incentive contracts

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