
70 73 76 79 82 85 88 91 94 97 100
103
106
109
112
115
118
121
124
127
130
Cost
Pro
fit
Target Cost $100.00
Target Profit 12.00 (12.0%)
Target Price $112.00
Ceiling Price $130.00 (130%)
Share Ratio:
Over 70 / 30
Under 70 / 30
Target C
ost
Target Profit
0/100
70 / 30 (under)
70 / 30 (over)
All three offers are financially identical
Offeror B
Offeror A
Offeror C
Incentive Geometry Understanding Share Lines
Any point along the same share line is financially equal as long as:
• CPIF: Min & Max Fee $ are held constant
• FPIF: Ceiling Price $ are held constant
Incentive Structures In Negotiations
Alternative Settlement Offers:
Which would Contractor choose?
Offer A Offer BTarget Cost $10.00M $9.50M
Target Profit 1.00M 10% 1.14M 12%
Target Price $11.00M $10.64M
Ceiling Price $12.50M 125% $12.83M 135%
Share Ratio
Over 70 / 30 80 / 20
Under 70 / 30 80 / 20
Answer: It depends
FPIF Alternative Offers($ Mil)
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.00
7.50
7.75
8.00
8.25
8.50
8.75
9.00
9.25
9.50
9.75
10.00
10.25
10.50
10.75
11.00
11.25
11.50
11.75
12.00
12.25
12.50
Cost
Pro
fit
Offer A Offer B
Offer A Offer B
Target Cost $10.00 $ 9.50
Target Profit 1.00 (10%) 1.14 (12%)
Target Price $11.00 $10.64
Ceiling Price $12.50 (125%) $12.83 (135%)
Share Ratio:
Over 70 / 30 80 / 20
Under 70 / 30 80 / 20
Target C
ost A
Target C
ost B
Target Profit A
Target Profit B
FPIF Alternative Offers($ Mil)
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.00
7.50
7.75
8.00
8.25
8.50
8.75
9.00
9.25
9.50
9.75
10.0
0
10.2
5
10.5
0
10.7
5
11.0
0
11.2
5
11.5
0
11.7
5
12.0
0
12.2
5
12.5
0
Cost
Pro
fit
Offer A Offer B
Offer A Offer B
Target Cost $10.00 $ 9.50
Target Profit 1.00 (10%) 1.14 (12%)
Target Price $11.00 $10.64
Ceiling Price $12.50 (125%) $12.83 (135%)
Share Ratio:
Over 70 / 30 80 / 20
Under 70 / 30 80 / 20
If Ktr expects final cost to be $9.5M or less he should
choose Offer A
If Ktr expects final cost to be more than $9.5M he should choose Offer B
Incentive GeometryIn Source Selection
Competition can drive overly aggressive incentive geometry
Government should seriously consider specifying incentive geometry in RFP (except Target Cost).
• Target Fee % / Profit %• Min & Max Fee % / Ceiling Price %• Share Ratios
Lessens risk of unrealistically: narrow RIE or low ceiling price
Summary
Select right contract type
Incentivize acquisition outcomes
Create arrangements that fairly reflect risk
Keep it as simple as possible