Matching Contract type to contract risk.pdf - CPRG_Vol4 Page 1 of 184 1.0 Chapter Introduction When used in this chapter the terms\"contract type

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Unformatted text preview: CPRG_Vol4 05-04-2018 Page 1 of 184 1.0 Chapter Introduction When used in this chapter, the terms "contract type" and "type of contract" refer to the contract compensation arrangement. The contract compensation arrangement is the method of determining the dollars due to the contractor under the contract. In this chapter, you will learn about the development and application of common compensation arrangements: 1.1 Matching Contract Type To Contract Risk Points to Consider (FAR 16.103 ( )). Contract type selection is the principal method of allocating cost risk between the Government and the contractor. There is no single contract type that is right for every contracting situation. Selection must be made on a case-by-case basis considering contract risk, incentives for contractor performance, and other factors such as the adequacy of the contractor's accounting system. Your objective should be to select a contract type that will result in reasonable contractor risk with the greatest incentive for efficient and economical contract performance. Selecting the proper contract type will make the work more attractive to more potential offerors, thereby increasing competition. As you match contract type to contract risk, consider the following: • • • • • • • Identify available contract types; Consider acquisition method; Consider commerciality of the requirement; Consider cost risk associated with the contract action; Consider appropriate performance incentives; Consider the accounting system adequacy; and Document the selection decision. Identify Available Contract Types. The table on the following pages compares the most common type of contract arrangements. Most of those arrangements fit into two general categories fixed-price and cost-reimbursement, but labor-hour and time-andmaterials contracts have characteristics of both: • Fixed-Price (FAR Subpart 16.2 ( )).Under a fixed-price contract, the contractor agrees to deliver the product or service required at a price not in excess of the agreed-to maximum. Fixed-price contracts should be used when the contract risk is relatively low, or defined within acceptable limits, and the contractor and the Government can reasonably agree on a maximum price. Contract types in this category include: ◦ Firm fixed-price (FFP) ◦ Fixed-price economic price adjustment (FPEPA) ◦ Fixed-price award-fee (FPAF) ◦ Fixed-price incentive firm (FPIF) ◦ Fixed-price incentive with successive targets (FPIS) ◦ Fixed-price contract with prospective price redetermination (FPRP) ◦ Fixed-ceiling-price contract with retroactive price redetermination (FPRR) ◦ Firm fixed-price level of effort term contract (FFPLOE) • Cost-Reimbursement (FAR Subpart 16.3 ( )).Under a cost-reimbursement contract, the contractor agrees to provide its best effort to complete the required contract effort. Costreimbursement contracts provide for payment of allowable incurred costs, to the extent prescribed in the contract. These contracts include an estimate of total cost for the purpose of obligating funds and establishing a ceiling that the contractor cannot exceed (except at its own risk) without the approval of the contracting officer. Contract types in this category include: ◦ Cost (CR) ◦ Cost-sharing (CS) ◦ Cost-plus-fixed-fee (CPFF) ◦ Cost-plus-award-fee (CPAF) ◦ Cost-plus-incentive-fee (CPIF) • Labor-Hour and Time-and-Materials (FAR Subpart 16.6 ( )). There are two other types of contract compensation arrangements that do not completely fit the mold of either fixed-price or cost-reimbursement contracts. Labor-hour and timeand-materials contracts both include fixed labor rates but only estimates of the hours required to complete the contract. They are generally considered to most resemble cost-reimbursement contracts because they: ◦ Do not require the contractor to complete the required contract effort within an agreed-to maximum price; and ◦ Pay the contractor for actual hours worked. 3/12/2019 CPRG_Vol4 05-04-2018 Page 2 of 184 Comparison of Major Contract Types Principal Risk to be Mitigated Use When.. Firm Fixed-Price (FFP) Fixed-Price Economic Price Adjustment (FPEPA) None. Thus, the contractor assumes all cost risk. Unstable market prices for labor or material over the life of the contract. • The requirement is welldefined. • Contractors are experienced in meeting it. • Market conditions are stable. • Financial risks are otherwise insignificant. The market prices at risk are severable and significant. The risk stems from industry-wide contingencies beyond the contractor's control. The dollars at risk outweigh the administrative burdens of an FPEPA. A fixed-price, ceiling on upward Elements A firm fixed-price for each line item or one or more groupings of line items. Contractor is Obliged to: Provide an acceptable deliverable at the time, place and price specified in the contract. adjustment, and a formula for adjusting the price up or down based on: • Established prices. • Actual labor or material costs. • Labor or material indices. Provide an acceptable deliverable at the time and place specified in the contract at the adjusted price. Fixed-Price Incentive Firm (FPIF) Fixed-Price Fixed-Price Award-fee (FPAF) Risk that the user will Moderately uncertain not be fully satisfied because of contract labor or material requirements. judgmental acceptance criteria. A ceiling price can be established that covers the most probable risks inherent in the nature of the work. The proposed profit sharing formula would motivate the contractor to control costs to and meet other objectives. • • • • A ceiling price Target cost Target profit Delivery, quality, and/or other performance targets (optional) • Profit sharing formula Judgmental standards can be fairly applied by an Award-fee panel. The potential fee is large enough to both: • Provide a meaningful incentive. • Justify related administrative burdens. Prospective Redetermination (FPRP) Costs of performance after the first year because they cannot be estimated with confidence. The Government needs a firm commitment from the contractor to deliver the supplies or services during subsequent years. The dollars at risk outweigh the administrative burdens of an FPRP. • A firm fixedprice. • Standards for evaluating performance. • Procedures for calculating a fee based on performance against the standards Provide an acceptable deliverable at the time Perform at the time, and place specified in place, and the price the contract at or fixed in the contract. below the ceiling price. • Fixed-price for the first period. • Proposed subsequent periods (at least 12 months apart). • Timetable for pricing the next period(s). Provide acceptable deliverables at the time and place specified in the contract at the price established for each period. 3/12/2019 CPRG_Vol4 05-04-2018 Contractor Incentive (other than maximizing goodwill) 1 Typical Application Page 3 of 184 Generally realizes an additional dollar of profit for every dollar that costs are reduced. Generally realizes an additional dollar of profit for every dollar that costs are reduced. Commercial supplies and services. Long-term contracts for commercial supplies during a period of high Realizes a higher profit by completing the work below the ceiling price and/or by meeting objective performance targets. Generally realizes an additional dollar of profit for every dollar that costs are reduced; earns an additional fee for satisfying the performance standards. For the period of performance, realizes an additional dollar of profit for every dollar that costs are reduced. Production of a major system based on a prototype Performance-based service contracts. Long-term production of spare parts for a major system. inflation 1 Principal Limitations in FAR Parts 16, 32, 35, and 52 Generally NOT appropriate for R&D. Variants Firm Fixed-price Level of Effort. Must be justified. Must be justified. Must be negotiated. Contractor must have an adequate Must be negotiated. accounting system. Cost data must support targets. MUST be negotiated. Contractor must have an adequate accounting system that supports the pricing periods. Prompt redeterminations. Retroactive Redetermination Successive Targets Goodwill is the value of the name, reputation, location, and intangible assets of the firm. Comparison of Major Contract Types Cost-Plus IncentiveFee (CPIF) Cost-Plus Cost-Plus Cost or Award-Fee Fixed-Fee Cost- Sharing (CPAF) (CPFF) (C or CS) Time & Materials (T&M) Principal Risk to be Mitigated Highly uncertain and speculative labor hours, labor mix, and/or material requirements (and other things) necessary to perform the contract. The Government assumes the risks inherent in the contract -benefiting if the actual cost is lower than the expected cost-losing if the work cannot be completed within the expected cost of performance. Use When.. An objective relationship can be established between the fee and such measures of performance as actual costs, delivery dates, performance benchmarks, and the like. Objective incentive targets are not feasible for critical aspects of performance. Judgmental standards can be fairly applied.1 Potential fee would provide a meaningful incentive. Relating fee to performance (e.g., to actual costs) would be unworkable or of marginal utility. • The contractor expects substantial compensating benefits for absorbing part of the costs and/or foregoing fee or • The vendor is a non-profit entity No other type of contract is suitable (e.g., because costs are too low to justify an audit of the contractor's indirect expenses). 3/12/2019 CPRG_Vol4 05-04-2018 • Target cost • Performance targets (optional) • A minimum, maximum, and target fee • A formula for adjusting fee based on actual costs and/or performance Page 4 of 184 • Target cost • Standards for evaluating performance • A base and maximum fee • Procedures for adjusting fee, based on performance against the standards • Target cost • If CS, an agreement on the Government's share of the cost. • No fee • A ceiling price • A per-hour labor rate that also covers overhead and profit • Provisions for reimbursing direct material costs Contractor is Obliged to: Make a good faith effort to meet the Government's needs within the estimated cost in the Schedule. Make a good faith effort to meet the Government's needs within the ceiling price. Contractor Incentive (other than maximizing goodwill)1 Realizes a higher fee by completing the work at a lower cost and/or by meeting other objective performance targets. Typical Application Research and development of the prototype for a major system. Elements Principal Limitations in FAR Parts 16, 32, 35, and 52 Variants • Target cost • Fixed fee Realizes a higher fee by meeting judgmental performance standards. Realizes a higher rate of return (i.e., fee divided by total cost) as total cost decreases. If CS, shares in the cost of providing a deliverable of mutual benefit Large scale research study. Research study Joint research with educational institutions. The contractor must have an adequate accounting system. The Government must exercise surveillance during performance to ensure use of efficient methods and cost controls. Must be negotiated. Must be justified. Statutory and regulatory limits on the fees that may be negotiated. Must include the applicable Limitation of Cost clause at FAR 52.232-20 through 23. Completion or Term. Emergency repairs to heating plants and aircraft engines. Labor rates must be negotiated. MUST be justified. The Government MUST exercise appropriate surveillance to ensure efficient performance. Labor Hour (LH) Consider Acquisition Method (FAR 14.104 ( ) and FAR 16.102 ( ),). The acquisition method selected for a particular acquisition may limit the available choice of contract type: • Simplified Acquisition. When using simplified acquisition procedures purchase orders are normally firm fixed-price. You may use an unpriced order in certain situations when it is impossible to obtain firm pricing prior to issuing the purchase order. Whenever you use an unpriced order, the order must include a dollar limit on the Government's obligation and the contracting officer must follow-up to assure timely pricing. • Sealed Bidding. When using sealed bidding procedures: ◦ You will normally use a firm fixed-price contract. ◦ You may use a fixed-price contract with economic price adjustment if the contracting officer determines (in writing) what type of contract is necessary to protect the contractor and the Government against significant fluctuations in labor or material costs or to provide for contract price adjustments in the event of changes in the contractor's established prices. ◦ You must not use any other contract type. • Negotiation. When using the negotiation procedures prescribed in FAR Part 15: ◦ You may use any contract type or combination of contract types that will promote the best interests of the Government, as long as you meet the specific limitations in FAR Part 16. ◦ You must not use any contract type not prescribed in the FAR unless authorized by agency regulation or a FAR deviation. 3/12/2019 CPRG_Vol4 05-04-2018 Page 5 of 184 Consider Commerciality of the Requirement (FAR 12.207 ( )). When acquiring a commercial item: • You normally should use a firm fixed-price contract. • You may use a fixed-price contract with economic price adjustment if the contracting officer determines (in writing) what type of contract is necessary to protect the contractor and the Government against significant fluctuations in labor or material costs or to provide for contract price adjustments in the event of changes in the contractor's established prices. • You must not use any other contract type in acquiring commercial items. Consider Cost Risk . Encourage contractors to accept reasonable cost risks of contract performance. However, requiring contractors to accept unknown or uncontrollable cost risk can endanger contract performance, substantially reduce competition, and/or substantially increase contract price. To realistically choose the proper contract type to meet a specific contract situation, you must consider the proper allocation of cost risk. Cost estimates, whether they are the offeror's proposed or the Government's recommended, are point estimates. In all contracts involving forward pricing, the point estimate is a projection of what the estimator believes is most likely to happen. Since things rarely happen exactly as predicted, there is usually some variation between projected and actual cost. The greater the potential variability between the projected and actual cost, the greater the cost risk. 3/12/2019 CPRG_Vol4 05-04-2018 Page 6 of 184 Quantitative analysis techniques can provide invaluable information about the distribution of values around the most likely future cost. For example, consider the confidence interval when your estimate is based on sampling analysis and the prediction interval when your estimate is based on regression analysis. However, use this information wisely. If the variance is large, attempt to determine why the interval is so large and what can be done to narrow it, before you select a contract type to share the risk. As a minimum, your appraisal of cost risk should consider two areas of particular concern, contract performance risk and market risk. • Performance Risk. Most contract cost risk is related to contract requirements and the uncertainty surrounding contract performance. The lower the uncertainty the lower the risk. Therefore, your appraisal of cost risk should begin with an appraisal of performance risk. For larger more complex contracts, you will likely need assistance from other members of the Government Acquisition Team (e.g., representatives from the requiring activity, engineering staff, contracting, and program/project management). ◦ Areas that you consider should include: ◦ Stability and clarity of the contract specifications or statement of work; ◦ Type and complexity of the item or service being purchased; ◦ Availability of historical pricing data; ◦ Prior experience in providing required supplies or services; ◦ Urgency of the requirement; ◦ Contractor technical capability and financial responsibility; and ◦ Extent and nature of proposed subcontracting. ◦ The figure below depicts what happens as the contract requirement becomes better defined. COST RISK AND CONTRACT TYPE Cost Risk High Requirement Definition Vague _________________________________________________ ________________________________ Low Well-defined 3/12/2019 CPRG_Vol4 05-04-2018 Page 7 of 184 Production Stages Concept Studies & Basic Research Exploratory Development Test/ Demonstration Full-scale Development Full Production Follow-on Production Contract Type Varied CPFF CPIF, FPIF CPIF, FPIF, or FFP FFP, FPIF, or FPEPA FFP, FPIF, or FPEPA • Performance risk should be reduced from a high to a relatively low level, as the requirement progresses from vague to welldefined and experience with the product increases. ◦ Research and development contracts generally have a rather high performance risk. This is due to the factor of illdefined requirements that arise from the necessity to deal beyond, or at least very near, the upper limits of current technology (i.e., "the state of the art"). ◦ Follow-on production contracts generally have a relatively low performance risk. Requirements are well known, there is a cost history to draw on, contractors have experience producing the product, etc. • As performance risk changes, so should contract type. Note that cost-reimbursement, time & materials, or labor-hour contracts are generally associated with higher-risk requirements and fixed-price contracts are generally associated with lowerrisk requirements. • Market Risk. Changes in the marketplace will also affect contract costs. Preferred acquisition practice calls for forward pricing of contract efforts, because forward pricing provides a baseline which you and the contractor can use to measure cost or price performance against contract effort. ◦ Forward pricing requires the contracting parties to make assumptions about future changes in the marketplace. A volatile market will increase the cost risk involved in contract pricing, particularly when the contract period will extend several years. What will material and labor cost two years from now? Will material shortages occur two years from now? In cases where these unknown costs are significant, contract period risk becomes an important consideration in selection of contract type. ◦ Fixed-price contracts with economic price adjustment, for example, are designed specifically to reduce this risk for contractors. Consider Appropriate Performance Incentives (FAR 16.103(b) ( )). Select the contract type (or combination of types) that will appropriately motivate contract performance. • When the risk involved is minimal or can be predicted with an acceptable degree of certainty, use a firm fixed-price contract, because it best utilizes profit to motivate efficient contract performance and cost control. • When there is no reasonable basis for firm pricing, consider other contract types. Using a firm fixed-price contract may limit competition, encourage inflated contract pricing, and efforts to control costs may actually hamper effective contract performance. Consider Accounting System Adequacy (FAR 16.104(h) ( )). Before agreeing on a contract type other than firm fixed-price, you must ensure that the contractor's accounting system will permit timely development of all necessary cost data in the form required for the proposed contract type. A careful account system review is particularly important when the contractor's only experience has been with firm fixed-price contracts. Document the Selection Decision (FAR 16.103(d) ( )). Assure that the contract file contains documentation showing why the particular contract type was selected, unless you are: • Making a fixed-price acquisit...
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