You are on page 1of 125

THE GEORGE WASHINGTON UNIVERSITY LAW SCHOOL PUBLIC LAW AND LEGAL THEORY PAPER NO.

587 LEGAL STUDIES RESEARCH PAPER NO. 587

INCENTIVE CONTRACTING RALPH C. NASH, JR.


WITH A FOREWARD BY

VERN EDWARDS
Accepted Paper

GOVERNMENT CONTRACTS MONOGRAPH SERIES (GWU 1963)

This paper can be downloaded free of charge from the Social Science Research Network at

http://ssrn.com/abstract=1928629

Electronic copy available at: http://ssrn.com/abstract=1928629

FOREWARD
Throughoutthe20thCenturyandcontinuingintothe21st,Governmentfederalagencies

haveusedincentiveprovisionsincertainoftheircontractsinordertomotivate (incentivize)contractors.Today,FederalAcquisitionRegulation(FAR)Subpart16.4, IncentiveContracts,describesfivetypesofincentivecontracts.Thefivetypesfallinto twobroadcategories:(a)thepredetermined,formulatypeincentivesand(b)theaward feeincentives.TherearethreepredeterminedformulatypeincentivesFixedPrice Incentive(FirmTarget),FPI(F);FixedPriceIncentive(SuccessiveTargets),FPI(S);and CostPlusIncentiveFee,CPIF.TheCPIFwasusedbytheU.S.Navyforshipbuildingasearly asWorldWarI,andtheFPI(F)hasbeeninusebythemilitaryservicessinceWorldWarII. Suchincentiveswereusedthroughoutthe1950s.Theiressentialfeatureshavechanged littleinallthattime. Themoderneraofincentivecontractingbeganin1962,whenSecretaryofDefense

RobertS.McNamaraorderedthemilitaryservicestouseincentivecontractsinsteadof costplusfixedfeecontractswheneverpracticable,andtheArmedServicesProcurement Regulation,predecessortotheFAR,waschangedin1962toputthenewpolicyintoeffect. Incentivecontractsarecomplicated,thusin1962theDepartmentofDefenseandthe NationalAeronauticsandSpaceAdministrationpublishedthefirsteditionoftheirfamous INCENTIVECONTRACTINGGUIDE.Officialpublicationswerehardtocomebyinthosedays beforefreelyavailablecopyingmachinesandtheinternet.Thankfully,in1963Professor RalphC.Nash,Jr.ofTheGeorgeWashingtonUniversityLawSchoolpublished,INCENTIVE CONTRACTING,GOVERNMENTCONTRACTSMONOGRAPHNO.7,whichwasthefirstandmost

Electronic copy available at: http://ssrn.com/abstract=1928629

comprehensiveguidetoincentivecontractingavailabletothoseunabletogetacopyofthe officialDODandNASAguide.At$5.00percopy,itwaswortheverypenny. Thelast(1969)editionoftheDOD/NASAIncentiveContractingGuideisstillwidely

availableontheinternetandisanessentialreferenceforallwhomustnegotiateand administerincentivecontracts.ProfessorNashsvaluablemonographwentoutofprint longago,butthegoodnewsisthatthankstoProfessorStevenSchooneroftheGWULaw School,itisbeingrepublishedinitsoriginalformandmadefreelyavailableonline.Thisis welcomenews,becausetheDepartmentofDefensehasdirectedthemilitaryservicestouse FPI(F)contractsinsteadofcostreimbursementcontractswhenitmakessensetodoso, andwecanexpectasurgeintheiruseinthenearfuture.TheFPI(F)contractisthemost complexofallofthestandardpricingarrangementsdescribedinFARPart16,Typesof Contracts,andthepeoplewhowillhavetonegotiateandadministerthemaregoingto needalloftheguidancethattheycanget. Thethreepredeterminedformulatypeincentivesmakecontractorprofitadependent

variableofanyoneorsomecombinationofthreeindependentvariables:(1)incurred allowablecost,(2)timetodelivery,and(3)productorservicetechnicalperformance.The partiescantieprofittoincurredcostalone,ortoacombinationofcost,delivery,and technicalperformance.Theincentivesarepredeterminedbecausethepartiesagreein advanceonamethodofdeterminingtheprofitoutcomeforanycost,delivery,ortechnical performanceoutcomewithinspecifiedlimits.Theyareformulatypebecausethe independentvariablesincurredallowablecost,delivery,andtechnicalperformance aredefinedquantitativelyandprofitisamathematicalfunction.Thus,oncetheparties

Electronic copy available at: http://ssrn.com/abstract=1928629

havenegotiatedthetermsoftheincentive,theultimatepayofftothecontractorcanbe objectivelyforecasted. Exceptforafewreferencestooldregulations,ProfessorNashsmonographisjustas

usefultodayasitwasin1963.ThemostusefulpartsareChaptersIthroughV.Thematerial containedinthosechaptersispracticalguidanceabouthowtothinkabout,negotiate,and administerallthreeoftheformulatypeincentivearrangements,andthatguidance, especiallyconcerningincentivesoncost,isasuptodateasever.Moreover,asistypicalof allofProfessorNashsworks,itisstraightforwardeasytounderstand. ChapterIbrieflyprovidessometheoreticalandhistoricalbackground.ChapterII thengoesintoconsiderabledetailabouthowtoplanandnegotiatecostincentive arrangementsandcontainsthemostusefulmaterialformostreaders.Thisisacritically importanttopicifweassumethatthepartiesareseriousabouttryingtoestablishan incentivestructure,orgeometry,tousethecurrentlypopularterm.ProfessorNashs emphasisisonsoundcostestimating,thoughtfuluncertaintyandriskanalysis,andfair pricenegotiation.Thisisincontrasttotheoftenunfortunateapproachofusingrulesof thumb,suchasa5050sharelineand120percentceilingprice.Theauthorassumesthat thepartieswanttothinkthingsthrough,ratherthanjustgetthemoverwithandgeton withthejob. ChapterIIIaddressestheplanningandnegotiationofincentivesondeliveryand performance.FARPart16requiresthatanyincentiveondeliveryand/orperformance mustbeaccompaniedbyanincentiveoncost.Multipleincentivecontractsarethemost complexofallandareverydifficulttoplan,negotiate,andadminister.Thatisbecausethe

costincentiveandthedeliveryand/orperformanceincentiveareofteninconflict.The contractorhastodecidetospendmoreinordertoacceleratedeliveryorimprovetechnical performanceorforegothosebenefitsinordertosavemoney.Thepotentialeffectofthat conflictonprofitmeansthatthepartiesmustmaketradeoffdecisionsduringplanningand negotiationandduringperformance.Thechallengeforthepartiesistonegotiatea structurethatworksfairlyforboth.Theconsequencesofcost/delivery/performance tradeoffscanbedifficulttoanticipatewithoutthoroughanalysisandperhapsevensome advancedmathematics.Itwasforthatreasonthatenthusiasmforpredetermined,formula typemultipleincentivearrangementscooledconsiderablyinthelatterpartofthe1960s andearly1970sandhasneverbeenfullyrekindled.Predeterminedformulatypemultiple incentiveswereeffectivelyreplacedbythesubjectiveawardfeeincentive.However,severe criticismbytheGovernmentAccountabilityOfficeofDODsuseofawardfeeincentive arrangementsduringthe1990sandtheearlypartofthenewcenturycausedthemtofall outofafavor,atleastwithinDOD.Anyattempttoestablishapredeterminedformulatype multipleincentivecontractmustapproachedwithgreatcare,andProfessorNashs monographisagreatstartingplaceforguidanceandthinkinginthatregard. InChapterIV,ProfessorNashaddressestheallimportantquestionofwhenitisit appropriatetouseanincentive.Althoughsomeofthismaterialiscouchedintermsofnow expiredregulations,theexpositionthatbeginswiththesectionentitled,CriteriaforUseof Incentivesandthatcontinuestotheendofthechapterismustreading.Alotofdecision makingabouttheuseofanincentiveistheresultofmanagerialfiatanincentiveisused becauseitiseasiertodothatthantoexplaintomanagementwhyyoudonotwantto,or becauseofsomeruleofthumbaboutriskplusorminusXdegreeofcostuncertainty.

Incentivesmakelifemorecomplicatedandthebenefitsarenotalwaysworththetrouble. Thus,thedecisiontouseoneshouldbemadethoughtfullyandcarefully. Finally,ChapterVisoneonthemostinterestingpartsofthemonograph,becauseit addressesthepotentialcostimpactofcertaincontractclausesincludingwarranty, inspection,changes,limitationofcost,andterminationclausesontheadministrationof theincentive.Thereisalmostnoguidanceanywhereabouttheadministrationofincentive contracts.ProfessorNashraisesquestionsabouthowcertainclausescouldaffectthe incentiveswhentheyresultinincreasesorreductionsinperformancecost.Hedoesnotgo intogreatdepth,buthehighlightsissuesandconcerns.Thesearematterstoponderand thinkthrough,becauseifthepartieswereseriouswhentheystructuredtheirincentive, andbelievethatitcanandwillmotivatethecontractortoreducecosts,thenmaintenance ofincentiveeffectivenessisacrucialconsiderationwheneveraclauseaffectsperformance cost.Theymustthinkthrougheachandeverycostimpactinordertoavoidenervating distortionoftheoriginalformula. Thelasttwochaptersofthemonographhavenopracticalapplicationtodayandare mainlyofhistoricalinterest.TheRenegotiationActisnolongerwithus,thecostplus awardfeecontracthasbeenfullyexplicatedandhasfallenintodisgraceanddisusebythe DepartmentofDefense,andmoremodernrulesfortheevaluationandconsiderationof contractorperformancehavereplacedthesystemsoftheearly1960s. Aclosingcomment:Therehasbeenagreatdealofresearchaboutincentivecontracts

thathassoughttoanswerthequestion:Dotheywork?TheFPI(F)contractisthemost studiedofallofthecontracttypes.Theanswertothatquestionisthatrespectablecritics

havelongdoubtedtheeffectivenessofincentivecontracting.ResearchersfromHarvard, RandCorporation,andtheGovernmentAccountabilityOffice,andotherinstitutionswho haveanalyzedthedocumentedevidenceofincentivecontractoutcomeshavelongand consistentlydoubtedthegeneraleffectivenessoftheestablishedforms,butIknowofno seriousresearcherwhohasflatlysaidthattheydoordonotwork. Contractincentiveshaveanintuitiveappealandenthusiasmfortheminsome circleshasbeenfedbycountlessundocumentedclaimsofsuccess,includingsometalltales andphonysuccessstories.Enthusiasmforincentiveshaswaxedandwanedseveraltimes inthefivedecadessinceSecretaryofDefenseMcNamaralaunchedthemoderneraoftheir use.Interest,ifnotenthusiasm,isontheriseagain.Thatbeingthecase,ProfessorNashs treatiseisagoodstartingplaceforthosewithoutmuchexperienceinthisintriguing,if troublesomeanddubious,approachtocontractpricing. VernonJ.Edwards September2011

Government Contracts Monograph No. 7

Incentive Contracting
by

Ralph G. Nash

COPYRIGHT 1963 THE GEORGE WASHINGTON UNIVERSITY

CONTENTS I. Introduction
The Profit Motive History of Incentive Contracting Incentive Contracting and Risk

1
1 3 4

II.

Incentive on Cost
Elements of the Incentive Formula Target Cost Target Profit or Fee Ceiling Price Maximum and Minimum Fees Sharing Arrangement Negotiation of the Incentive Formula Analysis of Incentive Formulas Broad Range of Variation in Incentive Centracts

3
9 9 14 16 19 21 26 31 35

III.

Performance and Delivery Incentives


The Trade-off Analysis Choosing the Goals for Incentives Performance Goals Delivery Goals Interrelationship of Performance and Delivery Goals Determining the Target and Range for Incentive Application Spedal Problems in Performance Incentives Special Problems in Delivery Incentives Arriving at a Balanced Incentive Formula

39
39 41 42 45 46 47 50 52 54

IV.

Use of Incentive Contracts

62
62 63 66

Requirements of the Regulations Research and Development Procurements Manufacturing Procurements

Criteria for Use of Incentives 1. Firm Specifications 2. Ability to Estimate Costs 3. Management Ability of the Contractor 4. Management Freedom 5. Time Use of Performance and Delivery Incentives

<7 5 ^8 70 72 74 75 76

V.

Terms and Conditions


Warranty Clauses Inspection Clauses Changes Clauses Delays Limitation of Cost and Interim Funding Clauses Termination Clauses Other Terms and Conditions

SO
82 83 84 87 88 89 91

VI.

Renegotiation
Comparison of Renegotiation and Incentive Contracting Operation of Incentive Contracts under Renegotiation Judicial Review of Renegotiation

94
94, 96 98

VII.

Other Incentives
Program Incentives Value Engineering Cost Plus Award Fee Contracts Performance Rating Systems

101
101 104 106 111

FOREWORD
In the Fall of 1962 the Government Contracts Program at The George Washington University began offering a special two day course in Incentive Contracting. This course was given in response to the large need for training that resulted from the change in Department of Defense policy on types of contracts. To date, the course has been taken by approximately 400 people representing a diverse group of companies and numerous Government agencies. During the class discussions in this course, the students have identified numerous problems that have arisen through the use of incentive provisions. In the discussion of these problems, a great deal has been learned by all participantsincluding the instructor. This monograph is a direct result of those interesting course sessions in the fact that it attempts to identify and analyze these problems which the course discussions have raised. What can a monograph on incentive contracting accomplish? This question is best answered by first stating that it cannot provide complete guidance on when and how to use the incentive contract. The incentive contract is too complex and the underlying conditions for use are too diverse to allow this. In addition, real expertise in incentive contracting can only be achieved by working on these contracts on a daily basis. However, this monograph does attempt to describe some of the basic techniques that can be used in negotiating and administering incentive contracts. It also contains a discussion of the major considerations to be taken into account when deciding whether to use this type of contract. It also identifies a large number of problems that have arisen in the use of incentive contracts and raises numerous questions on various facets of the current Department of Defense policy as it is being applied at the present time. It is hoped that this type of analysis will aid the reader in understanding some of the more obscure aspects of the incentive contract. In this way, this monograph attempts to provide background information that can be used by the practitioner, in either the Government or industry, who must solve the problems of incentive contracting on a day-to-day basis. One point should be made with emphasis. The criticisms contained in this monograph, whether implicit or explicit, are meant to be constructive. The author is an advocate of incentive contracts and can cite a number of examples from his experience where the use of an incentive contract has worked to the benefit of both the Government and the

contractor. He is firmly convinced that the incentive contract, properly used, will encourage better performance by contractors and will also sharpen their management techniques thereby making them better able to compete for business in the future. Thus, the criticisms should not be construed to run to the basic concept of incentive contracting but only to the way that concept is being applied in practice. The concept of profit motivation and the use of incentives is here to stay. The intelligent contracting ofiicer or industry representative can not change this trendhe can only learn how to use it to the best advantage possible.

Chapter

INTRODUCTION
In March 1962 the Department of Defense issued a revision to the Armed Services Procurement Regulation placing much greater emphasis on the use of incentive contracts. ^ This revision did not create any new form of contract. However, it did restate the rules governing the selection of the proper type of contract to strictly limit the use of cost plus fixed fee and redeterminable fixed price contracts. Thus, the incentive contract was left as the major alternative to the firm fixed price contract in many contracting situations where it has had little use in the past. The result of these regulation changes has been a substantial increase in the use of incentive contracts in defense procurement^ and a large amount of general interest in the incentive contract as a vehicle for improved procurement. The purpose of this monograph is to analyze incentive contracting as it is being used at the present time, to discuss the techniques that can be used in formulating an incentive contract and to explore some of the unsolved problems inherent in the present incentive contract.

The Profit

Motive

The essence of the incentive contract is that it offers a contractor more profit i f he reduces costs or improves performance and less profit if costs increase or performance goals are not met. Hence, the increased use of this type of contract is a recognition by the Government that the profit motive offers an excellent means to induce contractors to perform their contracts efficiently. It is also a recognition that profit makes up a small percentage of the total cost which the Government incurs when it procures supplies or services; and, therefore, that any real reduction in
1 Revision 8 to the I960 Edition of the Armed Services Procurement Regulation (ASPR), 15 March 1962. The changes involved a complete rewriting of Section III, Part 4 of the ASPR which is presently available in a 1963 Edition. 2 See the statement of Thomas D . Morris, Asst. Sec. of Def. (I & L) before the Subcommittee on Government Operation, House of Representatives, May 23, 1963, 5 C C H 1963 Govt. Contracts Rep. 1[80,082 giving the following comparative statistics for the Department of Defense: Type of Contract 9 mos. F Y 1961 9 mos. F Y 1963 CPFF 38.0% 22.7% Finn fixed price 30.4% 41.3% Cost plus incentive fee 2.7% 10.7% Fixed Price incentive 9.7% 14.8% AU other 19.2% 10.5%

procurement costs can only be achieved in the cost area. Viewed in this way, incentive contracting is an offer to contractors to allow them to earn larger profits on Government work i f they can reduce costs or better performance goals. One essential point must be raised early in the discussion of incentive contracts. The incentive contract which is being used by the Department of Defense is a well defined type of contract that is directed toward the pro jit incentive in terms of the profit that is to be made in the performance of that specific contract alone. Thus, when the term "incentive contract" is used, it should not be thought that such a contract gives a contractor incentive in general, or that it brings into play many of the other types of incentives which operate in Government procurement. The "incentive" being referred to is only this limited incentive of profit on the specific contract in question. For instance, the contract does not bring into play the incentive to obtain additional future business or the incentive to assure future profits. Neither does it cover any incentive that may be present to increase profits on other contracts that are being performed at the same time. O f course, the non-profit incentives such as the desire to aid the national defense or desire to excel for the sake of excellence are not brought into play. This definition of the incentive contract is not intended as a criticism. The contract could not be expected to bring all of these other types of incentives into play. However, by thus delimiting the function of the incentive contract, its purpose can be better understood and its effectiveness can be evaluated with greater precision. It cannot be denied that these other incentives are present, and sometimes their presence may completely overweigh the presence of profit incentives in the contract being performed. For example, in the development contract situation, a contractor may be able to increase his profits under the incentive formula by reducing costs at the expense of performance; yet, he knows that if he takes this course of action he will design an inferior product reducing his chance of a follow-on contract to manufacture that product and creating ill-will in the Government which will reduce the possibility of the award of future development contracts. Here the profit-on-this-contract incentive conflicts with the future business-future profit incentive and it is not difficult to predict that the future profit incentive will prevail in most such cases. Thus, an incentive not provided for in the contract can easily override the contract incentive. One other basic point must be made about incentive contracts. The

incentive contract is entered into by negotiating a target or set of targets with the understanding that variations of actual performance from the targets will result in gains or losses of profit by the contractor. It can thus be argued that to the extent the targets are too high or too low, the contractor will obtain a windfall profit or a lower profit than the quality of performance would merit. The truth of this argument is so obvious that it cannot be refuted. However, this fact that windfall profits can result from incentive contracts should not be taken as a reason why incentive contracts should not be used.^ Even i f there is a built-in windfall profit in an incentive contract, the fact that the contractor shares in the costs under the contract gives a continuing incentive to reduce costs. Thus, once the contract is negotiated, the presence of the incentive formula provides a continuing incentive during performance of the contract as long as the contractor can see that additional profit can be earned by improved performance.

History of Incentive

Contracting

The principle of incentive contracting in Government procurement is not new. The firm fixed price contract has long been accepted as the best form of contract; and this contract is, of course, the ultimate incentive contract since the contractor accepts f u l l responsibility for all cost overruns. The only difference between the incentive contract and the firm fixed price contract is that in the use of the incentive contract the contractor takes a smaller share of the total cost responsibility. Thus, we find a W o r l d W a r I shipbuilding contract containing a 50/50 sharing arrangement on a cost plus incentive fee basis.* Even earlier, the first airplane manufacturing contract is found to contain a performance incentive provision providing a target speed of 40 mph and a target price of $25,000 with a sliding scale of payments based on actual airspeed of the plane. This contract had a very steep incentive with a price of $15,000 if the minimum airspeed of 36 mph was obtained and a price of $35,000 if the maximum airspeed of 44 mph was reached.^ Hence, incentive provisions have been used for many years.
^ 3 The House Armed Services Committee and the General Accounting Office have criticised incentive contracts because of their tendency toward "windfall" profits. See H . R. Rep. 1959, 86th Cong., 2nd Sess. 28-33 (I960). *See United States v. Bethlehem Steel Corp., 315 U . S. 289 (1942). It is interesting to note that this early contract contained incentive for cost reductions only. There was no sharing of cost overruns. 5 Contract between the Signal Corps, United States Army and the Wright Brothers signed Feb. 10, 1908.

Disregarding these early informal uses of incentive provisions, the first major use of incentive contracts on a formalized basis can be found in the aircraft industry after World W a r II. There the incentive contract became the established form of contract in the follow-on production situation where the dollar value of the contracts was large, the configuration of the aircraft was constantly changing and the companies were often financially incapable of taking large risks. In this situation the work was normally begun on a letter contract or a delayed target incentive contract with the target price being established after a substantial amount of the work under the contract had been completed. In this industry, the contractors had cost accounting systems where lot costs were collected and used for pricing purposes; and the learning curve technique was available to estimate future costs. Thus, the major use of the incentive contract was in a situation where the aircraft was already designed and previous articles had been manufactured, where unusually accurate cost information was available, where good pricing techniques were present and where the contractor had incurred a substantial amount of experience on the job to be done. The incentive contracts which resulted were normally performed without substantial variance from the negotiated targets as demonstrated by the graphs set forth in Figure 1-1. The recent history of incentive contracting has been quite different from that of several years ago and the results are difhcult to predict. However, we do know that the present incentive contracts cover a group of products much more diverse than in the past, that the cost accounting systems and estimating systems backing up the present incentive contracts are not as accurate as those of the aircraft industry and that the work covered tends to be earlier in the life of the weapon system (development work rather than manufacturing work in many cases). Judging from these facts, it is probable that the targets in the present incentive contracts will be less accurate with a commensurate larger variation of actual performance from target than in the past.

Incentive

Contracting

and Risk

It is commonly stated that the incentive contract increases the risk which a contractor takes when he enters into a contract. This statement can be misleading unless it is carefully analyzed. First, the risk that is being considered is the pricing riskthe risk that the estimate of the cost of the work or the performance target is a poor one and therefore

161 INCENTIVE CONTRACTS SETTLED BETWEEN JULY 1959 AND DECEMBER 1961
VARIATIONS BETWEEN T A R G E T COST A N D FINAL A C T U A L COST By Dollars Based on Final Contract Cost
AMOUNTS $961 IN MILLIONS

$434
$378

$447

$460

$315

$40 $21 or more 16-21% 11-16% 6-11% under 6% under 6% 6-11% 11-16% ABOVE $9 16-21% 21% or more

21%

PELOW TARGET

TARGET

TARGET

FIGURE 1-1

BY N U M B E R =-1 .

O F CONTRACTS 39

27

15

10

11

21% or more

16-21%

11-16%

6-11%,

under 6%

under 6%

11-16%

16-21%

21% or more

BELOW

TARGET

TARGET

ABOVE TARGET

FIGURE 11 -

that the cost or performance target cannot be met. Excluded from the term are other risks such as the risk of using scarce resources on unprofitable work or the risk of jeopardizing some other market by undertaking work in the defense market. The risk covered by an incentive contract is therefore a limited one. Second, the incentive contract only increases risk if it is used as an alternative to a cost plus fixed fee contract or some other form of contract where the Government assumes the pricing risk. The incentive contract is not always used in such a situation. Many times in the past the incentive contract has been used as an alternative to a firm fixed price contract rather than a cost plus fixed fee contract. In such cases, the incentive contract is used as a device to reduce rather than to increase risk. Inherently, the incentive contract is more like a cost reimbursement type contract than a fixed price type contract (the contractor's share is usually in the range of 1^-25% and the ceiling comes into play in a very small percentage of the incentive contracts which are written). Hence, great care must be exercised in evaluating incentive contracts to determine the true purpose for the use. In many cases, it may be found that the parties are using it to reduce risk by the contractor. T o determine the amount of risk in an incentive contract, it is also important to evaluate the specific terms of each incentive formula. A contract can be written in incentive form and yet contain very little incentive because of the sharing arrangement or ceiling used. In order to evaluate the amount of risk in any incentive contract, a detailed analysis must be made of the formula and the background facts in the case. In any case, the term "incentive contract" should not be automatically equated with risk until the facts have been checked and it has been determined that the contract actually does impose some substantial amount of risk on the contractor.

Chapter

II

INCENTIVES ON COST
The most frequently used incentives are incentives on the cost of performance of a contract. Such incentives are the most simple to administer, the most widely desired by the Government and the easiest to negotiate. This chapter will cover the method in which these cost incentives function and the considerations to be taken into account when negotiating a contract containing such cost incentives. Later chapters will consider performance incentives, the proper use of incentives and other aspects of incentive contracting. The ASPR specifies two basic types of contract providing incentives on costthefixedprice incentive (FPI) and the cost plus incentive fee (CPIF) contract.6 They differ in the fact that the FPI contract contains a fixed ceiling price, has an unlimited range of sharing of costs and is settled by a negotiation of a final "fixed" price near the completion of performance while the CPIF contract contains no ceiling, has a range of cost sharing limited by the minimum and maximum fee, and is settled by vouchering all costs. However, the incentive formulas in these two types of contract operate in a very similar manner and they will be considered simultaneously in the following section. An incentive contract relating the incentives only to the cost of performance can be looked at simply as a method of varying the contract price by a predetermined formula in accordance with the actual cost incurred by the contractor. The method by which this variation takes place is set forth in the incentive "formula"; and, of course, the essential aspect of the formula is that profit decreases as costs rise and increases as costs are reduced. However, there are several other aspects of the formula including price ceilings, limitations on the maximum and minimum profit and the sharing percentages. The essential point to regognize is that the pricing arrangement in an incentive contract is expressed by a formula which establishes the price to be paid over any variation of cost which may be incurred rather than at a fixed point. Thus, in graph form it can be said that the pricing arrangement is ex6 ASPR 3-404.4 and 3-405.4. It should be noted that ASPR 3-404.4 also provides for the fixed price incentive contract with successive targets. This is a special form of fixed price incentive contract which provides for a preliminary target which is redeterminabie , based on later cost experience. The successive target contract is infrequently used and will not be discussed further in this monograph.

pressed as a line on a graph rather than as a point. See for example, the graphs in Figures 2-1 and 2-2 which portray the "normal" FPI contract and the "normal" CPIF contract. These graphs indicate the amount of profit to be paid to the contractor at any level of actual cost incurred in the performance of the contract.

Elements

of the Incentive

Formula

In order to analyze the operation of the incentive formula, each element of the formula must be understood. These elements are somewhat different in the two main types of incentive contract, but their functions tend to be quite similar. The elements that are the same will therefore be discussed together with separate consideration given to the unique elements. These elements can be listed as follows:
Fixed Price Incentive Cost Plus Incentive Fee

Target Cost Target Profit Ceiling Price

Target Cost Target Fee Minimum Fee Maximum Fee Sharing Arrangement

Sharing Arrangement Target Cost

The target cost in either type of incentive contract is normally the focal point of the negotiation of the contract since it is generally accepted practice to attempt to arrive at a mutually acceptable target cost before establishing the remainder of the formula. This practice results in a detailed analysis by the Government of the proposed costs of performance followed by a negotiation of these costs on an item by item basis.'' There is a presumption that through this process, the parties will agree on the target cost and proceed to use that negotiated target cost as the basis for establishing the remainder of the formula including the target profit or fee.^
7 ASPR 3-807 contains the requirement for either "price or cost analysis" in all negotiated procurements. It is there stated that cost analysis is required in cases where there is no adequate competition. This rule applies to almost all incentive contracts, 8 This presumption that the target cost can be agreed to is particularly apparent in the new ASPR section on profit - ASPR 3-808. There it is provided that the profit to be paid on the contract is to be determined by applying fixed percentages to each type of cost (material, labor, overhead, etc.) in the target cost.

FIXED PRICE INCENTIVE CONTRACT Formula: Target Cost Target Profit Ceiling Price Sharing Arrangement $100 9 % 121% 75/25

60

70

80

90

100

110

120

130

140

150

COST $

FIGURE 2-1

COST PLUS INCENTIVE FEE CONTRACT Formula: Target Cost Target Fee Maximum Fee Minimum Fee Sharing Arrangement $100 6% 10% 2% 85/15

F I G U R E 2-2

The target cost is also important in the operation of the incentive formula since it is the fulcrum around which the formula revolves. Thus, the formula states that if actual costs exceed target costs, profit is reduced and if actual costs are less than target costs, profit is increased.Q Hence, the target cost is the basis for setting the profit or fee in the negotiation and also serves as the point around which profit or fee fluctuates during contract performance. In addition, the target cost inevitably is the point which critics will look to as the level of cost which the Government accepted as a fair estimate of the cost of performing the work. Thus, if the actual cost is less than the target cost, the Government is susceptible of criticism that it negotiated too high a target cost and gave the contractor a "windfall" profit. In these circumstances it can readily be seen that the target cost is a very important element in the incentive formulaespecially in the negotiation stage of the incentive contract. However, its importance can be greatly over-emphasized. Actually, after the contract has been negotiated, it can be asserted that the target cost becomes an insignificant element. Thus, although the contract formula is stated in terms of variations from target costs, it could just as easily be stated in graph form as a line with no indication of the point that was designated the target cost point on the sharing line. Hence, in Figure 2-1 the target cost is stated as $100 but it could be omitted and the result would be the sameas long as the sharing line is not changed. Following this reasoning, once the entire formula is established, the target cost can be ignored during contract performance. This somewhat oversimplified analysis of the target cost is useful because it suggests several approaches which can be used when the negotiation of the target cost becomes difficult or impossible. For instance, it is perfectly possible for the parties to negotiate the sharing line of the contract without ever agreeing on a specific target cost. Actually this is exactly what occurs when they agree to use a compromise target cost for purposes of setting the formulawhen the contractor will not agree to a cost of less than $100 and the contracting officer will not go higher than $90, but they agree to use a target cost of $95 to proceed with the negotiation. There is no need to make this compromise since the same result can be accomplished by agreeing on the profit level at $90 and
9The prescribed contract clauses are set forth in ASPR 7-108.1 (FPI) and 7-203.4(b) (CPIF). In both cases the language of the clause uses the target cost as the focal point for operation of the incentive formula.

at $100 and then establishing the incentive formula around these two points instead of a single target cost point. Or the parties might attempt something even more radicalthey might negotiate the cost and profit levels for minimum and maximum fee in a CPIF contract and establish the entire formula based on their agreement on those two points; perhaps, following the example above, minimum fee of 2% at a cost level of $125 and maximum fee of 15% at a cost level of $70. Such an agreement could readily be a sound basis for negotiating the formula for the contract. The above techniques are important because they suggest a means of solving the major problem in the negotiation of target cost. That is the problem of reaching agreement on the specific cost lev^l which can be used for a target. In spite of the presumption to the contrary, even when the target cost for a follow-on manufacturing contract is being negotiated, it is often difficult to agree on the last 5% of controverted costs; and when a development contract is the subject of incentives, it will be much more difficult to reach complete agreement. This difficulty is natural in the costing of major programs where there are a large number of unknown factors and the parties have an inevitable bias in favor of construing those unknowns in their own favor. Thus, even when the negotiating parties can agree that target cost should be at a theoretical level at which the contractor will perform using normal efficiency and ingenuity, alternate negotiating techniques are often needed to avoid the impass over target cost. The final consideration in discussing target cost is the determination of what cost level it represents. It is easy to say that target cost should be set at the level of cost which the contractor will most likely attain under normal performance conditions. However, during the negotiation much of this is speculative and the parties usually find that they disagree on the so-called contingency area even though they agree on the basic principle. The regulations allow contingencies which are "foreseeable within reasonable limits of accuracy" to be included in target costs,io but this provision is only a partial solution to the problem. Does this mean that all contingencies which are not susceptible of accurate costing must be kept out of the target? If this is so, the contract will normally be underpriced since some of these contingencies will inevitably occur during performance and there will be no similar items in
" A S P R . 15-205.7.

the target cost which can be reduced in order to offset the effect of such additional costs. It can be argued that the contractor is protected from loss due to the occurrence of contingencies in an incentive contract through the agreement of the Government to reimburse costs above the target cost. However, this argument overlooks the fact that such protection is only partial with the contractor sharing all such costs and incurring a commensurate erosion of profit. It can be further argued that this possibility is a part of the additional risk present in an incentive contract and is therefore a justification for the higher level of target profit or fee. Most contractors, however, are hesitant to accept this argument. This problem of contingencies becomes critical when a contractor is asked to submit cost estimates for the same work on several types of contracts. Should the estimated cost be the same for CPIF as for FPI the same for firm fixed price as for cost plus fixed fee.? The only difference is the contingency factors and the normal reaction of contractors to such a request has been to increase the cost estimate as the form of contract places more risk on the contractor. However, such a solution highlights the presence of contingencies and may lead to great difficulty in negotiation of the target cost. This area is thus one of the unsolved problem areas in incentive contracting and one which can make the negotiation of the target cost extremely difficult.

Target Profit or Fee


The profit factor in incentive contracting is called profit in the FPI contract and fee in the CPIF contract. However, the element is the same in either type of contract. The earned profit on these contracts is composed of two segmentsthe target profit which is negotiated at the outset and set forth in the contract and the amount of profit gained or lost under the terms of the sharing arrangement. The target profit is usually the largest portion of the total profit and thus is a most important element in the original negotiation of the incentive formula. The target profit in an incentive contract, of course, is no different from the profit factor in any other form of Government contract. It is the compensation to the contractor for undertaking the work and its amount varies in accordance with the risk which the contractor takes, the contribution which he makes (facilities, manpower, management.

etc.) and the difficulty of the job.^^ Since one of the major elements in this determination of profit is risk, it should normally be expected that the FPI contract will carry a higher rate of profit than the CPIF contract. 12 i^, addition, in either case, the level of the target cost should be an important factor in establishing the target profit rate.^^ If the parties negotiate what they believe to be a "tight" cost, a higher profit rate can be expected whereas if the target cost includes substantial contingencies, the target profit rate can be expected to be less. Of course, in this sense, the target profit can be an important negotiating tool for the contracting officer since he can offer a higher profit rate to a contractor if the contractor is willing to take a lower target cost. In the past the ranges of profits on the different types of contracts have been roughly as follows: Firm Fixed Price Fixed Price Incentive Cost Plus Incentive Fee Cost Plus Fixed Fee 10-14% 8-10% 5- 8% 5- 8%

It can be seen that there has been a substantial difference in profit rates based on the type of contract (and the pricing risk) used. As a matter of fact, the above rates reflect a differential because of risk which is very similar to the differentials stated in the new ASPR profit guidelines. The most difficult problem in this area is whether the CPIF contract should carry a higher rate of fee than the CPFF contract. Most contractors will argue that it should since there is a greater risk of losing profit through an overrun. On the other hand, some contracting officers have argued
11 See ASPR 3-808 providing a new technique for determining the proper amount of profit to be paid on each contract. This new "weighted guidelines method" of computing profit assigns a specific range to each of the factors which affect the profit. It also adds a profit factor to cover the past performance record of the contractor. " A S P R 3-808.5 (c) (5) provides the following ranges of "risk" profit: Cost plus fixed fee 0-1% Cost plus incentive fee including cost incentive only i _ 2% Cost plus incentive fee including cost, performance and delivery incentives 1/ - 3% 1 2 Fixed price incentive including cost incentive only 2-4% Fixed price incentive including cost, performance and delivery incentives 3-5% Prospective price redetermination 4.5% Firm fixed price 5-7% "See ASPR 3-808.5 (c) (3).

that there is intrinsically no greater risk since it is a cost reimbursement type contract with as great a possibility of earning additional fee on the one hand as losing fee on the other. The new profit regulations seem to indicate a slightly higher rate of fee for the CPIF contract although the differential might be quite small in a specific contract. At the present time the only limitation on the rate of target fee in a CPIF contract is the statutory limitation of 15% for experimental, development or research work and 10% for other types of work.^^ However, these same limitations apply to the maximum fees in CPIF contracts with the result that if the target fee rate approaches these limits, it would be exceedingly difficult to arrive at an incentive formula that was acceptable to a contractor. The problem would be, of course, that such a formula would operate primarily on the penalty side. It should be emphasized that this limitation on fee is applicable only to CPIF contractsit has no application to FPI contracts.

Ceiling Price
This element of the incentive formula is peculiar to the FPI contract and is the element that makes this type of contract more risky than the CPIF contract. It is also the major distinguishing feature between the two types of incentive contracts. Thus, it is fair to say that a CPIF contract with a ceiling (this is occasionally suggested) contains the same pricing risk as a FPI contract and should carry the same profit percentages as a FPI contract. The ceiling price is normally stated as a percentage of the target cost of the contract. Thus, in a contract with a target cost of $100 and a target profit of 9% ($9) a ceiling price of 120% would be $120 as compared to the target price (target cost plus target profit) of $109. It can be seen that this method of stating the ceiling is somewhat misleading since the amount of cost protection which the ceiling provides is less than 20%. Under these circumstances, one of the initial steps in the evaluation of any ceiling is to determine the actual amount of cost protection which is given. Taking the example in Figure 2-1 it can be seen that the slope of the sharing line changes at a cost of $116at that
i*ASPR 3-405.4 (c). This requirement was changed by Revision 2 to the 1963 Edition of ASPR issued 15 August 1963. The prior ASPR provision limited the target fee to the admmistrative limitations - 10% for experimental, developmental and research work and 7% for other types of work. These limitations were not compatible with the new profit guidelines set forth in ASPR 3-808 and were removed at the same time these profit guidelines were issued.

point the contractor has $5 profit remaining under the formula (target profit of $9 minus $4 share of the $16 overrun). Thus, at this point his remaining profit exactly equals the dollars between the formula price and the ceiling priceindicating that from this point on, the contractor will not get any more costs reimbursed but will lose only profit dollars. In effect, at this point the contract becomes a firm fixed price contract with every additional dollar expended being a profit dollar. Hence, in this contract where the ceiling is stated as 121%, the cost sharing occurs only to 116% of the target cost; or stated differently, the contractor has cost protection of 16% over the target cost. Of course, this point will vary with each incentive formula and it is important to work it out in each case to obtain a true indication of the amount of cost protection that any formula gives. There has been a distinct trend in the past few years to reduce the amount of the ceilings on incentive contracts. Of course this is a method of increasing the risk which the contractor takes if it is assumed that the levels of target cost can be negotiated as closely with lower ceilings. At the present time the prevailing rate of ceiling appears to be in the range of 115% to 120% with relatively few ceilings exceeding this amount. Such ceilings actually give little cost protection to a contractor. For instance, consider the example of a contract with a target cost of $100, target profit of 10%, ceiling of 118% and share of 80/20. Under this formula the cost sharing point is $110at which point the contractor has $8 profit remaining. Hence, under this formula only 10% cost protection is givenwhen costs reach $110, the contract operates in the same manner as a firm fixed price contract with a price of $118. This also highlights another aspect of the ceilingsince it is the major point of risk in the FPI contract, the closer the ceiling is to target cost, the greater should be the rate of target profit to compensate for the additional risk. Conversely, the FPI contract with a higher ceiling should bear a lower rate of target profit. This raises the question of the function of the ceiling in the contract. We have seen that it defines the risk point for the contractor the point at which the contract becomes firm fixed price in nature. In addition, of course, it is the limit of the Government's obligation to pay the contractor and thus is important from the Government's point of view. The ceiling therefore becomes a crucial element during the negotiation of the contract. This is particularly apparent in the case of the average contractor who sees the ceiling as the loss point in the con-

tract and takes every step to keep it as high as possible. However, it should be recognized that as an incentive for more efficient performance after the formula has been established, the ceiling serves a secondary purpose. It is only an incentive at the outside limit of performancein fact it is better described as a deterrent than an incentive. It can exert a very strong influence on a contractor who is threatened with an overrun in cost which will carry him over the ceiling and produce a loss contract. However, for the normal contractor who is not in that position, the ceiling is a non-operating part of the incentive formula. If he is performing in the range of target cost, the ceiling plays no part in creating incentive. In the past the ceiling has been operative in a small percentage of FPI contractsnormally it has not come into play.is The primary incentive and the one which operates on each increment of performance is the sharing arrangement. The final problem that is encountered in the area of ceilings is that of negotiating the level of the ceiling. What criteria are available to tell the negotiator how high the ceiling should he? This has been a perplexing problem and one to which few precise answers have been developed. On one side many contractors argue that the ceiling is a product of the risk in the contractthe fact that the parties do not know enough about the job to be able to accurately price itand therefore that there is no way to price the ceiling. This is to say that the ceiling is the element in the formula that compensates for the unknown and the unknown cannot be priced. On the other hand some contracting officers have felt the need to more precisely define the factors which the ceiling is to cover. Perhaps agreement could at least be reached on the fact that the ceiling is necessary to cover the most remote type of contingencies. This is to say that any costs of such contingencies belong in the ceiling rather than the target cost. However, this very tentative solution leaves open the major difficulty of agreeing on the specific elements that require ceiling protection in a given contract situation. This is another unsolved problem in incentive contracting.
_ 13 See Fig M indicating that only a few incentive contracts in the past have resulted '^^^'^ corroborated in R A N D Memorandum, R M la T I, Procurement and Contracting: A n Economic Analysis" at p. 34, In the past, the dual facts that the contractor is concemed about the level of the ceilmg durmg the negotiation and the Govemment recognizes that the ceiling does not provide great incentive has allowed the parties to negotiate higher ceilings in exchange for lower startmg profit rates or higher sharing percentages. In such negotiations it was felt that both parties were benefitting. The present Government pressure to reduce ceilings has apparently eliminated this type of negotiating technique.
^olo^l^^lr''"'^^''

^^'^^^

iHaximum and Minimum Fees


The minimum and maximum fees are stated as a percentage of the target cost and are the elements in the CPIF contract formula which establish the outside limits of the contractor's profit. Such maximum and minimum fee limitations have no application in the FPI contract.!^ These elements define the range of fee which the contractor can earn and also the range of operation of the incentive sharing under the contract. Thus, in the contract set forth in Figure 2-2, the contractor's maximum fee of 10% is attained at a cost of $73.3 and the minimum fee of 2% is attained at a cost of $126.7. Any costs outside of these limits will not change the fee; hence, the contract outside of these limits is a CPFF contract. In view of the limitation which the maximum and minimum fees place of the operation of incentive under the contract, it is important that they come into operation sufficiently far from the target cost to allow for full functioning of the incentive sharing arrangement. Thus, in a contract where there is a possibility of a cost overrun of 30%, the parties should not place the minimum fee at a point where it takes effect before 130% of the target costs have been incurred. Conversely, where there is a possibility that the contractor might underrun the target cost, the maximum fee should not be attainable until the greatest possible underrun has been reached. The ASPR established norms for this placing of the minimum and maximum fees by stating that they should not normally be reached until variations of at least 25% from target cost have been attained. It is common practice for the minimum and maximum fees to be equally distant from the target fee.^^ Thus, with a target fee of 7% and a negotiated maximum fee of 13%, it could be expected that the minimum fee would be 1%. This general rule is one of convenience which allows each party to demonstrate superficially that the sharing formula is fair since the possibility of gaining or losing profit is theoretically equal; but, in fact, the establishing of the minimum and maximum
17 Prior to March 1962, the ASPR allowed a profit ceiling to be used in the FPI contract. The effect of such a limitation was to cut off the incentive when the limit was reached, and the deletion of this element from the ASPR at the time of the March 1962 revision was evidently a result of a policy determination that such incentive cutoflf was detrimental to the proper functioning of the FPI contract. i A S P R 3-405.4 (b). 13 ASPR 7-203.4 (c) (4) states that "the measure of the increase and the decrease in the fee shall normally be the same."

fees by this technique does not necessarily lead to such a result. For instance, in a contract where there is a possibility of overrunning by 40% but little hope of ever underrunning by more than 15% (a common situation in the development contract area) ,20 it is extremely difficult to have the minimum and maximum fees equidistant from the target; and doing so may seriously distort the entire formula. For instance, setting the minimum fee of 1% at the 40% overrun point and the maximum fee of 1 % at the 15% underrun point would produce 3 ? sharing percentages of 85/15 over target cost and 60/40 under target cost. Such percentages might be undesirable. Of course, minimum and maximum fees equidistant from target fee can be attained in this situation by setting the maximum fee at the 40% underrun point and using an 85/15 sharing arrangement for the entire contract. This solution, commonly adopted, merely disguises the issue by setting the maximum fee at a completely unattainable point which essentially reduces the actual maximum fee. A better solution is to regard the general rule of having these fees equidistant from the target fee as one that should be followed with caution and recognized as a rule of convenience rather than necessity. As discussed earlier, the maximum fee is subject to limitations. In experimental, research and development contracts it cannot exceed 15% of the target cost and in other contracts it cannot exceed 10% of the target cost. This limitation has no bearing on the fee earned on the contract as a percentage of actual cost of performance. Thus, in a contract with a target cost of $100, target fee of 8^0, share of 80/20 and maximum fee of 15%, if a contractor performed at a cost of $75 he would earn a fee of $13 (target fee of $8 plus incentive fee of $5) which is well within the maximum fee of 15% of target cost and yet is more than 17% of the actual cost of $75. Such a fee would completely meet the requirements of the regulations and statute.21 The mJnimum fee is, of course, subject to no limitations and can be stated in terms of a negative fee if the situation warrants the negotiation of such
20 This situation can easily occur when the target cost is set at the level of most probable performance where the chances of overrun and underrun are equal. Even in such a case, the amount of the overrun will probably be greater when an overrun occurs than will the amount of any underrun. See Figure 1-1 for an indication of this. 21 ASPR 3-405.1 (c). There is some question whether the limitation on the maximum fee can be considered statutory pursuant to 10 USC 2306(d) (which applies to cost plus fixed fee contracts) or administrative. If it is administrative a deviation from the requirement could be obtained in appropriate cases.

an arrangement.22 The use of a negative fee creates a contract with substantially greater risk than the normal CPIF contract since it presents the contractor with the possibility of actually losing money on a cost reimbursement type contract. Hence, such a contract should also include the possibility of much greater rewards than the normal CPIF contract. Such a contract, for instance, would probably contain a higher rate of target fee than the normal CPIF contract. The tendency in the past year has been to increase the spread of fees on these contracts so that it is not uncommon to see formulas in the following ranges: Contract A Target Fee Maximum Fee Minimum Fee 7% 14% 0% Contract B 070 13% -1% Contract C 15% 1%

Such broad ranges of sharing make this type of contract a riskier arrangement than the normal cost reimbursement contract thus putting real emphasis on the fact that this is an "Incentive" contract. Thus, as the range of sharing gets broader, the CPIF contract becomes more like a FPI contract in terms of risk and actual operation. For instance, a fee arrangement with the maximum fee at 15% and the minimum fee at -10% (as has been proposed) is essentially the same as a FPI contract. On the other hand, a contract with a maximum fee of 8% and a minimum fee of 5% is barely distinguishable from a CPFF contract. Thus, the spread between maximum and minimum fee is one of the most important elements in the establishment of the incentive formula for a CPIF contract.

Sharing Arrangement
The arrangement for sharing the costs on an incentive contract is the central element in the incentive formula since it is the element that is in operation continuously throughout the performance of the contract. Thus, in a contract with an 80/20 share80% of the costs paid by the Government and 20% paid by the contractorthis sharing arrangement applies to each dollar spent within the sharing range. Whether that dollar is an overrun dollar or an underrun dollar, the sharing arrangement has the same impact on the contractor. With this fact in mind,
22 ASPR 3-405.4 (b) states that when a high rate of maximum fee is used "the contract shall also provide for a low minimum fee, which may even be a 'zero' fee or, in rare cases, a 'negative' fee . . . "

it can be said ttiat the sharing arrangement is the element in the formula that provides the bulk of the incentive on the contract since it operates continually throughout the life of the contract. The contractor knows that with each dollar he spends, he is actually spending 20^ of his own money, and thus there is the incentive to economize throughout the range of performance of the contract. It follows that the larger the contractor share, the greater the incentive that the contract will provide. The structuring of the sharing arrangement is essentially the same in both CPIF and FPI contracts. However, the contractor's share is normally larger in the FPI contract since the parties are usually more confident of the validity of their cost estimates when entering into this type of contract. Thus, in the examples set forth in Figures 2-1 and 2-2, the CPIF contract carries a 15% contractor share while the FPI contains a 25% share. Both of these contracts, however, contain the most simple sharing arrangementa single sharing rate effective for the entire range of performance where the incentive operates. It is interesting to notice that even with this simple arrangement, the nature of the contracts themselves creates varying sharing percentages at different ranges of performance. Thus, in the FPI contract in Figure 2-1 the share becomes 0/100 after a 16% overrun has occurred and in the CPIF contract in Figure 2-2 the share becomes 100/0 after the minimum or maximum fees have been reached. In the most sophisticated uses of incentive contracts the single sharing arrangement throughout the entire span of costs is not used. Instead the parties to the contract agree on a set of varying sharing percentages at different levels of cost which more closely tailor the incentive formula to the exact objectives they are attempting to accomplish in using an incentive contract. For instance, a relatively frequent share variation is that of using larger shares at greater deviations from target cost. The following formula might be established: Target Cost $100 Share 95/5 for costs between $95 and $105 85/15 for costs between $85 and $95 and between $105 and $115 75/25 for costs between $70 and $85 and between $115 and $130. Such an arrangement, of course creates relatively little incentive in the area of the target cost but imposes greater rewards or penalties on

the contractor as his costs deviate from the narrow range around the target. This type formula places the emphasis on earning a profit approximating the negotiated target profit by performing at a cost level close to the target cost. Thus, it imposes greater penalties for larger overruns and gives little incentive to achieve the small underrun (which is often the only type of underrun that is attainable). When such differential sharing arrangements are used, it is important that the sharing percentages are sufficiently different to make a significant impact on the contractor during performance. For instance, there would be some doubt of the benefit of using a 90/10 share for one cost area and an 85/15 share for another cost area. The normal contractor probably could not foresee his costs with sufficient accuracy to enable him to utilize the extra incentive given. However, if the step in sharing percentages is from 90/10 to 75/25, the additional profit to be earned might justify additional management effort to enable the contractor to take advantage of the added inducement. Another frequently used variable sharing arrangement that is a simplification of the one discussed above is the plateau arrangement. In this case the parties use a reduced rate of sharing in a narrow area around the target with a higher share outside of this narrow range. For instance, the following formula might be established: Target Cost Share $100 100/0 for costs between $97 and $103. 80/20 for costs outside of this range.

Such a plateau actually creates a CPFF contract in the plateau area although sometimes a small share in the order of 95/5 is used in place of the 100/0 arrangement. In either case, such a contract gives little or no incentive for improvements within the plateau area and this is its greatest weakness. Such lack of incentive, of course, is relatively unimportant if the plateau is small. But, in numerous cases contracts have been negotiated with plateaus covering the 10% or 15% of costs surrounding the target cost. Such a contract contains no incentive in the exact area where there is a real need for incentive, for many of these contracts cover work on which it is not possible to achieve cost savings very far outside of this range of costs. In other words, in many incentive contracting situations, any cost saving inducement, to be effective, must operate in the narrow band of costs from 5% to 10% each side of target since that is the area where the contractor can exert real cost control.

Thus, the plateau is a dangerous device which must be carefully used to avoid a substantial loss of the incentives in the contract. A less frequently used variable incentive is one where a heavy share is utilized in a particular area where the parties would like to see the incentive function. For instance, in a contract with a target cost that appears to be tight and thus difficult of attainment, the Government might volunteer to give the contractor a greater share below target. To accomplish this purpose a formula as follows might be established: Target Cost Share $100 80/20 above target cost 65/35 below target cost

Such an arrangement represents the use of the inducement aspect of the incentive sharethe attempt to get the contractor to achieve cost reductions by offering him a larger share of the savings than normal. On the other hand, the same principle can be used on the penalty side of the incentive. Thus, a heavy share might be imposed on all overruns over 110% of the target cost. Or, as a third variation, a reverse-plateau type arrangement might be negotiated where the heavy share was in the middle of the cost spectrum with smaller shares further from target cost. Such an arrangement might be used in recognition that the major possibility for cost savings was in an area very close to target cost and therefore that the contractor should make a profit commensurate with his ability to control costs within this narrow area. It can be seen from the above discussion that there are almost unlimited possibilities in the tailoring of the sharing arrangement. The major point is that the sharing formula should he tailored to meet the needs of the parties on each contract.-^ There is no single good sharing arrangement. It is a question of whether the sharing arrangement meets the needs of the parties on an individual contract; and in this context, these needs should be equated to the creation of the maximum amount of incentive to reduce costs of performance commensurate with the accuracy of the original cost estimate. Thus, in constructing the sharing arrangement the parties should always ask, Where are the real areas where costs can actually be reduced on this job? and How can the formula be arranged to place the major incentive on good performance in these
-3 This point that incentive provisions must be tailored for each contract is made by Maj. Gen. W . Austin Davis in Incentive Contracting in Research and Development Contracting 103 (1963).

areas? In the same vein the questions can be asked, Where is there a possibihty of excess costs through bad management? and How can the incentive formula be tailored to impose harsh penalties in the event of such poor cost management ? One common tendency of the Government in negotiating sharing arrangements has been to favor the penalty aspect of the arrangement over the inducement aspect. This feeling has sometimes been manifested by an unwillingness to give large shares for underruns unless the contractor was willing to accept large shares in the overrun area. Occasionally it can be seen in the major emphasis during a negotiation being placed on the penalty portion of the sharing arrangement. Such approaches by contracting officers miss the point that often a contractor can be attracted by a positive incentive where he might be repelled by a penalty. In addition, the Government has as much to gain in the inducement area as in the penalty area (in both areas the Government normally gets the larger share of costs saved) and usually the two work together. Hence, this tendency to overemphasize the penalty aspect is to the interest of neither party. The recent trend in sharing arrangements has been to utilize larger contractor shares with the purpose of creating more incentive. In the past it was general practice for the shares on CPIF contracts to be in the range of 95/5 to 85/15 with an 80/20 share being considered a large one. At the same time, shares of 80/20 and 75/25 were the most frequent on FPI contracts. Now, larger shares can be expected with percentages in the range of 85/15 to 75/25 being used on CPIF contracts and 80/20 to 50/50 being used on FPI contracts. Sharing arrangements of this nature will definitely make the incentive contract a risktaking type of contract which will fully justify any larger profits which a contractor can make as a result of cost savings on such contracts. They will, of course, also increase the probability of contractors incurring losses on such contracts in some instances. However, the use of larger shares is the most direct way under the incentive type contract to place a larger portion of the risk on the contractor in accordance with the intent of current Department of Defense policy. It might be asked. How large a share can be negotiated before the contract becomes essentially afirmfixedprice contract? So far, no concrete answer has been given to that question. However, it would seem that contractors' shares of greater than 50% border on the firm fixed price contract. If this is so, it should be obvious that there would be

little utility in using such sharing arrangements. If the parties, for example, are willing and ready to negotiate a 25/75 share, it would seem more sensible to use afirmfixedprice contract where the share is 0/100 and save both parties the administrative effort required by the incentive type contract. Once a contractor is willing to accept over 50% of the risk, it is a small step to acceptance of all of the riskespecially when the contractor considers the additional freedom he has under the terms and conditions of thefirmfixedprice contract.

iSegotiation

of the Incentive

Formula

All of the elements of the incentive formula are closely interrelated and must be skillfully handed in order to create a well balanced formula which will serve the purposes of both parties. In combining these elements it should be remembered that since they often counterbalance each other or work at cross purposes, a change in one will usually call for a counterbalancing change in another element. In practice, these problems work themselves out during the actual negotiation where the elements of the contract can be manipulated until a mutually acceptable result is reached. Actually, the presence of a number of variables with which to work often eases the negotiation problem since if the parties cannot agree on one element they may be able to compromise their differences during the negotiation of another element. This is often true in the setting of the target cost and target profit where one can offset the other. In the following discussion, the combination of the elements of the incentive contract will be discussed progressively as they are brought up during a normal negotiation. One warning should be included at the outset. The incentive formula is made up of a number of variables all of which have effect on the end result of the negotiationthe profit that will be paid to the contractor. Since there are several variables, it is foolhardy to conduct this type of negotiation on an informal bargaining type give-or-take basis. The results of any formula that is offered for consideration should be carefully analyzed before such formula is accepted. This normally requires a detailed effort to compute the amount of profit which that formula yields at various levels of cost and a check of these results against the negotiation goals which have been established. Since both parties to an incentive contract are usually accustomed to discussing price in terms of cost elements plus a "fair" profit, the nego-

tiation initially centers on a determination of the target cost. This type of negotiation focuses on each item of cost in turn and attempts to achieve agreement between the parties or at least narrow the differences on a cost element basis. The end result is either agreement on a target cost or at least an understanding of the position of the other party and a determination of the amount of irreconcilable disagreement between the parties. For instance, in a situation where the contractor had proposed a target cost of $60,000,000 and the original Government estimate was $48,000,000, extensive negotiation might not and probably would not achieve complete agreement on the target cost, but this prolonged discussion of all of the elements of cost might bring the parties closer together where the contractor's position might be $57,000,000 and the Government position $52,000,000. Such a narrowing of the disagreement is of great help in an incentive negotiation since it permits the parties to write their contract by adjusting other elements of the formula. When the discussion of target cost has been completed (here it should be emphasized that it is not necessary to reach agreement on target costnegotiation in this area often reaches a point where further discussion is a waste of time), the parties will normally turn to the target profit or fee as the next item to be negotiated. The important aspect in profit negotiation is to remember that the profit is a variable and therefore that the profit must be analyzed at the level of cost for which the contract will most likely be performed. For instance, using the hypotheticalfiguresset forth above let us assume a profit offer by the Government and one by the contractor as follows: Government offer: Target Target Share Target Target Share Cost Profit Cost Profit $52M 5.2M (10%) 80/20 $57M 5.13M (9%) 80/20

Contractor offer:

At first glance, the amount of profit in these offers might seem to be very similar. However, if they are equated to the same actual cost figure, for instance $55M, then the Government offer provides profit of $4.6M and the contractor offer provides profit of $5.53Ma substantial difference. Or, from the contractor's point of view, while the Government offer of a rate of profit of 10% might seem very generous, that

offer actually provides profit at the actual cost level of $57M of $4.2M which is less than 7.4% of cost. Thus, if the contractor is convinced that his cost figure of $57M is an accurate one, the offer of the Government would probably be totally unacceptable. Conversely, the Government would find upon analysis of the contractor's offer that the profit rate was almost 11.8% at the Government cost estimate of $52M. This too would probably be completely unacceptable. Thus, in negotiating profit in incentive contracts the profit rate must be closely related to the level of cost at all times. Assuming for discussion purposes that the parties can agree on a profit of $4.95M (9%) at a cost level of $55M and realizing that there is no need to agree on these factors to continue the negotiation, how are the rest of the elements of the formula determined ? In a FPI contract this is not too difficult since the other factorsceiling and shareare so closely connected to the target cost and target profit that they will probably be determined during the negotiation of these two elements. For instance, in the above analysis we had to assume a sharing arrangement in order to be able to evaluate the impact of various profit factors. In addition, the risk in the FPI contract is so closely related to the ceiling and the profit is so closely identified with risk that it would be difficult to establish profit meaningfully without also agreeing on ceiling and share. Hence, in the hypothetical negotiation discussed above the 9% profit rate would probably be dependent on a ceiling between 120% and 125% (since both are median rates) and a share similar to the assumed share of 80/20. If the contractor desires a higher rate of profit, he should be willing to accept a lower ceiling and if he desires a higher ceiling, he should expect a lower rate of profit. In the case of a CPIF negotiation, the problem of establishing the other factors of the formula is not so easy. Here the factors are sharing arrangement and minimum and maximum fees. In setting these factors the following three variables come into play: 1. The sharing percentage. 2. The range of actual cost over which the fee will be shared. 3. The percentage of minimum and maximum fee. Since the determination of any two of these factors will automatically establish the third factor, the problem is to decide which of the three should be subject to the other two. This decision is primarily a matter of deciding which of the factors is primary to the purpose of the incen-

tive aspects of the contract and which is secondary. Normally, the first two factors will be primary and the third will be secondary since the sharing percentage determines the amount of incentive the contractor has at any given point of cost incurrence, and the range of sharing establishes the area within which there are any incentives operating whereas the minimum and maximum fee points are merely statements of the outside limits of incentive on the contract but not of the amount of incentive at any point of performance. Thus, the sharing percentage will in large measure determine the amount of profit motivation which the contract includes and the range of sharing will keep this profit motivation operating over a specified range of actual costs. In the hypothetical negotiation, then, the parties had agreed that the target cost should be between $52M and $57M which is the starting point for establishing the other factors. Based on this agreement they might next agree that the possible range of actual costs was from $45M to $75M and therefore that they wanted to share profit over this range. Upon further analysis they might agree that the sharing percentage should be relatively small in the middle range of actual costs and larger outside of this range. Thus, a share of 92.5/7.5 might be established for the middle range of $50M to $60M and a share of 85/15 for the outer range. Assuming that the parties then agreed on a target cost of $55M and a target rate of 7% the entire formula is set with the only problem being to compute the minimum and maximum fees to assure that the maximum fee does not violate the allowable limit. Such computation would indicate the following: Target Fee $3.85M Fee contribution from $55M to $60M at 92.5/7.5 $60M to $75M at 85/15 Minimum Fee Fee gain from

= $ .375M = $2.25M

Total fee Contribution $2.625M $1.225M ($3.85M-$2.635M) $50M to $55M at 92.5/7.5 = $ .375M $45M to $50M at 85/15 -$ .75M Total Fee Gain $1.125M $4.975M ($3.85M + $1.125M)

Maximum Fee

Since the rate of maximum fee is less than 9% it is within the limitations governing either a research and development contract or a manufacturing contract. It might be noted, however, that the minimum fee

is much further from target fee than is the maximum fee. This is due to the decision to share costs to a greater extent on the overrun side based on the recognition of both parties that the realities of the situation will not permit underruns of cost below $45M. If this is so there would be no purpose to be served from contractually agreeing to share costs down to $35M although such an agreement would balance the maximum fee with the minimum fee.^^ A better alternative would be to review the sharing arrangement to determine if it would be beneficial to increase the share of the contractor in underruns. This would give him a more equal opportunity to gain profit compared with his risk of losing profit and would also provide a greater incentive to reduce the costs. Thus, the share between $50M and $55M might be 90/10 and the share between $45M and 50M might be 75/25. Based on these figures, the maximum fee would become $5.6M which would be somewhat more equitable to the contractor. It can be seen from the above discussion that the parties must be careful in the way they analyze the various factors in the formula. It is easy to fall into the trap of establishing the factors on an arbitrary basis and thereby destroying much of the usefulness of the incentive contract. To negotiate a meaningful formula the parties must be aware of the relationship of the various factors, the effect of variations of each factor and the overall goals that they are attempting to achieve. Care must also be taken in using the incentive elements to effect compromises in the negotiation thereby distorting the formula. For instance, the easiest negotiation tool is the plateau sharing arrangement by which the parties compromise failures to agree on the target cost. For instance, if the Government will not go above $30M and the contractor will not go below $32, it is simple to reach agreement by using a 100/0 plateau between these cost figures. This practice eases the negotiation problems but greatly reduces the effectiveness of the incentive formula in operation since it provides no incentive in an area of critical costs. Another technique of this type is the use of CPIF contracts where there is sufficient cost information to justify the use of a FPI contract. The use of a CPIF contract may make it easy to settle the negotiation with the contractor since it substantially reduces his risk, but it also may substantially diminish the incentive which the contractor has to reduce costs during performance. The same effect is
-* See the discussion on p. 20 supra.

achieved by agreeing to lower contractor sharesa reduction of risk with a reduction in incentive. This is not to say that all contracts should have a maximum amount of risk but only to emphasize that the amount of risk (and incentive) that should be included in the contract should be determined by the essential aspects of the procurement and the position of the contractor undertaking the work and not by the desire to ease the problems of negotiation. Thus, the parties to the contract must be careful that they do not take actions in the negotiation that reduce the effectiveness of the contract during performance.

Analysis

of Incentive

Formulas

As stated earlier, the incentive formula is composed of a group of variables all of which work together to yield the final profit which a contractor will make on a contract. In the negotiation of such a formula, attention should not be diverted from this end resultthe final profit. Thus, in order to analyze any given formula, it is necessary to determine what amounts of profit that formula will yield at various levels of cost. This cannot be done by merely looking at the contract clause or the "shorthand" statement of the formula which we customarily use in discussing incentive contracts. It must be done in either chart or graph form. To negotiate incentive formulas without taking this step is foolhardy and should be avoided. Set forth in Figure 2-3 are several alternative formulas which a contractor might have offered to him in a negotiation or which he might feel he could obtain from a contracting officer by pursuing certain negotiating techniques. Figure 2-4 graphs these formulas and Figure 2-5 sets forth their results in chart form. It will be noted that in bothfiguresthe end result is the profit which results at selected levels of actual cost. To analyze which of the formulas is most desirable, the contractor must make some judgment of the level of cost which he believes can be achieved on the contract. He should also look at the effect of each formula in the event of a serious overrun or a real cost breakthrough to see if any formula gives him an unusual penalty or reward at these cost levels. He is then in a position to make a meaningful appraisal of the relative merits of each formula. The same technique can be used by a contracting officer, although, of course, he will be looking at somewhat different aspects of the formula. He will look to see if any formula gives an unusual amount of protection to the contractor and if the formulas give sufficient incentive in the area of lower costs to encour-

INCENTIVE FORMULAS
Formula AFPI Target Cost Target Profit Ceiling Share $100 9V27o 120^0 80/20

Formula BFPI Target Cost Target Profit Ceiling Share

81/2% 125% 85/15 over target 65/35 under target

Formula CCPIF Target Cost Target Fee Minimum Fee Maximum Fee Share $100 61/2% 3^/2% 9Vi% 90/IO

Formula DCPIF Target Cost Target Fee Minimum Fee Maximum Fee Share

71/2% 1 % 14% 85/15 over target 75/25 under target

FIGURE 2-3

FIGURE 2-4

INCENTIVE FORMULA COMPARISON (Chart)


PROFIT $ Cost ($) 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135
Formula A Formula B Formula C Formula D

16.5 15.5 14.5 13.5 12.5 11.5 10.5 9.5 8.5 7.5 5 0 5 10 15

20.75 19 17.25 15.5 13.75 12 10.25 8.5 7.75 7 6.25 5 0 5 10

9.5 9.5 9.0 8.5 8 7.5 7 6.5 6 5.5 5 4.5 4 3.5 3.5

14 14 13.75 12.5 11.25 10 8.75 7.5 6.75 6 5.25 4.5 3.75 3 2.25

FIGURE 2-5

age the contractor to perform in that area. He will also want to look at the general level of profit for each formula to assure himself that no formula gives an overall level of profit that is out of line with the demands of the job. For example, looking at the four formulas in Figure 2-3 as compared in Figures 2-4 and 2-5, it can be seen that Formulas A and B, the FPI formulas, are advantageous to the contractor if he anticipates performance close to the target cost with Formula A yielding the highest profit for slight overruns or target performance and Formula B giving the greatest profit for underruns in the range of 10% or greater. However, if the contractor is concerned about a substantial overrun, the CPIF formulas (Formulas C and D) are more attractive. From the point of view of the contracting officer. Formula B is attractive since it gives the greatest incentive for major underruns and has a relatively low rate of target profit. Between the two CPIF formulas, the contracting officer does not have such clear alternatives since Formula D, while giving the most incentive, yields the higher profit throughout almost the entire range of costs. It is at this point that the contracting officer must remember that the purpose of the incentive contract is to induce the contractor to reduce costs, and hence that he should normally choose the formula with greater incentive even though the profit payout is greater. For either party to the negotiation, this technique of charting or graphing the profit to be derived from an incentive formula is invaluable in giving perspective on the merits of the formula^by itself or in comparison with other formulas. Parties in negotiation of incentive contracts should be sure to avail themselves of such a technique.

Broad Range of Variation

in Incentive

Contracts

One of the misleading aspects of incentive contracting is the fact that the term "incentive contract" can be used to cover such a wide diversity of formulas that it becomes almost a meaningless term. This is to say that incentive contracts can be written which have little profit motivation and very little risk, yet they fall under the broad generic term "incentive contract." For instance, the following formulas have appeared in actual contracts negotiated recently: Formula A Target Cost Target Fee Minimum Fee $100 6% 5%

Maximum Fee Sharing Arrangement Formula B Target Cost Target Fee Minimum Fee Maximum Fee Sharing Arrangement

7% 95/5 $100 7% 4% 10% 100/0 23% each side of the target cost. 90/10 more than 2 % 3 ? from the target cost.

In Formula A the small range of fee and the low share produce a contract that is essentially a CPFF contract. The contractor runs some risk of attaining only the minimum fee of $5 but this rate of fee is quite similar to that normally earned on CPFF contracts. In Formula B the contract actually is a CPFF contract for any actual cost between $77 and $123. Outside of these broad limits sharing is imposed and the contractor runs some risk. However, the unusually wide range of the plateau makes the contract much more akin to the CPFF than the CPIF contract. These examples are merely two illustrations of the point that there are extremely wide variations possible in the CPIF category of contracts and that the contracts that fall within the range closest to the CPFF contract are not necessarily the "risky" contract that their name would imply. Another example taken from a recent contract illustrates this same tendency of diversity of incentive contracts in another direction: Formula C Target Cost Target Profit Ceiling Share $100 12% 115% 80/20

This FPI formula with virtually no ceiling protection is very similar to the maximum price redeterminabie fixed price contract which was used extensively prior to the change in DOD policy in March 1962. In this incentive contract, however, the contractor is entitled to additional profit for underrunning the target cost where in the redeterminabie contract the normal practice was to give the same rate of profit unless the contractor could demonstrate that cost savings resulted from actual effort on his behalf. The weakness of both of these forms of contract,

of course, is in the imphcit assumption by the Government that the target cost is set at a median point (a point of equal risk). It is difficult to believe that the contractor would agree to the contract ceiling price being set at the point of median risk unless he is under heavy competitive pressure. Thus, the normal assumption in this type of formula would be that the target cost must include sufficient protection so that the contractor does not run a heavy risk of losing money on the contract. It should also be noted that the two types of incentive contract tend to merge. For instance, consider the following formulas: Formula D Target Cost Target Profit Ceiling Share Target Cost Target Fee Maximum Fee Minimum Fee Share $100 81/2% 126% 80/20 $100 71/2% 15% -7% 85/15 for 10% either side of target. 75/25 for remainder of costs.

Formula E

It is difficult to determine which of these two contracts contains the greater risk, but it appears that the CPIF contract using Formula E contains equal risk and therefore does not pay a sufficient rate of fee in comparison with FPI contract using Formula D.25 In these cases the standard profit rate percentages must be used with some discretion, with the negotiating parties taking the entire formula into account rather than just the name of the contract type. It is in this area that the imposition of the artificial profit limitations on CPIF contracts set forth m the ASPR become a handicap to the negotiation of equitable contracts. A final statement should be made in discussing the unlimited variation possible in incentive contracts. An incentive contract can be either a means of making a contractor take more risk in a program or a means of affording him less risk. In the case of use of the incentive contract
This possibility is recognized by the new regulations on profit at ASPR 3.808.5(c) (5).

in tiie development area where the only alternative is the use of a CPFF contract, the risk is increased. However, in the situation where there is actual cost experience on the item being bought under a manufacturing contract and the contract is the fourth or fifth contract calling for the production of that item, the use of an incentive contract is a means of avoiding risk. Here the alternative would be afirmfixedprice contract and the incentive contract is a means of giving the contractor cost protection. It should be clearly understood that this was a major use of the incentive contract in its early days and it is still used quite often for this purpose.

Chapter III PERFORMANCE AND DELIVERY INCENTIVES

In contrast to cost incentives, the use of performance and delivery incentives is a relatively new phenomenon in government contracting. The purpose of this chapter will be to analyze the way these incentives function and the techniques that can be applied in using them. Discussion of when they should be used will be reserved until Chapter 4. However, it is appropriate to note here that the present ASPR policy requires use of performance and delivery incentives in most development contracts and they are also being used to some extent in initial manufacturing contracts. Thus, their use has become rather widespread in the past few years and it can be predicted that they will continue to be used extensively in the future. The use of these incentives can be analyzed in terms of the steps that are taken in arriving at an incentive formula incorporating them into the contract. These steps involve (1) choosing the performance and delivery goals to which the incentives can be applied, (2) determining the target and range of performance and delivery over which incentive profits will be spread and (3) assigning relative weights to each of the goals chosen in order to arrive at a balanced incentive formula. Each of these steps will be discussed subsequently. However, before undertaking this detailed discussion one very basic concept in this area must be explored. This is the "trade-off" analysis concept.

The Trade-Off

Analysis

This trade-off concept is the basic method by which we analyze the performance incentive contract to determine whether it is formulated in such a manner that it will yield the desired results for the Government. The concept is based on the assumption that once the incentive formula is negotiated and incorporated into the contract, that formula serves as the decision making tool for the contractor throughout the life of the contract. Thus, once the formula is set, the Government loses control of the performance decisions which are made on the basis of the incentive formula. For example consider a simplified incentive formula that includes the following three factors:

Cost Incentive 85/15 Performance Incentive $5,000 profit for eacli 5 mile increment of range Delivery Incentive $10,000 profit for each week Let us assume that during the performance of this contract the contractor finds that he has two alternate techniques for designing one component of the system as follows: Technique B Comparison of B to A (profit) Cost $300,000 $400,000 $15,000 Performance 500 miles (target) 530 miles 4- 30,000 Delivery on schedule 1 week slippage 10,000 Overall comparison +$ 5,000 Technique A

By applying the incentive formula to the different results forecast from the two design techniques, a profit differential has been computed for each factor influenced by the different techniques. For instance, the difference of cost of $100,000 will result in a penalty to the contractor of $15,000 if he used technique B (his share of the extra cost using the negotiated 85/15 sharing arrangement). The cumulative effect of this comparison of profit resulting from the two techniques indicates that the contractor will earn $5,000 additional profit under the incentive formula if he follows technique B rather than technique A. In accordance with the profit motivation of the incentive contract, such analysis indicates that he should follow technique B in these circumstances. Thus, by making such a trade-off analysis, the contractor can determine the most profitable course of action to take throughout the performance of the contract. Of course, we are assuming that he can accurately forecast the results of alternative approaches and we have simplified the statement of the problem above by assuming that all of the alternatives were within the range of sharing of incentive profits. However, the example illustrates the trade-off technique if these limits are kept in mind. The critical problem is whether the Government wants the contractor to follow technique B, spending an additional $100,000 and slipping the schedule one week in order to achieve 30 miles of additional range. If such result is desired, the incentive formula is satisfactory. However, if the Government would prefer that technique A be used under these

circumstances, the incentive formula has not accomplished one of its primary purposesthat of inducing the contractor to make decisions in accordance with the Government's interests. In this respect, the tradeoff device can be looked at as a technique for analyzing the incentive formula to determine if it is structured in the proper way. It is frequently used for this purpose. Actually, of course, to properly analyze an incentive formula numerous hypothetical trade-off analyses must be made in order to get a comprehensive view of the way in which the formula will work in practice. Without this type of analysis, the Government is running a great risk that the incentive formula will induce the contractor to make decisions that are not in the interest of the Government. Reserving further discussion of the trade-off technique until we have looked at other aspects of performance and delivery incentives, let us turn to a discussion of the steps that are taken in arriving at a performance incentive formula.

Choosing

the Goals for

Incentives

The first step in writing performance and delivery incentives is the selection of the goals which will be used as targets for incentive in both the performance and delivery area. The initial consideration in this selection process is the determination of the proper party to select those goals which will be used for incentive purposes. In the past the Government's Request for Proposal has usually not specified the goals to be used for incentive purposes but has merely indicated a desire to have such incentives incorporated in the negotiated contract. This has placed the burden of proposing these goals on the contractor. However, it would seem that the Government should take the initiative in this matter. Both the performance goals and the delivery requirements of the contract are a direct reflection of the needs of the Government to a large degree. (They may also reflect the existing technological state of the art.) Thus, the relative importance of these aspects of the procurement will frequently be much better understood by the Government than the contractor. It is also true that the resulting formula must be a fair reflection of the needs of the Government if it is not to result in a distorted contract. All of these considerations point to the desirability of the Government's designating the goals to be used for the incentive formula. The failure of the Government to assume this responsibihty in the past has evidently resulted from a feeling on the part of Government

procurement personnel that they are not fully competent to make this initial determination (perhaps because of their lack of confidence in their knowledge of the exact state of the art) and that there is benefit to be gained in having the contractor take the first step in this area (perhaps in order to reveal information relating to his competence to conduct the program). These considerations are particularly important in the case of a competitive procurement for development work where the Government is using the competitive process to determine the state of the art and the relative abilities of the competing contractors at the same time. In such case, the contractor is placed in a difficult position since he must select goals for the incentive formula without a completely clear understanding of the needs of the Government. Such procedure places a large premium on the ability of a contractor to determine the needs of the Government through personal contacts with Government employees and past knowledge of the program in question. It is clear that there is no simple solution to this problem. The best method to select the goals is for both parties to work together during the negotiation to select those which they mutually agree are best for the program. Unfortunately, this technique can only be completely used when the procurement is initiated on a sole source basis. When there is competition, the selection of goals for inclusion in the initial proposal will probably continue to be the responsibihty of the contractor.

Performance Goals
Assuming that the contractor must select the performance incentive goals in submitting his proposal, his problem is to determine the proper criteria for such selection. Since the contract will normally be a development contract (or perhaps an initial manufacturing contract) the work statement will generally consist of a performance type specification. This specification will be the normal point of departure since it contains numerous design goals which the Government has already determined to be applicable to the work to be done. The contractor will select a few of these performance goals for incentive application. The temptation will be to select those goals which are easy of accomplishment in order to assure that profit is not lost in the performance incentive area. This is a poor technique. The purpose of the performance incentive is to encourage good performance hence the goals selected should be those that best reflect the critical requirements of the program. The selection of

such goals for incentive application will also enhance the contractor's competitive position by demonstrating that he fully comprehends the program and the work to be performed. A major problem in this area is how many goals to use for incentive purposes. Of course, all of the goals stated in the specification could be used if performance against all of these goals were readily determinable. In most cases, this would create a very difficult problem in administering the contract. Hence, the normal solution has been to attempt to limit the number of goals with incentives to a small number, attempting to select those goals which best define the critical requirements of the product. In the case of an aircraft the following goals were used:26 Weight Empty Maximum Speed Stall Speed Take-off Distance Maximum Range Range Loaded Navigation System Performance Glide Bomb System Performance Loft Bomb System Performance System Reliability In the case of a missile the Air Force used goals as follows:27 Reliability Early Demonstration of Missile Lifetime of Missile in Orbit It should be noted that in both of the above cases, one of the performance incentives is reliability. This is a frequently used goal which merits special consideration since it is often a prime contract requirement, and yet it presents problems of definition and measurement. When reliability is used as a goal, special attention should be paid to the specification defining reliability and the test methods to assure that they are sufficiently definitive to avoid later disputes. In selecting goals for incentives it should be recognized that often
The Navy Bureau of Aeronautics contract for the development of the A2F. 27 The Air Force contract A F 04 (165)-36 with Space Technology Laboratories, Inc. for the development, test and launch of 10 missiles. See Aerospace Management 48 (October, 1962).

the goals in the specifications are overlapping. Hence, the specification for a missile will call for a set range and also specified goals for power and weight. Since the amount of propulsion and the weight are the two components of range of the missile, it may be feasible to use only range, excluding weight and power from the incentive formula. In this way simplification can be achieved. The ultimate aim, of course, is to select goals which give a balanced definition of the system requirements and can be handled with ease during the performance of the contract. Care must also be taken that the goals selected can be accomplished by the contractor with a minimum of effort by other contractors or the Government. This aim cannot always be achieved but it should be kept as a target since each time the contractor becomes dependent on effort of an outside party, he loses control of the work and loses some of the incentive to improve performance. For example, incentive goals calling for a standard of maintenance of Government personnel during field use of the equipment or calling for producibility of an end product by another contractor against the design delivered on a development contract create serious problems. In such cases a contractor is, to some extent, committing his incentive profits to the performance of a third, uncontrolled party. In addition, he extends the time of the contract to a large extent. These disadvantages indicate that such incentives should be avoided whenever possible. One of the major needs in selecting performance incentive goals is to choose goals that can be easily measured. The best method of assuring this result is to use goals whose achievement is already programmed for testing under the contract specifications. Use of such goals will not only assure that adequate test methods will be available but will save the expense of developing test procedures and conducting a test program solely for the purpose of determining whether the contractor met the contract requirements. Such a procedure of choosing a goal for incentives that required additional testing would increase the cost of performance and thus work directly against the purpose of the incentive contract of saving costs. This problem of adequate test procedures and specifications is an important one because the performance incentive contract can never be settled if the parties cannot agree on the results of the tests. For instance, if a sampling technique is to be used, all elements of the technique should be stated in writing. If the tests are to be conducted under actual conditions, a technique for conversion of the test results to some standard should be set forth. The ultimate objective, of course, is to

have a test procedure that is so well defined that there can be no disagreement on the results of the test. It should be mentioned that almost all of the problems in the selection of performance goals for incentive application could be solved if the Government would limit the use of performance incentives to those cases where improvements in performance are desired and the incentive contract is chosen as the vehicle for encouraging such improvements. The fact that this is not the policy at the present time leads to most of the difficulty in selecting goals for incentives.

Delivery Goals
In the delivery area, too, the contractor normally will be the party to select the goals for incentive application in thefirstinstance. Again his point of departure will be the requirement set forth in the Request for Proposal. However, he must decide whether to use end item delivery or performance milestones during the performance cycle. The argument for using end item delivery alone is that that is the element that is crucial to the Government. On the other hand, those who argue for the use of milestones feel that there is merit in applying incentives throughout the program and not just at the endthat in this way the contractor has more immediately perceptible incentives. Of course, even when the milestone incentives are used a major part of the weight would be applied to the final delivery point since it would be undesirable for the Government to pay incentive profit for meeting intermediate milestones if the final delivery were missed. In many cases the nature of the procurement may well determine the goals to be used in the delivery area. For instance, in a procurement for the initial production quantity of an item requiring preproduction samples to be submitted, the timely submission of such samples might be of such importance that the Government would insist on that date being one of the goals for the application of incentives. In the case of a development contract where the entire program is scheduled and performed in accordance with a PERT system, the tendency has been to use the milestone technique since the final completion date might be so far in the future as to be vague in its effect at the outset of the contract and the PERT system would provide an easy means of establishing milestone information (requiring only a selection of a small number of critical milestones). In a contract calling for the manufacture of a quantity of items the

problem arises of whether the delivery incentives should be applied to all items to be delivered or only a specified number of those items. Normally, it would be assumed that the delivery of the first item is the most difficult to achieve while it might be quite simple to deliver later items on or ahead of schedule. In such case, if it is decided to apply some incentive to each deliverable item on the contract, the Government will normally insist that a heavier weight be given to the early items than to the later items. The problem, again, is one of identifying the needs of the Government and creating an incentive formula that gives a fair representation of these needs. In this situation, the contractor is at a disadvantage if he is not intimately familiar with these Government needs. In selecting the delivery goals for incentive application the need for simplicity should also be considered. Since compliance with a delivery schedule is usually easier to demonstrate than compliance with a performance requirement, there is not as great a need to incorporate in the contract complex procedures for determining when the target has been met. However, in the delivery area, the problem of slippages due to excusable delays or acts of the Government can be a major one; and the possibility of incurring such slippages should be considered when the delivery goals are chosen. One technique to ease this problem is to use only a few delivery goals rather than using a large number. In this case, the contract adjustments to the delivery schedule can be kept to the small number necessary to keep the selected delivery goals on a current basis taking into account all such delays for which the contractor is not responsible.

Interrelationship of Performance and Delivery Goals


Performance goals and delivery goals are interrelated. For example, any delivery incentive is predicted on delivery of a service or product which meets the contract specifications. If the specifications are not met, the Government has the right to reject the item and insist on continued effort in an attempt to meet the specification requirements. In such case, the contractor can not have been said to have delivered and hence he has not earned any incentive profit under the delivery incentive. Thus, the delivery incentive functions as a back-up to any performance requirements in the contract including those which are being used for performance incentives. This interrelationship should be considered when choosing performance and delivery goals for incentive application

since it is often quite easy to simplify the structure of these incentives by allowing the delivery incentive to fulfill some or all of the needs of performance incentives. Hence, it might be possible to use only delivery incentives in a case where a performance specification were being used with the understanding that the contractor would earn a minimum fee on the delivery incentive if he did not meet the specification requirements. The difficulty in this technique is that often the Government does not have a real alternative of rejecting the workthe effort of redesigning or rebuilding would be far too co5tly in terms of the benefit to be received. In such case, the Government will accept the item with deficiencies and negotiate an adjustment in price to compensate for that deficiency. Such an action creates a difficult problem in settling the amount of profit earned under the delivery incentive since technically the Government could claim that there had never been any delivery in accordance with the strict contract requirements.

Determining

the Target and Range of Incentive

Application

When the performance and delivery goals for incentive application have been chosen, the range of incentive sharing must be determined. This involves the selection of a target for each goal and the determination of the amount of variation from that target that will be covered by incentive sharing. For instance, if one of the goals is weight, it might be decided that the fairest target weight was 100 pounds with incentive profit to be earned by the contractor for reductions in weight down to 90 pounds and incentive profit to be lost by the contractor for increases in weight up to 110 pounds. Such a determination, of course, involves a value judgment that the Government desires weight reduction down to 90 pounds and is willing to pay additional profit to obtain such reduction; and conversely that the Government can accept the item if it weighs up to 110 pounds. Thus, this aspect of creating the incentive formula, like the selection of the incentive goals, involves an intimate knowledge of the needs of the Government. Again, it would seem that the proper party to establish these aspects of the incentive formula is the Government rather than the contractor. However, in the past Requests for Proposal generally have not contained any such information with the result that the burden of making the decisions needed in this area rests on the contractor. In a sole source procurement, this can be overcome by consultation with the contracting officer; but in the competitive procurement situation, such consultation is often difficult to arrange. Hence, in

such cases, the contractor must use the best information at hand to propose an incentive formula with the knowledge that his proposal may be used in the evaluation process to determine his ability to perform the
work.28

The preliminary question to be asked in this process of determining the range of incentive application is why should the incentive cover a range of performance or delivery at ail ? This question is especially important since in many cases the Government does not want improved performance and cannot accept below-target performance. It would seem logical in such cases to place the entire incentive on meeting the target. This solution, however, results in a contract with a very unbalanced trade-off between performance or delivery and cost. For instance, let us assume the following two alternate situations where it has been decided to allocate $150,000 of incentive profit to the weight performance factor: Formula A Formula B ^ost Incentive 85/15 85/15 Performance Incentive on Weight Target 50 lb. Max. Weight 55 lb. M i n . Weight 45 lb. Profit sharing of $6,000 for each 1/5 lb. weight within 45 to 55 lb. range Target 50 lbs.

Incentive Profit of $150,000 if target is met; penalty of $150,000 if target is missed.

In the case of Formula A a contractor with an item that weighed 51 pounds would not take any action unless the cost of any additional effort would result in a weight savings of better than 1/5 pound for each $40,000 spent (at this cost he will gain $6,000 profit for attaining the 1/5 lb. weight saving and lose $6,000 as his share (15%) of the $40,000 cost expenditure). This is a normal trade-off situation. However, in the contract containing Formula B the contractor is in a radically different situation. If he delivers an item weighing 51 pounds, he will lose
28 It shoud be noted that ASPR does not require a full incentive proposal. ASPR 3-403(c) states that "proposals should be required to include proposed targets for the accomplishment of the Govemment's desired performance and schedule completion objectives, together with an estimate of the cost of doing so." Based on this language and considering the difficulties of proposing a full incentive formula, it might be suggested that the creation of the full incentive formula be done during the negotiation of the contract after the selection of the contractor has been made.

$300,000 profit. This gives him the incentive to spend up to $2,000,000 to achieve a weight reduction of one pound. This very likely would be a completely distorted trade-off which the Government would not want since 85% of such a $2,000,000 expenditure would be paid by the Government. This result is usual in the case where the incentive is focussed on the target only rather than being spread over a range of performance around the target. Thus, whenever possible, the sounder course is to utilize incentives which can be spread over some amount of performance around target. Another problem arises in selecting the target for the goal chosen for incentive application. Here the most apparent point of departure would be the specification requirements and delivery schedule set forth in the Request for Proposal. These are statements of the needs of the government and would probably be good targets from the point of view of the Government. However, the contractor must compare these Government requirements to his own abilities to determine if the requirements can be attained with normal technical and management effort on his part. From the contractor's point of view, the targets should be attainable without extraordinary effort if they are to be considered fair targets. Otherwise, the contractor may be entering into an incentive contract with a built-in profit reduction in the delivery or performance area. On the other hand, the targets proposed by the contractor may be an important part of the source selection process and the contractor that proposes targets which do not conform to the specifications and delivery schedule but which he feels are realistic may be seriously prejudicing himself in the contractor evaluation which the Government will make. For instance, the contractor may have decided to propose radar range as a target and the specifications may require range of 1500 miles. However, his evaluation of the state of the art may indicate that the achievement of such a range would require optimum performance with the probability that the range will fall in the area of 1400 to 1450 miles. The use of the 1500 mile range for incentive purposes will probably result in an ultimate reduction of the contractor's profit while the use of 1400 miles, as the target range in the proposal may affect his competitive position. Thus, the establishment of the targets for performance and delivery incentives may place the contractor in a competitive procurement in a real dilemma. Another difficulty which is encountered in establishing the targets is the lack of knowledge of the exact significance of the requirements in

the specification and delivery schedule. Are these Government-established requirements minimum acceptable figures, target figures or optimum figures } Without the answer to this question the contractor is in a very difficult position when he prepares his incentive proposal. Again, there is need for a great deal of communication between the parties to the contract in creating the incentive formula and without such communication the contractor is at a real disadvantage.

Special Problems in Performance Incentives


In establishing targets and ranges of incentive application in the performance area the contractor should look carefully at the existing state of the art. When the performance incentive contract is being used in the development or initial manufacturing area, the technical requirements should not require any advances in the state of the art but should be attainable without additional research effort. Hence, the need for such state of the art effort should warn the contractor that he is aiming at poor targets. In order to make such an analysis the business personnel and the engineering personnel in the contractor's organization must work together very closely, with the engineers furnishing information on the optimum performance and minimum expected performance attainable on each performance goal which is to be used for incentive purposes. A comparison of thesefigureswith the specification requirements should quickly tell the contradtor whether he is in a position to submit an incentive proposal or whether he must return to the contracting officer for additional information. Performance incentives may be based on individual performance factors such as range, speed, weight or reliability or they may be stated in terms of an overall evaluation of program performance. For instance, in a missile development contract containing an elaborate test program, the satisfactory completion of the tests may be the major concern of the Government. In such a case, a performance incentive similar to that se't forth in Figure 3-1 has been used. There, a point system is used to evaluate the contractor's performance with the weighting of the various test missions based on the purpose of the test. For instance, the first testfiringof the missile is for the purpose of proving the validity of the countdown procedure and the firing of the first stage of the missile. Hence, the heavy weight is assigned to these operations. In contrast, the purpose of the fifth test firing is to demonstrate complete system operation in getting the payload into orbit and the purpose of the tenth firing

PERFORMANCE INCENTIVE (Point System)

POINT ASSIGNMENT
Test #1 Countdown 1st Stage Firing 1st Stage Separation 2nd Stage Firing 2nd Stage Separation Payload Operation
20 80 0 0 0 0 100

Test #2
20 30 30 20 0 0 100

Test #3
20 20 20 30 10 0 100

Test #4
20 20 10 20 30 0 100

Test #5
20 10 10 20 40 0 100

Countdown 1st Stage Firing 1st Stage Separation 2nd Stage Firing 2nd Stage Separation Payload Operation (Partial) Payload Operation

Test #6 20
0

0 20 30 30
0

Test #7 20 0 0 10 20
50

Test #8 20
0 0

0
0 70

Test #9 Test #10 20 20 0 0 0 0 0 0 0 0 40 20


40

0 100

10 100

60 100

100

100

CONVERSION CHART

+ 2%

w
Ui

+1%

2 w ^ ir/
-2%
\

3%

-4%

Vm

'J(K)

SUO

TUO

oOO

5(X)

400

30(3

200

100

POINTS

FIGURE 3-1

is to test tlie operation of the payload in all of its required functions. These tests are weighted to reflect these purposes. It should be noted that weight is placed on the countdown procedure throughout the program to focus attention on an area where problems had occurred in the past. At the end of the contract the total points earned in the entire test program are totalled and converted to incentive fee using the table set forth in Figure 3-1. It should be noted in this conversion table that the contractor does not have to attain complete perfection to earn the maximum fee; neither does he have to fail completely to incur the full penalty. Of course, in creating such an incentive the contractor and the Government must evaluate the same factorsGovernment requirement and state of the artto establish a fair set of requirements. However, as the incentive system becomes more complex, the parties must exercise grea^ter care to avoid entering into a contract which neither gives the Government what it desires nor offers the contractor an opportunity to make a ^air profit on the work.

Special Problems in Delivery Incentives


In the delivery area it is often difficult to spread the incentive profit over a range of satisfactory delivery. This difficulty arises from the fact that delivery schedules are usually relatively inflexible and often the Goverrmient does not desire early delivery. This would be particularly true in cases where the end item was being procured for incorporation into a system and hence where early delivery would merely mean that the item remained in storage longer before use. In such cases, the delivery incentive becomes very similar to a liquidated damages provision with all of the incentive profit focussed on the meeting of the contract delivery schedule. When a milestone delivery incentive is being used, a different problem arises. There, the most desirable technique would be to spread the delivery incentive for each milestone over a range of delivery each side of that milestoneperhaps a month each side of the milestone date. If this is done, however, the interrelationship of the milestones must be consideredshould each milestone be separate from the previous milestone with a calendar completion date or should it be related to the meeting of the last milestone with a date stated in terms of that previous milestone. For instance, let us assume the following milestones as delivery targets:

Milestone #1 #2 #3 #4

Target 6 9 13 16 mo. mo. mo. mo. after after after after commencement commencement commencement commencement of work of work of work of work

In this case, it might be desirable to spread the incentive profit assigned to milestone #1 over one month either side of the delivery date. This would provide continuing incentive during a two month period and provide a smaller trade-off in relation to cost. However, should we then relate milestone #2 to completion of milestone #1 or relate it to the absolute date of 9 months after work commencement ? If we make it 3 months after meeting milestone #1, and also spread the incentive profit one month either side of this milestone, we cumulate the schedule slippage until the final milestone might be greatly slipped and yet the contractor could earn incentive profit because he performed well in relation to the preceding milestone. On the other hand, if the milestones are not connected, a contractor might miss milestone #1 by one month and remain at the scheduled pace for the remainder of the contract yet earn the minimum profit in the delivery area by also missing every other milestone by one month. Conversely, he might reach milestone # 1 one month early and earn a maximum profit by staying at the scheduled pace for the rest of the contract. In an eff^ort to solve this problem, delivery incentive contracts using the milestone system have often adopted a point system of incentives such as that set forth below:
Values Assigned AUI e stone Points Points Incentive Scale Ejfect on Profit Earned

#1 #2 #3 #4 #5 #6

1.0 1.0 1.5 1.5 2.0 4.0

03.55.57.510-

3 5 7 9.5 11

2% -1% 0 + 1% + 2%

In this example the meeting of each designated milestone earns the contractor a specified number of points which is then converted to a profit variation depending on the scale set forth in the contract. It should be noted that by weighting the milestones in this case the heaviest

emphasis is placed on the final milestones yet the arrangement does provide incentive throughout the program. This technique still has the disadvantage, however, of focusing the entire incentive around very narrow points rather than having minor variations in the profit earned or lost as the degree of advancement or slippage increases, although this is modified to some extent by the overlapping of assignment of profit to a range of points. Here, in the example, if milestone #1 is missed and all others attained the contractor will still earn maximum profit. On the other hand, since the program is cumulative to a large extent the incentive remains on the contractor to continue working up to the end of the contract. Hence, in the above example if the contractor misses all milestones except the final one, he still avoids the minimum profit. It can be seen that the ideal solution in the delivery incentive area is difficult to find. In general, it would seem desirable to use delivery incentives that were spread over a range of delivery whenever possible. When this is not possible, a compromise must be reached. In the case where milestones are being used, the most equitable solution might be allowing the milestones to be determined on a cumulative basis (each one depending upon the successful attainment of the previous milestone) except that the final milestone would be the most heavily weighted and would be based on a specific contract completion date. This would provide someflexibilitywithin the schedule and still provide the Government with the incentive on the desired final completion date.

Arriving

at a Balanced Incentive

Formula

When the goals for incentive application have been chosen and the targets plus the range of variation from target selected, the final step in creating the incentive formula is the assigning of relative weights in terms of incentive profit to each of the performance and delivery goals. This process, of course, also requires the determination of the incentive profit to be assigned to the cost area since in all cases where performance or delivery incentives are used, cost incentives must also be used.^o The problem is therefore one of arriving at incentive profits assigned
29 ASPR 3-407.2 (c) (1). There is some confusion regarding this requirement in relation to firm fixed price contracts. The firm fixed price contract is the ultimate cost incentive contract and therefore this provision should be interpreted to allow the use of performance and delivery incentives in firm fixed price contracts.

to each goal in the performance, delivery and cost area which will result in an incentive formula that provides reasonably valid trade-off decisions during the performance of the contract. The initial step that is usually taken in this area is the use of the relative weights for performance, delivery and costs which are usually spelled out in the Request for Proposal. The regulations state that these weights should be included in the Request for Proposal when multiple incentives arc used in development contracts although it is not clear what precise function the relative weights serve.^^ However, the practice has been to state these weights in percentage terms and it is clear that the weights do give an indication of the relative priorities which the Government wants given to the various areas. For instance, in the development area where the primary emphasis is on good engineering weights as follows might be used: Performance Delivery Cost 30% 30% 20%

In contrast, a development contract for a subsystem which must be delivered at a certain time to allow progress on the total system might have weight as follows: Delivery 50% Performance 35% Cost 15% Or, an initial production contract for an item where the development work had been completed and therefore the engineering was more definitive might have weights as follows: Delivery Cost Performance 40% 35% 25%

The easiest method of using these weights to allocate the incentive profit is to apply them to the entire incentive profit in the contract. In a CPIF contract situation this requires the prior negotiation of the minimum and maximum fees and the application of the relative weights to the difference between these fees and the target fee.^^ For
30 ASPR 3-403 (c). 31 See, however, p. 29 supra where it was determined that the minimum and maximum fees should not be determined initially but should be derivative figures resulting from the establishment of other aspects of the incentive formula.

instance, in a situation where the parties had negotiated a target cost of $10,000,000 and a target fee of $700,000, they might negotiate a minimum fee of $100,000 and a maximum fee of $1,300,000. If the relative weights specified by the Request for Proposal were: Performance 50% Delivery 30% and Cost 20%, it would be quite simple to divide the incentive fee of $ 6 0 0 , 0 0 0 into elements of $ 3 0 0 , 0 0 0 for performance, $ 1 8 0 , 0 0 0 for delivery and $ 1 2 0 , 0 0 0 for cost. These amounts could then be allocated to each goal within the performance and delivery area in accordance with the relative internal weights of the goals and the incentive formula would be established. Unfortunately, this technique will usually result in an incentive formula that is unbalanced in terms of trade-off decisions. The major reason for this lack of balance is that this technique does not give sufficient weight to the cost incentive in relation to the other incentives. For example, in the above hypothetical case, the cost incentive is only given $ 1 2 0 , 0 0 0 which must be spread over a substantial variation of costs from the target. Let us assume that the minimum coverage of the cost incentive of 2 5 % either side of target is used. In that case, the incentive fee of $ 1 2 0 , 0 0 0 would be spread over costs of $ 2 , 5 0 0 , 0 0 0 giving a contractor's share of slightly less than 5%. If, at the same time, we assume that the performance incentive will give the contractor an additional $300,000 for achieving maximum performance, a trade-off analysis will indicate that the contractor could overrun the contract by substantial amounts and still increase his profits by improving performance. The basic technique that is used to solve this problem of insufficient emphasis on the cost incentive is to create "overlap" in the incentives.^2 Overlap in this case signifies that the dollars of incentive fee that are assigned to each factor total more dollars than the difference between the contract target and minimum-maximum fees. For example, in the hypothetical case, the dollars of fee to be assigned to the cost incentive might be increased to $ 3 0 0 , 0 0 0 . This, of course, would allow a higher sharing rate to be used or, alternately, would allow the cost incentive to be spread over a broader range of costs. The result is more emphasis on costs, and trade-off decisions that reflect this additional emphasis. In the case where the results of all of the incentives exceeded the contract maximum and minimum fees, the contract minimum and maximum
32 The Department of Defense, Incentive Contracting Guide (1962) states that "it is D O D policy to incorporate cost overlap in CPIF multiple incentive contracts wherever possible." (p. 44)

would override the others and, o course, the contract should so state. For example, in the hypothetical case the contractor might lose $250,000 under the cost incentive, $150,000 under the delivery incentive and $250,000 under the performance incentive. In such a case the contract minimum fee would control and the contractor would lose only $600,000 rather than the $650,000 loss indicated by the separate incentives. In essence, however, the principle of overlap is sound since the possibility of reaching all of the minimums or all of the maximums in a multiple incentive contract is extremely remote. Thus, this is a useful device to achieve balance in the incentive formula. The technique for balancing the incentive formula described above is a trial and error technique. It involves spreading the incentive profit over the various incentive goals in accordance with the relative weights and then adjusting the results until rational trade-off figures are arrived at. It must be emphasized that the second step, the adjusting of the initial results in accordance with numerous trade-off analyses, is essential. Neither party to the contract should assume that the relative weights will yield a balanced incentive formula by themselves and an analysis of actual contracts written in this v/ay indicates that just the opposite is to be expected. For instance, a recent A i r Force contract contained the followed incentive figures Target Cost Target Fee Minimum Fee Maximum Fee Cost Incentive Variations from Target 0-$ 500,000 500,000-$l,500,000 l,500,000-$2,000,000 2,000,000-$3,000,000 $14,000,000 $1,000,000 0 $2,000,000 ($325,000) Shares 100/0 95/5 90/10 77.5/22.5

Performance Incentive ($675,000) Rehability $250,000 Early Demonstration $125,000 Lifetime in Paired Orbit $300,000
This is the same contract referred to in note 17 supra.

In the above formula the incentive fee has been spread 32.5% to the cost area and 67.5% to the performance-delivery area with no overlap. The result is that the contractor will almost inevitably maximize his profit if he incurs an overrun of $1,000,000 to $2,000,000, assuming that the expenditure of this amount of additional funds will provide sufficient additional engineering effort to assure better results in the performance and delivery area. (At the $1,500,000 overrun point, the contractor will lose fee on the cost incentive of $50,000 but will obtain the benefits of this expenditure of funds in the performance area where the incentive profits are large.) Such results can be expected when such a technique is used. An alternate approach to this problem is the use of a trade-off computation in the first instance. Such approach disregards the overall relative weights on the grounds that they are only statements of priority rather than precisefiguresto be apphed to the balancing of the incentive formula. In lieu of these weights, the parties utilize a trade-off concept where they determine the relative value of improvements in each area where incentives are to be used. Hence, in a $50,000,000 contract they might take an additional cost of 2 % or $1,000,000 and make a value judgment of the worth of this amount of funds. From the Government's point of view, this value judgment would be looked at in terms of what extra performance or early delivery is worth. The contractor would look toward the amount of extra performance or early delivery this amount could accomplish. Of course, if there was a disagreement, the Government would be expected to prevail since the problem is essentially to state a formula that gives the Government what it wants for its money. However, both points of view would be of value in making such a trade-off computation. The operation of such a trade-off computation can be seen in Figure 3-2 where an entire performance incentive formula is worked out. There the overall relative weights for the areas of performance, deliver and cost are disregarded completely and the entire formula is based on a trade-off computation made in the first instance. This direct approach to the problem may seem rather difficult since it is hard to arrive at the value judgments which are necessary to make such a trade-off computation. On the other hand, if the contracting parties are not able to determine these values they are not in a good position to utilize a performance incentive contract at all since they will have no valid method of determining whether the formula arrived at ac-

Establishing

the Formula in Performance

Incentive

Contract

Step 1. Choosing the criteria Performance 1. Range 2. Accuracy 3. Payload 4. Reliability Delivery 1. Complete concept drawings on guidance 2. Complete concept drawings on entire system 3. Complete detail drawings on entire system 4. Deliver prototype to test area 5. Successful completion of test program Cost Step 2. Determining the range of incentive application Performance Range 3000 5 0 miles Accuracy 8 rh 6 miles
Payload 20,000 3,000 lbs.

Reliabihty 70% 15% Delivery Guidance concept drawings 4 months after contract System concept drawings 6 months after contract System Detail drawings 13 months after contract Prototype delivery 17 months after contract Test Completion 23 months after contract 3 months (Since there was only three months allowable slippage or possible advancement of the delivery schedule, it was decided to place the entire delivery incentive on the final delivery date rather than on milestones.) Cost $50,000,000 plus 40% minus 20% (which is to say that the parties feel that the minimum cost of the program would be $40,000,000 and the maximum acceptable (but possible) cost of the program is
$70,000,000).

Step 3. Applying the weights to the criteria 1. A n internal value system value system must be devised to interrelate all of the factors chosen for application of incentiveshence:
10 miles range = 1 mile accuracy = 500 lb payload = 2 % reliability = 1 week time = $500,000 cost

2. The sharing arrangement best suited to the contract must be establishedhence:


90/10 between $45,000,000 and $65,000,000 80/20 between $40,000,000 and $45,000,000 $65,000,000 and $70,000,000 and between

FIGURE 3-2

3. The individual performance and delivery incentives must be computed. Using the 90/10 sharing arrangement based on the internal value system established in paragraph 1. above, the computation is as follows: Performance Range5 miles equals $25,000 fee Accuracy14 mile equals $12,500 fee Payload10 lbs. equals $1,000 fee Reliability1% equals $25,000 Delivery 1 day equals $7,143 (It should be noted that the increments of performance and delivery have been chosen on the basis of the smallest measurable increment of performance or delivery as determined by the test procedures available. Hence, in the case of range it was determined that the range of the missile could not be measured more accurately than : 5 miles.) 4. The target, minimum and maximum fees must be negotiated hence: Target fee $3,500,000 ( 7 % ) Maximum fee $6,500,000 ( 1 3 % ) Minimum fee $ 500,000 ( 1 % ) Step 4. Checking the formula for the proper amount of overlap 1. The total amount of incentive fee dollars resulting from the individual incentives must be computedhence: Performance Range $250,000 Accuracy $300,000 Payload $300,000 Reliability $375,000 Total Performance Fee Variation $1,225,000 Delivery $800,000 Total Delivery Fee Variation $ 800,000 Cost +$1,500,000
$2,500,000

Total Cost Fee Variation Total Fee Variation

+$1,500,000 $2,500,000 $3,525,000 14,525,000

2. The total incentive fee dollars resulting from the overall formula is $3,000,000. 3. The overlap is therefore: + 525,000 1,525,000 4. A value judgment must be made whether this is so much overlap that it may keep one of the incentives from operating.

FIGURE 3-2

complishes the purpose of motivating the contractor to make sound trade-off decisions during the performance of the contract. Hence, a performance incentive contract negotiated without good trade-off figures can be no more than a rough approximation of an expression of the requirements of the Government; and, if such figures are available or can be arrived at, they should be used in the first instance to establish the incentive formula. Analysis of the above discussion will indicate that the aspect of present use of performance and delivery incentives which creates the major difficulty in achieving a balanced formula is the use of performance and delivery goals which are chosen somev/hat arbitrarily for the purpose of counterbalancing cost incentives. If the Government desires improved performance or delivery, it should have no difficulty in determining the value of such improvements and establishing the incentive formula to reflect such values. However, in most
cases, the Govermnent merely ivants target performance in all aspects

of the contract. In such case, it would seem possible to focus the incentive formula on target performance without assigning incentives to many aspects of performance, delivery and cost. For instance, the contract could state that a bonus of 5% fee would be paid if the contractor met all of the targets in performance, delivery and cost (penalties could also be included for cost overruns). In such a contract, the contractor would not be able to make up for failures in one area by doing better in another. He could not compensate for an overrun of costs by improving performance. He would have incentive to plan and carry out the work in such a way that he had the best opportunity of meeting not bettering the requirements. In summ.ary, the incentive formula should reflect the needs of the Government and the abilities of the contractor. Perform.ance and delivery incentives for their own sake are not hkely to improve Government procurement and may do it great harm by paying profits which are out of line with the work performed by the contractor. On the other hand, performance and delivery incentives which are v/ell conceived can be of great benefit to both the Government and the contractor. The proper use of performance and delivery incentives therefore offers a great challenge to both contracting officers and contractors.

Chapter IV USE O F INCENTIVE CONTRACTS


The greatest changes that have occurred in the incentive contracting area in the past few years have been in the general understanding of contracting personnel of when such contracts should be used. Prior to i960 the incentive contract was primarily used for airframe contracts involving follow-on procurement. It was not used very extensively for other types of commodities and was hardly ever used for earlier stages of procurement such as research or development. However, in the past few years, the use of the incentive contract has been greatly expanded. Thus, at the present time the incentive contract is being used for all types of commodities and for almost every type of procurement from research to overhaul and repair. This chapter will analyze the current concepts of the proper use of incentive contracts and some of the background of these present concepts.

Requirements

of the

Regulations

On March 15, 1962, the section of the ASPR dealing with types of contracts was completely revised to state new rules governing the selection of the proper type of contract. This revision placed stringent restrictions on the use of the CPFF contract and gave increased emphasis to the incentive contract types. It was promulgated after almost a year of discussion within the military departments and coordination with industry. It thus represented a statement of a general concensus of opinion that government procurement could be improved by the inclusion of greater profit motivation with less reliance on the CPFF contract where the contractor had little motivation to reduce costs. This revision also substantially reduced the use of the redeterminabie fixed price types of contractsin effect leaving four major profit bearing types of contracts for use by contracting officers. These four types are firm fixed price, fixed price incentive, cost plus incentive fee and cost plus fixed fee. Although not explicitly stated, this new ASPR appears to relate contract type to the stage of the procurement with the following preferences being either stated or inferred:

Type of Procurement

Normal

Type of

Contract

Research Development Initial Manufacturing Follow-on Manufacturing

Cost plus fixed fee Cost plus incentive fee Fixed price incentive Firm fixed price

In the following discussion these preferences will be analyzed.

Research and Development Procurements


In these two types of procurements, the ASPR contains specific language covering the proper type of contract to be used.^^ In the research area, the CPFF contract has usually been the type of contract used and the new rules appear to indicate that in most cases use of the CPFF contract is still to be expected. However, in the development area, the ASPR requires the use of incentive contracts which represents a radical change of policyone of the major changes in these new ASPR provisions. Until this time, it was always assumed that the lack of definite knowledge about the work to be done with the related lack of reliable cost estimates precluded the use of any type of contract in the development area which imposed a pricing risk on the contractor. Under the new regulations, the parties must find a way to avoid these pitfalls in order to use the incentive type contract in development situations and it is assumed that the CPIF contract will be the type of incentive contract selected. One very important factor should be noted in assessing this change
34 ASPR 3-403. Paragraph (b) states: "(b) Research. In the majority of research programs, including preHminary explorations and studies, the work to be performed cannot be described precisely. Hence, the negotiation of cost-plus-a-fixed-fee or cost-sharing contracts frequently is necessary. However, where the level of contract effort desired can be identified and agreed upon in advance of performance, ngotiation of a firm fixd-price contract should be considered." Paragraph (c) calls for the use of incentive contracts in all "major systems developments, and in other development programs where use of cost and performance incentives are considered desirable and administratively practicable." This paragraph does not provide whether CPIF or FPI contracts are generally applicable. However, the normal knowledge of the state of the art and the definitive program requirements at the beginning of a development program would indicate that the CPIF contract would be used in the majority of cases. On the other hand, there are several recent indications that the Department of Defense is aiming for increased use of FPI contracts for development. For example, the new D O D Instruction on Program Definition will evidently contain a statement that it is applicable when a FPI development contract is to be used. The T F X development contract also will be written on a FPI basis. Hence, the assumption that the CPIF contract is normal in development may be obsolete.

in poliq^. The new ASPR not oniy prescribes incentive contracts for development work but also contains some relatively firm criteria governing the undertaking of a development contract. Thus, it states that "a iinal commitment to undertake specific product development and test should be avoided until preliminary exploration and studies have indicated a high degree of probability that the development is feasible and the Government generally has determined its desired performance objectives and schedule of completion."35 x^is provision states two separate requirements for the undertaking of a development project: 1. No unsolved state of the art problems. 2. A definitive work statement or specification. In this way, the ASPR draws a very strict line between research and development and provides that work will not be undertaken in the development area until the research has yielded satisfactory results. Under these rules, a procuring agency should not enter into a contract where it programs research solutions as they are needed to fit into a product development cycle. It must have the solutions before it undertakes the development program. It can be seen that this approach greatly reduces the difficulty of using a CPIF contract for the development effort since that effort is predicated on a relatively stable technical situation at the time the development program is commenced. In addition, there is the requirement for specifications in the form of a defined set of performance objectives. This requirement prohibits the practice of developing the work statement during performance of the contracta technique that was not infrequently used under the prior combined research and development contracts. In order to make this requirement for a firm definition of the work more practical, the Department of Defense has initiated a new procurement techniquethe program definition phase of the procurement cycle.36 In this phase, prior to the development effort, the procuring activity contracts for a short effort by one or more of the leading contractors to define and analyze the program requirements. This definition is a joint effort of the contractors and the government technical personnel with the end result being a statement
35 ASPR 3-403(c). 3 For a more detailed description of the Program Definition phase, see Rubel, R&D mtracts: Pohcies and Problems in Research and Development Contracting 25 (1963).

of the work to be done that is fully comprehended by both parties. In this phase the contractors will conduct sufficient preliminary engineering to become aware of the problems they will face in undertaking the development effort and their cost estimates will be improved because of this knowledge. Thus, this phase has the primary purpose of laying the groundwork for the development contract. Under these conditions, the use of the incentive contract for development type work may not seem to impose too great a risk on the contractor. However, there are two problems which seem to remain. First, this use of the incentive contract assumes that development work under these conditions is primarily a matter of management of technical mianpowerthat the technical risks have been removed. While the conditions laid down certainly reduce these risks, it is inevitable that there will be a certain residue of technical risksthe occurrence of unforeseen technical difficultiesthat may require the expenditure of substantial additional sums of money to reach a solution. When this occurs on an incentive type development contract, the contractor will suffer a sizable loss of profit through the working of the incentive formula since the result will almost inevitably be a substantial cost overrun. Thus, this major risk will remain although it may operate in only a relatively small percentage of development contracts. Second, there is the problem of the inability of procuring activities to separate research from development in the large number of small or medium size procurements which make up a major part of government procurement. It seems clear that such separation has not occurred and will not occur in many procurements, yet it is equally clear that incentive contracts are being and will be used for many of these combined research and development procurements.^^ In such cases, the same circumstances which have created large overruns in the past unsolved technical problems and badly defined scopes of workwill tend to operate in the incentive contracts to the detriment of the contractor. Furthermore, in these cases such conditions tend to work ultimately to the detriment of the Government because the contract terms are usually not sufficiently well defined to enable the Government to
37 The Department of Defense has established goals for types of contracts which provide that only 12.3% of defense procurement dollars will be placed on CPFF contracts by fiscal 1965. See Morris statement, supra note 2. In order to meet these goals it is clear that contracting officers must utilize incentive contracts in all possible situations regardless of the specific requirements of the ASPR limiting their use to cases where development is separated from research.

hold the contractor to the job; and faced with a major overrun, he will tend to reduce his contract effort to avoid the excess costs. Thus, in the situation requiring an overrun to successfully complete the job, a contractor who would be willing to incur that overrun on a CPFF contract (where he is merely doing additional work for no fee) may very well be unwilling to incur the overrun on a CPIF contract (where he must contribute perhaps 15% or 20% of each overrun dollar until the minimum fee is reached). When the incentive contract is used for a combined research and development contract, such difficulties can be readily foreseen.

Manufacturing Procurements
The ASPR contains no definitive statement regarding the preferred type of contract to be used for manufacturing work. However, by deleting the redeterminabie fixed price type contract and virtually eliminating the CPFF contract from this type procurement, the contracting officer's choices have been greatly limited. He can avail himself of one of the incentive types of contract or the firm fixed price contract for manufacturing work. Of course, the firm fixed price type contract is clearly the preferred type of contract for all procurementsespecially in the manufacturing area.^^ However, in the initial manufacturing contract where there is no prior cost experience in manufacturing the product, it is often very difficult to arrive at a mutually acceptable firm fixed price by negotiation. Hence, one of the incentive types of contract can be expected to be the most prevalent form of contract in this contracting situation. The CPIF contract, of course, imposes less risk on the contractor but its profit structure is not at all conducive to sound contracting in this area. Such a contract has a maximum fee limitation of 10% leaving little room for the incentive formula to operate above the target fee. Thus the contractor using a CPIF contract for manufacturing work will either find himself With an incentive that operates primarily in the fee reduction area or that contains a low rate of target fee. Hence, in order to obtain a profit commensurate with the work performed under such a contract, the tendency will be to use a FPI contract. There is great variety from one contract to another in this area of effort, however, and there will therefore
38 ASPR 314.2(b) ( I ) .

also be substantial use of both the CPIF and firm fixed price type contracts for initial manufacturing work. In the follow-on manufacturing area, once reliable cost data is available from the earlier production, both parties should strive to use the firm fixed price contract. On smaller contracts, this has been the general practice but in large dollar volume contracts, the use of firm fixed price contracts has been infrequent. It is in this area that the FPI contract has been used as a risk reduction device allowing a contractor to transfer the major portion of the risk to the Government even after all of the major problems have been solved. Although this type of contracting will undoubtedly continue, the trend to higher sharing percentages and lower ceilings under the new ASPR greatly reduces the advantages of the FPI contract as a risk-reduction device. It therefore would appear inevitable that there will be more use of firmfixedprice contracts in the follow-on manufacturing situation.

Criteria for Use of

Incentives

The ASPR provisions emphasize the use of incentive type contracts for certain types of effort, but they generally fail to give guidance on the prerequisites for use of such provisions. However, in many contracting situations the critical factor is not the type of effort to be accomplished but the underlying condition of the procurement at the time that the contract is negotiated. Unless certain conditions are present, the parties will be running great risks in using a risk-taking type of contract such as an incentive contract. Therefore, these prerequisites for use of incentive contracts should be analyzed in order to provide some insights into the problems which the use of such a form of contract can create and the pitfalls that should be avoided. Without such analysis, there is a great risk that the parties will enter into this type of contract not realizing the problems which may arise during performance that can destroy all of the benefits which the use of incentive provisions might otherwise create. This section will list and analyze the major prerequisites for the use of incentives. Such a list is not only applicable to incentive contracts since it is really a list of the prerequisites for the use of any contract where the contractor takes the risk of performance of the job within an established price. The requirements listed would therefore be most necessary in a firm fixed price contract with a declining necessity as the form of contract imposes less risk on the contractor. Since the incentive

forms of contract are in the middle of the risk-scale, the application of these prerequisites to such contracts is a relative matter depending on the amount of risk involved in the particular incentive contract in question. Thus, a FPI contract with a low ceiling would require substantial compliance with the prerequisites whereas a CPIF contract with low sharing by the contractor would require compHance to a much smaller degree. However, their presence would be required to some degree in every incentive contract and it is therefore useful to set them out in some detail. These prerequisites are as follows:

1. Firm Specifications
This element is placedfirston the list because it is of primary importance in any analysis of the proper type of contract to use for a procurement. The specifications or statement of work is the heart of any contract and, if a contractor is to be expected to take the pricing risk on a contract, he should insist that the work be sufficiently defined that there will be no dispute at a later date of either the scope of the job or the extent of the power of the Government to order changes in that work scope without altering the price. For instance, there have been numerous cases in the past under CPFF contracts of contracts citing specifications which had not been written at the time the contract was signed making a contract agreement to perform work the scope of which was to be agreed on at a later date. Such an arrangement is not good contracting even under a CPFF contract but it may be necessary in some cases because of the urgency of the program which the Government is procuring. However, the use of this technique in an incentive contract should never be accepted by a contractor since it places him in a position of offering to do an unknown quantity of work on a cost sharing basis (under the operation of the incentive formula). Another similar technique is the technical direction procedure which has been used so often in research and development situations. Technical direction is theoretically limited to directions within the scope of work; but in these type contracts in the past, the scope has been so broadly stated that this clause frequently gave the Government the right to prescribe the method by which the job would be performed and the amount of work that would be done. Such a contract arrangement is definitely not compatible with the incentive contract since it takes most

of the control of the job out of the hands of the contractor; and it is not proper to expect a contractor to take a pricing risk unless he can take action to control his costs. Other examples could be given but the essential requirement is that the contract spell out the scope of the work when it is entered into. In many cases this requirement must be met by using performance type specifications in the contract. In such a case the burden of firm specifications rests on the contractor not the Government; and he must assure himself that he has, in house, a relatively definitive method of meeting the contract performance requirements. If under performance specifications the contractor has not planned the job and done the necessary preliminary work to have arrived at a firm method of proceeding, he is placing himself in the same positionof entering into a risk type contract without firm specifications. In the desire to obtain business, this is not an infrequent occurrence but it is one that should be avoided. One way to avoid contracting without firm specifications is to break out of the original contract the part of the work that has not been defined. For instance, in a development program the test effort often is badly defined at the outset of the development work. Rather than contract for the test effort as a part of the entire incentive price at that time, it is much sounder to reserve the negotiation of target cost of the test effort until the work is defined. Proper timing should still enable the parties to negotiate the cost of the work before performance and such a procedure will create a much sounder basis for the contract. It should be emphasized that the problem of firm specifications is not only a problem for the contractor. Although he may be the party in the first instance that feels the impact of being forced to do extra work at the same target cost and thus to share in the cost of that extra work, most contractors in such a position almost immediately react by processing claims for equitable adjustments in the contract price. If such claims are successful, of course, they transfer the cost burden to the Government and give the contractor the right to extra profit. Of course, the Government will attempt to resist such claims but a statement of work that is ill-defined or vague places the Government in a poor position in this regard. In such cases, the contractor is frequently able to use the vagueness of the specifications to his advantage in processing such claims. Thus, the Government may be the ultimate loser when the work is not adequately defined in the contract.

2. Ability to Estimate Costs


This second prerequisite, the ability to estimate costs, follows closely after the requirement for firm specifications. If the specifications are not well defined, it is clear that good cost estimating ability cannot be present since the parties would have no firm statement of the scope of the effort to be costed. However, even when the specifications are firm, cost estimating ability may still be lacking. This is particularly true in the case of development or initial manufacturing efforts where the contractor has never performed the work before and hence has no actual cost experience on which to base his cost estimates. In such cases the estimate must be based on some statistical estimating technique or some technique which compares the estimate of costs to costs incurred on some similar program or programs. In either case, the validity of the estimate is subject to question. In some cases such estimates may be very reliable while in other cases they may be little better than educated guesses. The importance of the cost estimate is that it serves as the basis for the target cost in the contract. With good estimating techniques the problems in negotiating the target cost are reduced to a minimum and the parties will have little difficulty in reducing their differences to a small percentage of the contract price. In such cases, the agreement on a target should not be difficult. However, if the estimating techniques are not sound enough to be persuasive, the parties will have a difficult time minimizing their differences. After much negotiation, for instance, there may be a 20% to 30% variance in the respective target cost figures of the contractor and the Government. In such cases, the negotiation of the target becomes a matter of negotiation table strategy and bargaining power with the likely result that the target cost will not reflect a reasonable cost of doing the work. Such cases have led to situations where the contractor allegedly made "windfall" profits because of an inflated target or where a contractor has incurred a substantial overrun that was built-in at the original negotiation. Either case can result in a negation of the incentive in the contract. In the case of the excessively high target cost, the contractor may have little incentive to reduce costs since that would further increase his profit with additional unfavorable publicity. In contrast, in the case where the target cost is unreasonably low, the contractor may be close to the point of minimum fee (in a CPIF contract) and thus may treat the contract as a CPFF contract. Or he may at-

tempt to cut costs drastically thereby jeopardizing the performance of the contract. In any case the negotiation of a target cost based on bad cost estimates will work to the disadvantage of both the contractor and the Government. It is clear from the above discussion that the need for cost estimating ability applies to the Government as well as to the contractor. Since the immediate purpose of the ability to estimate costs is to establish a sound target cost and this must be done through the process of a bilateral negotiation, both parties must go into the negotiation with good cost estimates. If the Government has no estimating ability of its own, it is reduced to the process of questioning the contractor's estimate with the presumption that if no flaws can be found, the estimate is sound. Such a negotiating procedure is known to be a poor one and many Government negotiators therefore become quite defensive when placed in this position. The result is that the Government negotiator in this position will often arrive at a somewhat arbitrary cost figure which is substantially lower than the contractor's cost estimate and move from this cost figure with great reluctance. Such a technique makes negotiation very difficult, and, in the face of the strong bargaining power of the Government, may result in the ultimate negotiation of a low target cost. Thus the need for a good ability to estimate costs by the Government is apparent. In reviewing this need for cost estimating ability, it can be argued that the type of contract which is applicable to a given contracting situation can be determined by the accuracy of the cost estimate. Hence, the following guidelines might be proposed:
Accuracy of Estimate Type of Contract

95-100% 85- 95% 70- 85% less than 70%

Firm Fixed Price Fixed Price Incentive Cost Plus Incentive Fee Cost Plus Fixed Fee

In using such figures, the accuracy of the cost estimate might be appraised by the contracting parties at the time the estimate is prepared; or it might be arrived at on the basis of the amount of disagreement that was present at the conclusion of the negotiation of target cost. This, of course, is merely another method of identifying the amount of pricing risk that is present in a given contracting situation. The

basic concept might be useful even though the figures set forth above are subject to disagreement.

3. Management Ability of the Contractor


When the first two prerequisites have been met and the parties find that they have the ability to determine a reasonable target cost, a question must be raised regarding the management ability of the contractor. The essence of the incentive contract is that it is a technique for rewarding a contractor for better management of the work. In other words, the incentive should motivate the contractor to undertake a definite program to perform the work efficiently and economically. The contract should not be a gambling arrangement or one that yields additional profits based on circumstances outside of the control of the contractor. Of course, since the incentive formula works on the entire contract cost regardless of whether it is under the influence of the contractor or not, there are bound to be certain costs that increase or decrease without any effort by the contractor. But such uncontrolled costs should be minimal in the incentive contract. In order to assure that the profits earned under the incentive formula are earned as a result of contractor-initiated improvements, the management ability of the contractor must be surveyed before the contract is entered into. The type of management ability that comes into play in this type situation can be broken into two segments. First, the contractor must have a system that generates and disseminates timely information on the progress of the work under contract. In the cost area such information would indicate the status of the costs incurred in relation to final costs on the job and it should yield a revised estimate of final costs during contract performance. In the schedule area the same type of incremental information is necessary. It is not enough to know after the fact that something went wrongthe contractor must be able to forecast the effect of variations from the contract plan. The second element of management ability is the ability to use the information that is generated. The contractor must have an organization that is responsive to the information on contract performance and that can translate that information into management decisions that will correct the mistakes that are made during the course of the work. The common technique of information generation is a PERT or PERT/COST system. The normal method of assuring the proper use of this information in managing the work is the project organization where

the company is made responsive to a project group which monitors the information and manages the job. These two techniques have one thing in commonthey are expensive. Both involve the employment of additional manpower and equipment in order to process and utilize the information required. In major programs, they have demonstrated that they are useful tools for management and they certainly give a contractor the ability to intelligently perform under an incentive contract. However, it should be questioned whether such extravagant techniques should be used on smaller programs or on contracts where the contractor does not have such systems presently in being. Theoretically, it is a good thing for all contractors to have better management ability but when the acquisition of that ability requires a substantial increase in the overhead of the contractor, some judgment must be used before the requirement for such systems is haphazardly imposed. For instance, it is not uncommon for this package of management ability to add 5% to the cost of performance. For a contractor in a competitive product area this amount might be the difference between profit and loss. The imposition of this amount of management ability might be fatal for such a contractor. This situation prevails in the case of smaller contractors and especially in the case of subcontractors under major prime contractors. One answer to this problem is to use incentive contracts without requiring such management ability. Of course, this transfers the problem to the contractor since he then must face the fact that he is taking a risk on his own initiative. If he is accusomed to doing business on a CPFF basis, he will probably feel that the use of these management systems, to some degree, is necessary to cope with new risks. If he is afixedprice type contractor, he will probably be adjusted to the risb and will have found a way to cope with them within his present system. However, neither solution will be entirely satisfactory to the Government since it will not be getting the type of information which it desired in order to monitor the performance of the contractor under the contract. Thus, even without a contract requirement for management systems, the trend will be in the direction of creating such systems when incentive contracts are used. Therefore, before the decision is made to use an incentive contract, the question should be raised whether the possible savings to be encouraged by this type of contract will be offset by the cost of initiating additional management of the job.

4. Management Freedom
Along with management ability, a contractor needs freedom of operation in order to successfully perform an incentive contract. The amount of freedom needed is relative; but the underlying requirement is that the contractor be able to make the basic management decisions on the contract on his own initiative. In a development contract, these decisions would be oriented in the technical direction while in a manufacturing contract, they might be more closely tied to the business area. However, the requirement is the same in both cases. If the contractor cannot make the decisions, he cannot manage the work; and if he cannot manage the work, it makes no sense to pay him incentive profit or penalize him for poor performance on the contract. This is a difficult area because in the past few years the Department of Defense imposed a cumulative number of management controls on contractors working under cost type and incentive type contracts. Such controls as make or buy approvals^^ and overtime approvals^^ plus greatly increased scrutiny of the management techniques of contractors were added to the existing requirements such as subcontract approval**^ and design review. The result is a large amount of customer control of contract performance that substantially reduces the contractor's freedom to control his costs. These controls can be traced directly to the eff^orts made by the Government to prevent mismanagement of CPFF contracts where the Government was obligated to pay for such mismanagement. However, to a large extent, they are not compatible with the type of contract where the contractor is taking a substantial amount of the risk. Thus, these contract-imposed type of controls tend to be contradictory to the basic principles of incentive contracting.42 There is another impediment to freedom of operation in Government contracts. This is the frequent interrelationship of a contract with other contracts. For instance, in a weapon systems program, it is frequent for several contractors to be performing simultaneously, with each dependent on the performance of the others. In such a case, each contractor must evaluate his own freedom of operation before he agrees
39 See ASPR 3-903. o See ASPR 12-102. * ^1 See ASPR 3-903. 42 One suggestion that is under consideration at the present time is to amend the ASPR to provide that certain of these clauses would not be used if the incentive sharing was over a certain percentage. This would give the contractor the additional freedom only if he agreed to assume a certain portion of the contract cost responsibility.

to use an incentive contract. In some cases, there might be such an interdependence that an incentive contract would make no sense unless some technique could be worked out to have all of the contractors share the incentive or have it apportioned among them.*^ such a case, however, most contractors are very reluctant to subject their profits to the performance of some other company. The solution is therefore normally one of segregating the responsibility so that each contractor is subject to profit sharing on only his own effort. A similar occurrence arises in the case of Government furnished property. Here the contract language often protects the contractor against the risk of non-delivery of the property or the delivery of unsuitable property allowing for an adjustment in the target cost if such event occurs.^* However, the contractor should assure himself that the contract gives him such protection.

5. Time
The final prerequisite is timeadministrative time to allow the parties to negotiate the contract and performance time to enable the contractor to take the type of management action that is necessary to properly perform this type of contract. It is undoubtedly true that the complexity of the incentive contract requires more time in order to reach agreement of the parties and finalize the contract language. Since administrative lead time is normally lacking in most procurements at the present time, the need for additional time imposes a real burden on Government procuring activities. The solution to this problem has been the use of some interim form of contract such as the letter contract for the early stages of performance. This is not a good solution since it allows the contractor to perform part of the contract without the operation of incentives and thus partially negates the incentive principle. In this area the use of incentive contracts with their additional requirements for administrative lead time tends to compound the existing problem of shortage of time and the resulting use of undesirable types of interim contracts to compensate for this shortage.
43 Another method of solving this problem is to provide in the contract that the incentive provisions do not apply if the failure is the fault of some other contractor. Such a technique has been used in performance incentives where equipment furnished by other contractors is an integral part of the system and may be the cause of non-performance or under-par performance. 4* The standard Government property clauses, ASPR 13-502 and 13-503, contain such protection.

The other type of time that is needed is performance time. This requirement arises because of the cycle time needed to effect management actionthe time to generate information on contract performance, interpret that information and take corrective action. Thus, in order to have management, the contract must run for a certain minimum length of time. It would seem that a minimum requirement would be six months while we know that most incentive contracts in the past have had a performance period of two years or more. Such an amount of time gives the contractor a full opportunity to effect efficiencies and earn incentive profit. In summary, the prerequisites which have been discussed all aim at the same basic principles. An incentive contract should give the contractor a definite goal in terms of work to be performed and target cost and should give him the opportunity to increase his profit by performing efficiently. The elements in the contract which reduce this opportunity by removing the contractor's initiative should be eliminated from the contract to the greatest extent possible. The contract should be tailored to allow the contractor to have responsibility; and the greater the responsibility that he is given, the greater the amount of risk that can be imposed by the terms of the incentive formula. Ideally, the contract should not penalize the contractor except for his own actions. In practice this ideal can never be achieved, but the parties should strive to attain the ideal to the greatest possible degree when they formulate the contract.

Use of Performance

and Delivery

Incentives

Although the above principles apply equally to performance and delivery incentives, these types of incentives also present some unique problems. As was determined in Chapter 3 these incentives are complex and create difficulties in arriving at a balanced formula. Their use is thus a great imposition on both parties to the contract in terms of administrative time and effort. They are also quite apt to result in poor contracts since their effect on future performance is often difficult or impossible to predict at the outset of the work when the incentive formula is established. Thus, the use of delivery and performance incentives can create some definite disadvantages for the parties. On the other hand, there is a firm body of opinion that states that performance and delivery incentives are necessary in development contracts to prevent undue emphasis on cost incentives during the prosecu-

tion of such work. This appears to be the present position of the Department of Defense where the use of performance and dehvery incentives is considered almost mandatory in development contracts. It is based on the reasoning that the primary purpose of the development contract is the design of a technically sound product with reduced costs being an important but secondary aspect of the job. It is therefore reasoned that the use of cost incentives only in such a contract would not give sufficient emphasis to the primary aspect of the job but would motivate the contractor to reduce costs at the expense of developing a satisfactory product. To prevent this occurrence the ASPR requires the use of performance and delivery incentives in all major systems developments and in other development programs where they "are considered desirable and administratively practicable."45 Since when performance and delivery incentives are used cost incentives must also be used, this means that the entire package of incentives will normally be used in development contracts. The difficulties which this policy creates require that it be examined critically. There is no question that the basic premise on which the policy is based, that the essential purpose of the development contract is not cost reduction but good technical work, is sound. Therefore, if performance and delivery incentives must be used to assure good technical work, the additional administrative effort and contract complexity must be accepted as a necessary penalty. But are such incentives necessary to keep the emphasis of the development contract on good technical performance ? It would appear that in many cases the answer is no. At this point an examination of the nature of the development contract is necessary. We have noted that this type of contract will normally have performance specifications and that, to be suitable for incentives, these specifications should be quite definitive. In such case, these specifications will call out numerous design goals which the contractor is required to meet to successfully complete the development effort. Whether or not performance incentives are used, these design goals remain contract requirements; and, at best, only a few of them will be used for incentive purposes. In any case, in order to successfully perform the contract, the contractor must achieve the goals or obtain a deviation from that requirement. Thus, irrespective of the performance incentives, the Government has the contractual right to insist on per A S P R 3-403(c). See also the statement in ASPR 3-402(b) (2).

forraance in accordance with the design goals. Of course, the contract will normally be a cost reimbursement type contract which tends to impose certain limits on this right by requiring that the Government reimburse all (under a CPFF contract) or the major part (under a CPIF contract) of the additional costs of meeting the performance requirements. But the contractor has not completed the work until the design goals are met. He therefore does not have the contractual right to perform in an inferior manner through reduced costs in order to increase his profits. The same analysis holds for the operation of delivery incentivesthey supplement the already-present delivery requirements of the contract but they do not alter the basic contract. If the above analysis is accurate, the use of performance and delivery incentives is not really a technique of counterbalancing cost incentives but one of providing new and additional incentives in a contract. Of course, the analysis hinges on the adequacy of the specifications. If they are sufficiently definitive that the contractor can be held to their requirements, it is perfectly feasible to use only cost incentives in a development contract relying on the specifications to assure good technical performance. On this basis, it is maintained that performance and delivery incentives should not be used in all or even most development contracts as a matter of general practice but rather should be used only when the Government desires improvements in performance or in delivery.Then these incentives are used as an inducement to the contractor to encourage performance or delivery that is better than that required by the specifications or delivery schedule. This solution to the problem of when to use performance and delivery incentives has the major advantage of limiting their use to cases where there is a clear need for them. The situation where the Government only wants target performance and where therefore it is very difficult to write a satisfactory incentive formula is no longer a problem because performance incentives would not be used.^^ There the Govemment would rely entirely on cost incentives. The problem of choosing the performance factors for application of performance incentives is also eliminated since these incentives would only be applied to factors where
4 In spite of the fact that the Department of Defense appears to be using performance and delivery incentives to counterbalance cost incentives a careful reading of ASPR 3.402(b) (2) and 3-407.2 might indicate that the ASPR policy is actually to use performance incentives only when improved performance is requireid. 47 See the discussion at p. 61 supra.

improved performance is desired. The result would be substantially fewer performance incentive contracts which also confers a benefit in reduction of administrative time necessary to negotiate and administer such contracts. The end result would be more meaningful use of performance and delivery incentives and more attention to the incentives that are used,"*^

48 This suggested limitation of the use of performance incentives is probably opposed to the current opinion of the Department of Defense. See, for example, the Morris statement to Congress note 2 supra, that "too little use is being made of performance targets in incentive contracts due to the inexperience of our negotiators and to the need for much closer collaboration between technical and procurement personnel in defining performance objectives." In addition, there is a segment of industry that would be opposed to reduced use of performance incentives because these incentives allow greater flexibility in balancing losses by gains in other areas. Thus if a contractor overruns a multiple incentive contract, he still can avoid fee reduction by bettering performance targets. It should also be noted that this opinion of contractors in favor of performance incentives will undoubtedly be greatly reinforced by the new profit rules which give a substantially greater rate of starting profit or fee when performance and delivery incentives are used. See ASPR 3-808.5(c) (5) which prescribes the following profit increments based on the type of contract used: CPIF (cost incentive only) 1-2% CPIF (performance and delivery incentives) IV2 FPI (cost incentive only) 2-4% FPI (performance and delivery incentives) 3-5%

Chapter V

TERMS AND CONDITIONS


The general terms and conditions of a contract are an essential part of that contract since they detail many of the undertakings and risks of the parties to the contract. Hence, it is important that such terms and conditions be given careful consideration to assure that they allocate the risks of the contract fairly, in accordance with the pricing arrangement used. In the case of incentive contracts this type of attention has not been given to the prescribed contract clauses with the result that the clauses frequently create risks which are quite divergent from the workings of the incentive contract itself. This chapter will analyze some of these problems. The basic concept behind this discussion will be that contract clauses increase the cost of performance of a contract. O f course, the generalization is not always true but in most cases it is a fair statement of fact.^^. For instance, the Changes clause allows the contracting officer to alter the work with commensurate cost increases, the labor clauses require minimum standards for wages and working conditions, warranty clauses require a contractor to perform additional work after delivery, and clauses requiring Government approval of contractor actions require administrative costs as well as possible additional costs of performing the work in a way desired by the Government.^^ Since this cost impact of contract clauses is present, the initial question must be raised of the method which these clauses relate to the incentive provisions of the contract. D o the contract clauses work in conjunction with incentive or at cross purposes to incentive? In order to answer this question, initial consideration must be given to the method of handling the costs incurred because of the operation of each clause. These costs could (a) be included as a part of the total cost of performance with the result that the contractor shared in them, (b) be the subject of an "equitable adjustment" with the result that the target cost and target profit or fee were adjusted upward to cover them, or (c) be "allowable" costs outside of
It can be argued that some contract clauses merely codify the common law and therefore do not increase the costs but merely clarify the undertaking of the parties. It might be suggested that one method of dealing with this problem of the cost of contract clauses would be to estimate (1) the cost of the work excluding the clauses and (2) the cost of the clauses in the contract. While this seems extremely difficult at this time, following such a procedure might eventually result in a better understanding by all parties of the effect of these contract clauses.

the incentive formula with the result that the contractor would get f u l l reimbursement of the costs but no additional profit or fee. Each clause, of course, should specify which alternative is being used, and the ultimate consideration in selecting the proper alternative is the interrelationship of that clause to incentive. It makes little sense to pay the contractor incentive profit for a cost reduction arising out of a clause over which he has no control. On the other hand, the contractor should not be penalized incentive profit because of the operation of such a clause. Thus, ideally, the treatment of incentive profit recovery under contract clauses would be based on the amount of control which the contractor is allowed under that clause. In practice this principle appears to have had little application. A second area to be analyzed in discussing contract clauses in incentive contracts is their interrelationship to the incentive provisions of such contracts. This is particularly important where performance and delivery incentives are being used and the provisions governing the operation of these performance and delivery incentives contain requirements somewhat different from the specifications or delivery schedule of the contract. In this case the proper interpretation of clauses which also relate to performance and delivery such as termination or correction of defect clauses becomes difficult. In this area, all existing problems could be solved by careful legal draftsmanship when the contract is being prepared. Finally, it must be emphasized that special care is needed in dealing with clauses for incentive contracts. Over the years contract clauses have evolved for firm fixed price and CPFF contracts which have been subjected to much actual use and have stood the test of time. In general, it can be said that these clauses have grown to reflect the risks in these two types of contract with the CPFF clauses generally placing greater burdens on the contractor since the Government is paying all of the costs of performance. However, with incentive contracts, very few special clauses other than the incentive clauses have yet evolved.^i As a result, the general provisions of the incentive contract are usually the same as the other types the FPI using firm fixed price general provisions and the CPIF using CPFF general provisions. This procedure can result in a complete change in the risk aspects of these
S l i t should be noted that the ASPR contains specific clauses covering the incentive aspects of the contract. See ASPR 7-108.1 for the FPI clause and ASPR 7-203.4(b) for the CPIF clause.

contracts with the anomalous result that sometimes a contractor takes a greater risk under the clauses of a CPIF contract than under those of a FPI contract.

Warranty Clauses
The clauses dealing with warranties illustrate all of the problems discussed above.52 A warranty undoubtedly increases the cost of performance since it requires a contractor to undertake additional work in correcting deficiencies after delivery.^^ How should such costs be handled under an incentive contract.^ It might be argued that since deficiencies are caused by poor performance by the contractor (bad design or manufacture) , the costs of correcting such deficiencies should be costs of performance of the contract in which he would share under the incentive formula. There is merit to this argument in recognizing that good design or manufacture should be subject to the contract incentives and that these aspects of contract performance are very much subject to the control of the contractor. However, this raises the problem of how much cost is to be included in the target cost to cover warranty costs. If the target cost is to represent a cost level attainable with "normal" or even "above average" performance, some warranty costs must be included since no contractor can be expected to be perfect. Yet such costs are generally not susceptible to very accurate estimation and thus fall into the "contingency" category. The result is that incentive contracts frequently contain a warranty provision without a commensurate amount of funds in the target cost to cover the work. In such cases the contractor is agreeing to accept a penalty for all warranty work. Such a result does not seem to be a fair one or one in keeping with the general concept of incentives. A technique for solving this problem is to remove warranty costs
52 Some contract provisions designate this area one of "guarantee" rather than warranty. For purposes of this discussion the terms will be considered to have the samej meaningprovisions which give the Government the right to reject an item afier delivery. This should be contrasted to correction of defect provisions which deal with the Government's rights before delivery. The usage in this area, however, is very imprecise and each clause should be analyzed to determine when the liability ceases. 53 It should be noted that Navy Contract Law (1959 ed.) states at p. 556 that the Navy's experience on advertised contracts is that the use of a guaranty clause had litde cost effect oa bid prices. See Government Contracts Monograph No. 2, Government Contract "Waranties (1961) at pp. 34 and 42 where two other commentators agree that warranties can result in substantial additional costs.

from the incentive formula completely.^4 This technique avoids the difficulty of estimating these costs in advance but has the disadvantage that it removes incentives from this area. However, whether incentives on warranty costs are necessary is subject to question since a warranty defect is usually not different from a "before-delivery" defect except in point of time of discovery and incentives on "before-delivery" defects would still be operative. Turning to the specific clauses used in incentive contracts, we find no ASPR clauses prescribing warranties for FPI contracts. Such clauses are therefore subject to departmental regulations. In the CPIF contract, however, there is an ASPR clause.^s This clause makes warranty costs an "allowable cost" of performance of the contract and would therefore appear to place such costs within the incentive formula.^^ Thus, under this clause a contractor would have to include warranty costs in the target cost in order to avoid a loss of profit from the incurrence of such costs. Conversely, if the parties decide to keep warranty costs outside of the incentive formula, the language of the clause would have to be changed and an ASPR deviation obtained.^"^

Inspection Clauses
A l l incentive contracts will normally contain a clause requiring the contractor to correct defects in the items being delivered under the contract when those defects are discovered prior to delivery. A t the present time these clauses provide that the cost of such work will be considered a cost of performance of the contract and hence will be subject to the incentive formula with the contractor sharing in such costs. In the case of the FPI contract this is specifically stated in a special Inspection clause for use in FPI contracts.^^ CPIF contracts it is done
54 The simplest method of accomplishing this removal of warranty costs is to issue contracts without warranty provisions. This policy is followed by the Air Force and to a substantial extent by the Army. See Air Force Procurement Instruction 7-4029 and Army Procurement Procedure 1-358, both of which provide that warranties will not be used if they result in an increase in price. 55 See the clauses in ASPR 7-203.5 paragraph (b) and 7-402.5 (a) (1) paragraph (b). 56 These clauses contain a specific cross reference to the Allowable Cost, Fixed Fee and Payment clause of the contract. In a CPIF contract, of course, this should be changed to refer to the Allowable Cost, Incentive Fee and Payment clause. 57 See ASPR 1-109. 58 The special clause is set forth in ASPR 7-103.5 (b) and states in part: "Prior to the establishment of the total final price, the cost of replacement or correction shall be considered as a cost incurred, or to be incurred, for the purpose of negotiating the total final negotiated contract. After the establishment of the total final price, all replacements or

by the provision that such costs will be "allowable costs" on the contract.^^ The effect of these provisions, of course, is that the contractor will lose profit in the event of a correction of a defect unless the target cost includes an amount to cover such costs.^^ In contracts containing performance incentives, there will be some question of whether the correction of defect provisions apply to the performance standards in the incentive provisions or in the specification. For instance, often the performance incentive provisions will call for lesser performance at a reduced profit and increased profit for greater performance. If the Government tests the item and finds that its performance indicates that the contractor is entitled to a certain amount of profit, does that level of performance become the contract standard thereafter ? For example, the specification might call for a speed of 800 knots but the aircraft might perform in tests at 820 knots with the contractor earning a substantial bonus for this extra performance. Must all subsequently delivered aircraft attain the speed of 820 knots} The difficulty here is that the later aircraft will probably be on order under another contract using the original specification calling for the 800 knot performance. In such case, unless the parties to the contract have agreed to amend the specification to reflect the results of the test program, the contractor may very well be subject only to the original specification requirement. It would appear that this interpretation might also apply to subsequent items being delivered on the contract in which the performance incentives were included. Thus, this is another area where clarification is needed when performance incentives are used.

Changes Clauses
The Changes clause is the most frequently invoked clause in incentive contracts and one that contains its own standard for cost effect on the incentive formula. That standard is the "equitable adjustment." In gencorrections made by the Contractor shall be accomplished at no increase in the total final price." Prior to Revision 12 to the I960 edition of ASPR (26 Nov. 1962) the inspection clause used in FPI contracts had stated that such corrections of defects would be "at the expense of the Contractor." The costs of such work, however, were included in the total costs of final contract performance prior to final redetermination. Hence, the new language merely clarifies a confusing statement but does not change the accepted practice. 59 See the clauses in ASPR 7-203.5 and 7-402.5 (a) (1). ^^'ASPR 15-205.7 provides that prices may contain a reasonable amount to cover the cost of such contingencies if they "arise from presently known and existing conditions, the effects of which are foreseeable within reasonable limits of accuracy."

eral this equitable adjustment provision means that any additional work ordered under the changes clause will result in a negotiated increase in target profit or fee.^i In such an event the contractor is fully protected by the equitable adjustment provision providing that all costs of the change are covered by the "equitable adjustment." Unfortunately, there is legal doctrine to the effect that all such costs may not be included in the equitable adjustment and there is therefore a requirement that a contract include some amount in the target cost to cover these unrecoverable costs of changes.62 The estimation of such costs is a virtual impossibility with the result that normally such costs are not included in the target cost and the contractor takes the risk of losing profit if such costs are incurred. The changes clause in incentive contracts creates another problem that of the proper method to handle changes which reduce the cost of performance. The normal rule of equitable adjustments following the cost effect on the contractor would be expected to be applicable when such a change was ordered by the contracting officer. But what of the case where the contractor originates the cost-saving change ? Should the equitable adjustment not contain some profit incentive in order to encourage the contractor to submit such changes ? It has been argued that the term "equitable adjustment" is sufficiently broad to allow such a negotiated adjustment reducing the cost but increasing the profit. However, such procedure has not been common practice and will probably not be adopted very frequently in the future.^^ Actually, the problem has been solved to a large extent by the increased use of value engineering provisions which are intended to solve this specific problem.^'^ If an
61 See H . K . Ferguson Co., ASBCA 2826, 57-1 B C A 1[1293. The proper measure of an equitable adjustment has been the subject of much recent discussion. See Ribakoff, Equitable Adjustments under Government Contracts, Government Contracts Monograph No. 3, Changes and Changed Conditions (1962); Spector, Confusion in the Concept of the Equitable Adjustment in Government Contracts, 22 Fed. B. J. 5 (1962); McBride, A Reply (to Mr. Spector), 22 Fed. B. J. 235 (1962); Duncan, Equitable Adjustments under Fixed Price Contracts, 22 Fed. B. J. 307 (1962). 62 Under the older version of the Changes clause (still used in construction contracts), the equitable adjustment did not cover any increased costs of work not changed by the change order (consequential damages) United States v. Rice, 317 U . S. 61 (1942). Under the present version of the Changes clause used for supply contracts the equitable adjustment has been held not to cover costs incurred prior to the issuance of the change order, Weldfab, Inc., IBCA 268, 61-2 B C A ^3121; Comp. Gen. Dec. B-140040 (1962). 63 An alternate method of rewarding the contractor for such a cost-saving suggestion would be to process the change at no change in either target cost or target profit. In that case, the contractor would benefit by the negotiated share of the cost savings. 64 See ASPR Section I, Part 17.

incentive contract does not contain such value engineering provision, the treatment of these type changes under the changes clause will remain subject to the individual interpretation of contracting officers and contractors. A problem of contract language also exists in the use of changes clauses in incentive contracts. The clause normally used for cost reimbursement supply contracts is broad enough to allow adjustment of the entire incentive formula if the nature of the change required such an adjustment.^s For instance, a change could require an adjustment in the performance targets in a performance incentive contract or it might require an adjustment in the sharing percentages of the cost incentives. However, the clause for fixed price type contracts is not as broad.^^ In both cases, there is a question whether such adjustments are possible under the language of the incentive clauses of the contract. For example, the FPI clause provides:^''
(i) Equitable Adjustment Under Other Clauses. If an equitable adjustment in the contract price is made under any other clause of this contract before the total final price is established, the adjustment shall be made in the total target cost and may be made in the total target profit. If such an adjustment is made after the total final price is established, adjustment shall be made only in the total final price.

The CPIF clause provides


(h) When the work under this contract (including any supplies or services which are ordered separately under, or otherwise added to, this contract) is increased or decreased by contact modifications, appropriate adjustments in the target cost and target fee shall be set forth in an amendment or supplemental agreement to this contract.

This language seems to limit the broad equitable adjustment language of the changes clause in that it calls for adjustments to target cost and target profit or fee only. In addition, the language of the two clauses (Changes and Incentive) used in the FPI contract casts real doubt on the right to formula adjustments or adjustments to other contract pro63 ASPR 7-203.2 The clause states in part: "an equitable adjustment shall be made (i) in the estimated cost or delivery schedule, or both, (ii) in the amount of any fixed fee to be paid to the Contractor, and (iii) in such other provisions of the contract as may be so affected . . ." The clause for cost reimbursement research and development contracts (ASPR 7-404.1) contains the same language. 6 ASPR 7-103.2. This clause, in part, only provides the following: "an equitable adjustment shall be made in the contract price or delivery schedule, or both . . . " 67 ASPR 7-108.1. 68 ASPR 7-203.4(b).

visions. It is therefore important, particularly in the case of performance incentive contracts, that this language be clarified to express the intent of the parties that changes may result in adjustments to other terms and conditions of the contract as well.

Delays
One of the major problem areas in incentive contracting is the effect of Government-caused delays on the incentive profits of the contractor. The normal rule in Government contracting is that a contractor may not be compensated under the contract for such delays unless specific contract language provides for an equitable adjustment when such delay occurs.69 While there are a few clauses in use which provide for such an equitable adjustment, i.e., the property clauses,'^^ the Price Adjustment for Suspension, Delays or Interruption of Work clause used in construction contracts^ ^ and the optional Stop Work Orders clauses for supply and research and development contracts,'^2 jt has not been common practice to include such clauses in incentive contracts. The result is that contractors on incentive contracts run a sizeable risk that they will lose incentive profits in the event of Government or third party delays. Since incentive contracts are usually complex, they frequently involve much cooperation between the Government, other contractors and the contractor on the contract with a substantial risk that such cooperation will not occur. Hence, the contractor entering into such a contract should insist that contract language covering this problem be included in the contractat the very least a Stop Work Orders clause should be included. There should be no hesitation on the part of the Government to use such contract language since there should be no intent in an in69 In many cases recovery can only be obtained in a suit for breach of contract. See Speck, Delays, damages on government contracts; - constructive conditions and administrative remedies, 26 Geo. Wash. L. Rev. 505 (1958); Seltzer and Gross, Federal government construction contracts: Liability for delays caused by the Government, 25 Fordham L. Rev. 423 (1956); Anderson, Damages for delay in the law of government contracts, 21 So. Cal. L. Rev. 125 (1948). 70 ASPR 13-502 "Government-furnished Property" for use in fixed price type contracts and ASPR 13-503 "Government Property" for use in cost reimbursement type contracts. 71 ASPR 7-604.3. 72 ASPR 7-105.8, 7-205.7, 7-304.6, 7-404.5. These clauses are applicable to both fixed price and cost reimbursement type supply and research and development contracts. It should be noted, however, that the language of these clauses only covers the type of work stoppages specifically ordered by the Government. It does not cover those work stoppages which are caused by the Government (normally referred to as "constructive" suspensions of work). These clauses are therefore somewhat limited in scope.

centive contract to penalize the contractor for the acts of others and such language makes it possible to obtain an administrative resolution of any delays rather than being forced to litigation. Another problem arises in the delay area when delivery incentives are being used. In such case, the contractor must be extremely careful that there is language in the contract providing for an adjustment to the delivery schedule in the event of an excusable delay. If the contract is CPIF, the general provisions normally will contain a provision which can be interpreted as providing such relief.'^^ However, in the FPI contract, the general provisions do not include such language. In these general provisions, the only excusable delays language is in the Default clause and such language would probably not be applicable to the delivery incentive provisions.'^^ Therefore, in such case the contractor must be sure that a separate excusable delays provision is included in the clause providing for delivery incentives. It is recommended that such a clause contain two specific requirements, 1) that the contracting officer amend the delivery schedule whenever excusable delays are encountered and agreed on and 2) that the contractor identify such delays within a specified reasonable amount of time after the delay is incurred. Such provision will create an orderly method of processing claims for excusable delay at a time when the facts are available rather than delaying the negotiation of all such claims until the end of the contract when the incentive profit is being finally settled. This latter method of negotiating delay claims long after the fact has created great problems for both parties in the past with the result that often a fair settlement of such claims has been almost impossible to achieve.

Limitation of Cost and Interim Funding Clauses


One of the most troublesome delay problems in incentive contracts can result from delays in funding of the work under either the Limita73 The "Excusable Delays" clause provided for by ASPR 7-203.11 and 7-403.5. While this clause is phrased in terms of protection from default termination rather than in general terms, it does provide: "Upon request of the Contractor, the Contracting Officer shall ascertain the facts and extent of such failure [to perform} and, if he shall determine that any failure to perform was occasioned by any one or more of the said causes, the delivery schedule shall be revised accordingly , . ."It should be noted that this clause does not require the contractor to submit his claim for delay at any given time in relation to the occurrence of the delay. 74 The "Default" clause is set forth in ASPR 8-707.

tion of Cost clause'5 in a CPIF contract or the interim funding clause^^ of either a CPIF or FPI contract. In the event the Government does not fund the contract effort as required to allow efficient performance by the contractor, the clauses give the contractor the sole recourse of stopping the work. However, in many programs this is not a real alternative and the contractor is therefore forced to continue workingperhaps at a reduced level of effortpending the receipt of additional funds. Such a course of action will very likely increase the total cost of performance and vitally affect performance and delivery. However, in the CPIF contract the contractor is not entitled to an equitable adjustment for such a delay with the result that he will incur a loss of profits. It is interesting to note that in an Air Force FPI contract containing an interim funding provision, the contractor will be entitled to such an equitable adjustment by virtue of the A i r Force interim funding clause prescribed for use in FPI contracts."^^

Termination

Clauses

Default termination provisions creates an anomaly in incentive contracting. In the FPI contract the standard fixed price default clause is used,^8 with the result that the contractor assumes a very large risk the risk of not being reimbursed for the work performed plus the risk of being assessed reprocurement costs. On the other hand, in the CPIF contract the normal cost reimbursement termination clause is used.'''^ In that case the contractor takes very little risk since the clause provided for the payment of all costs incurred plus fee for any delivered items. This substantial difference in the risk imposed on the contractor would not appear to be logical when the similarity of CPIF and FPI contracts is considered. In contrast, termination for the convenience of the Government is
'5 ASPR 7-203.3 and 7-402.2(a). 76 See, for example, the Air Force clauses "Limitation of Government's Obligation" set forth in AFPI 7-4054. 77 AFPI 7-4054(a). Paragraph (5) provides: If the Contractor incurs additional costs, or is delayed in the performance of the work under this contract, solely by reason of the failure of the Government to allot additional funds in amounts sufficient for the timely performance of this contract, and if additional funds are allotted an equitable adjustment shall be made in the price or prices (including appropriate target, billing and ceiling prices where applicable) of said items or in the time of delivery or both." The clause used by the Air Force for cost reimbursement contracts (AFPI 7-4054(b) ) does not contain this equitable adjustment provision. 78 ASPR 8-707. 79 ASPR 8-702.

handled in a very similar manner in the two types of incentive contracts. There the normal procedure is to have the costs of performance prior to the termination paid on a cost reimbursement basis (in the fixed price type contract completed supplies are paid for at the contract price) and to negotiate the profit or fee on a percentage of completion basis. This type of procedure would be applicable to the incentive contract with the major question being the proper method of conducting such a negotiation when the costs and profits or fees are targets rather than firm figures. For instance, what profit or fee leveltarget profit or target profit plus (or minus) incentive profitdo the parties deal with when they apply the percentage of completion ? It would seem that only incentive profits earned at the time of termination could be included although this would work a harsh result on the contractor that was 99% complete on the accomplishment on some incentive factor of the contract which would substantially increase his profit. The FPI clause specifically states this rule but the CPIF clause contains no provision governing this eventuality.^^ Another difference between the treatment of convenience terminations in CPIF and FPI contracts is in the limitation on the total termination price (excluding settlement costs). In the case of the FPI contract this limitation is the contract ceiling^^ whereas in the CPIF contract the limitation is the contract target cost. In this area, the contractor must be more careful of cost overruns in the CPIF contract than in the FPI contract. Another problem arises when performance and delivery incentives are used. Are the default termination provisions subject to these provisions or to the contract specification and delivery schedule? For instance, an incentive provision might provide for incentive profits to be paid over a range of performance on a target on weight of the end item varying from 965 lb. to 1005 lb. with the specification calling for a weight of 985 lb. Or, the incentive provisions might call for penalties for delivery up to one month after the contract delivery schedule. It
80 ASPR 7-108.1. The clause provides: "(h) Termination. If this contract is terminated prior to the establishment of the total final price, prices of supplies or services subject to price revision under this clause shall be established pursuant to this clause for (i) completed supplies accepted by the Government and services performed and accepted by the Government, and (ii) in the event of a partial termination, supplies and services which are not terminated. The termination shall be otherwise accomplished pursuant to other applicable provisions of this contract." 81 ASPR 8-701 (b) contains a special provision for use in FPI contracts which so provides.

can be argued that these incentive provisions, being special provisions, limit the right of the Government to terminate for default since they effectively constitute an agreement by the Government that a weight of 1005 lb. or delivery one month late is acceptable performance of the contract subject only to the reduction of profit or fee called for by the contract. On the other hand, it might be argued that these incentive provisions merely create alternative rights (to pay less profit or to terminate for default) of the Government. This problem could be solved, of course, by stating the agreement of the parties in the contract; but, at the present time, contracts including performance and delivery incentives do not normally contain such provisions.

Other Terms and Conditions


The incentive clause used with FPI contracts contains the following paragraphs: ^2
(j) Exclusion From Target Price and Total Find Price. Whenever any clause of this contract provides that the contract price does not or will not include an amount for a specific purpose, such provision shall mean that neither any target price nor the total final price includes or will include any amount for such purpose. (k) Separate Reimbursement. The cost of performance of an obligation that any clause of this contract expressly provides is at Government expense shall not be included in any target price or in the total final price, but shall be reimbursed separately to the extent reasonable and allocable.

These clauses remove the cost results of other clauses not providing for equitable adjustment of the contract price from the workings of the incentive formula and yet allow the contractor to be reimbursed for extra costs resulting from such clauses outside of the incentive provisions of the contract. Thus, the contractor does not have the obligation of sharing in such costs under the incentive formula. A n example of clauses to which these provisions apply are the clauses relating to patents where it is stated that the contractor will take certain action at the expense of the Government. It should be noted that there is no similar language in the CPIF contract provision. From the above discussion, it can be seen that a great deal of care must be exercised when the terms and conditions of an incentive contract are being negotiated. This is particularly true when such a contract contains incentives on performance and delivery. O f course, the
" A S P R 7-108.1.

contract terms and conditions cannot be expected to cover every eventuality, however remote. But they should contain an expression of the understanding of the parties to the contract on the major events that may occur during performance of the contract; and, in this respect, the present language leaves much to be desired. The best solution to this problem would be a separate set of general terms and conditions for use with incentive contracts. When considering the feasibility of such tailored general terms and conditions for incentive contracts, it is useful to raise the question whether these terms and conditions should be different for FPI and CPIF contracts. It can be argued that actually both the Government and industry would be benefited by the demise of the CPIF contract. This contract, of course, contains a technique for reducing the risk for the contractor through the use of minimum and maximum fees. However, it has the distinct disadvantage that it does not contain a definitive procedure for final contract settlement. In this regard the FPI contract provides for a final redetermination of the contract price where all of the remaining problems can be negotiated and resolved. On the other hand, the CPIF contract merely calls for a settlement of the final fee after all costs have been billed with the stipulation that that final fee is subject to adjustment for all subsequent claims. O f course when performance and delivery incentives are used, provision must be made for a negotiation to establish the fee to be paid as a result of these factors. But, in any event, the CPIF contract can rarely be said to be closed or settled completely. It would seem to be to the advantage of both parties to reach a definite point where incentive contracts were known to be settled at a firm price. This goal could be accomplished by abolishing the CPIF contract and providing that in cases where the risk of the contractor should be reduced, that be achieved under an FPI contract by using a higher ceilingin the range perhaps of 40 to 50%. In addition, the sharing percentages could easily be tailored to fit any situation reducing the risk by using lower contractor shares as desired. This course of action would have two added advantages. First, it would provide the Government with a ceiling on all incentive contracts thus giving some assurance that the work would be accomplished within a known figure. In support of such ceiling, it can be argued that any program where the contractor is unwilling to accept a 40 to 50% ceiling is unsuitable for incentives at all and therefore that such a procedure would not be altering the pres-

ent concepts of incentive contracting. Second, the single form of incentive contract would make it easier for the Government to draft a set of general provisions for incentive contracts and would preclude the necessity of using provisions which contain different degrees of risk in the CPIF and FPI contracts when in many cases the contract formulas actually impose a very similar amount of pricing risk on the contractor. In conclusion, it should be emphasized that this discussion of problems with contract clauses does not purport to be all-inclusive. Indeed, every time that the interrelationship of these clauses is discussed, additional problems are raised and areas of needed clarification are identified. The foregoing analysis should therefore be taken only as a representative discussion covering the type of problems that should be considered in reviewing contract provisions. In any specific contract negotiation, such a review must cover the specific requirements of the contract and details of the incentive formula. Following such a review, every effort should be made by both parties to draft clauses which clarify the intent of the parties to the greatest extent possible.

Chapter VI RENEGOTIATION
The interaction of renegotiation and incentive contracting has been of concern to both industry and the Department of Defense for several years. This concern is often reflected in industry views that incentive contracting can never be effective as long as the threat of renegotiation is present to take away the profits earned on incentive contracts.^^ The Department of Defense evidently felt the same concern since it held extensive discussions with the members of the Renegotiation Board in the early months of 1962 when the new regulations on incentive contracts were being written. However, no agreement was reached on exemptions from renegotiation for incentive contracts and the Renegotiation Act continues to apply to these contracts.^* Thus, it is important to understand the interrelationship of renegotiation and incentive contracting in order to assess the effect that the renegotiation process can have on the negotiation and performance of incentive contracts.

Comparison of Renegotiation and Incentive

Contracting

Renegotiation embodies an "earned profits" concept of profit evaluation. Thus, it takes back all "excessive" profits which a contractor has made in any year on sales to the Government, and the definition of "excessive" profits provides for an appraisal by the Renegotiation
83 This contention has been made repeatedly by representatives of industry. See, for example. Report on the Renegotiation Act of 1951, H . Doc. No. 322, 87th Cong., 2d Sess. (1962) (hereinafter cited as Renegotiation Report). This report cites the industry recommendations that incentive contracts be exempted from the Act (p. 57). This position is also taken in the National Security Industrial Association Report of Cost Reduction Study (1962) at p. 167. It is interesting to note that the Government has also expressed some concern in this matter. Thus, the Summary of Conclusions and Recommendations of the Department of Defense Procurement Management Improvement Conference held from 14-16 February, 1962 contains the following statement (p. 23): "Renegotiation is a valuable safeguard against the realization of excessive profits on defense contracts, but renegotiation policies must recognize the validity of profits earned under an incentive arrangement. (Procurement personnel should carefully document both good and bad performance by incentive contractors so that they may clearly support to the Renegotiation Board the profits paid these contractors.) Unless this recognition is given, industry cannot be motivated to accept arid use incentive contract more widely." 8* See Release No. 3-62 of the Renegotiation Board (April 17, 1962). In this release the Board stated that it was aware of the new emphasis being placed on incentive contracts by the Department of Defense, that it gives full consideration to the factor of efficiency in its analysis of profits made on incentive contracts and that it was confident that the proper application of the renegotiation process would not impede the incentive program of the Department of Defense.

Board of the contractor's efficiency, economy in use of materials, facilities and manpower, contribution to the defense effort and numerous other f a c t o r s . T h e consideration of these factors by the Board allows a contractor to present evidence of positive action that he has taken to reduce costs and increase profits and such evidence will justify a higher rate of profit. It also allows him to justify the higher rate of profit if he took large risks, had a large investment or dealt in a complex business. The entire review of this relationship of profit to the contractor's business is made after the fact and all sales during the year are considered on a combined basis. Thus, losses during the year are offset against profits for that year with the renegotiation review covering the net results. Incentive contracting is quite different from renegotiation. While its purpose is to encourage the contractor to "earn" additional profit by undertaking cost reduction programs and management efficiencies, the incentive contract pays the additional profits established by the incentive formula on any cost savings regardless of whether they result from the contractors effort or from some other cause. O f course, one of the major causes of incentive profits without extra effort in the performance of the contract by the contractor is the overpricing of the contract target in the initial negotiation. Such incentive profits have been characterized at "windfall" profits. Similar results occur when the contractor realized cost savings because of extra volume or because of a technical breakthrough made by some other party. Such results are not necessarily a weakness of incentive contracts but are a necessary consequence of the need for a relative degree of simplicity in the operation of the incentive formula. However, they do demonstrate that incentive contracting is conceptually very different from renegotiation. In the renegotiation process, the parties look at the amount of profit after completion of the work and the contractor attempts to demonstrate that he "earned" the profit. In incentive contracting, profit is paid on the basis of a preestablished formula without regard to whether it was "earned" or occurred through some outside event. This difference between incentive contracting and renegotiation furnishes the basic reason why the renegotiation process should be equally applicable to the incentive contract as to other types of contract. The
85 Renegotiation Act of 1951 1 0 3 ( e ) , 65 Stat. 7, 50 U.S.C. A p p . 1 2 1 3 ( e ) (1951).

purpose of the Renegotiation Act is to preclude excessive profits on defense contracts. To a large degree, the term "excessive" can be equated with the term "unearned." Hence, to accomplish its purpose, the Renegotiation Act must continue to apply to any form of contract where the contractor can be paid a profit that is not earned. The main criteria to be used m determining whether a contract falls in this area is whether it was priced based on f u l l competition or the price was established by negotiation. In the cases where cost estimates and negotiation are used to establish the price, the risk of unearned profits is greatly increased because of the lack of information available to the Government to assure that the price is as low as possible. The firm fixed price contract that is written without competition is the prime example of this type of contract but the incentive contract also normally falls in this category. Thus, the incentive contract is one of the types of contract to which renegotiation must apply if it is to continue to serve its purpose.

Operation of Incentive Contracts Under

Renegotiation

One conclusion that might be drawn from the above analysis is that an intelligent contractor with an incentive contract will not attempt to earn too much profit because of the risk that it will be taken away through the renegotiation process. This conclusion is wrong. The fact that the renegotiation process is based on a concept of "earned" profits provides the contractor the opportunity to present a f u l l justification to the Renegotiation Board substantiating the fact that he earned all of the profits under the incentive formula. The regulations of the Board encourage such a presentation by allowing for separate consideration of incentive contracts ^6 and by speUing out the method that the contractor can use to identify earned profits by comparing estimated costs to actual costs.s^ Such procedure will not assist the contractor who obtained an extra incentive profit through the occurrence of some event outside of his control, but it should be of material benefit to the contractor who can demonstrate the fact that the incentive profits were earned as a result of his efforts. It can be seen that under the existing rules renegotiation does allow the contractor to justify "earned" profits and thus should not work as a
86 Renegotiation Board Regulations fl460.2(b). 87 Renegotiation Board Regulations p460.9(b) (5).

disincentive in contract performance. However, there is one remaining area where the disincentive effect is still present. This is the situation where the contractor finds himself in a position to save a large amount of money on the contract and yet cannot demonstrate that the savings resulted from his own efforts. In such a case, the profit on the contract might become quite sizable and there is an incentive not to realize the savings but to spend the money thereby protecting the remaining profit from renegotiation. This disincentive is an inherent consequence of the renegotiation process and, of course, it works even more strongly in the firm fixed price contract situation. However, it should be emphasized that this disincentive results only when there is a prospective "windfall" profit. It does not operate when the profit is determined only by the efforts of the contractor and therefore should not impede the contractor from making every effort to reduce costs by efficient performance. The nature of renegotiation as an "earned" profits phenomenon makes it extremely important for a contractor to document his efforts in contract performance for later presentation to the Renegotiation Board or court. It is often a number of years after performance before such facts are needed but at that time they are vital in demonstrating a contractor's contention that the profits were earned. In order to assure that such facts are available when needed, any contractor with an incentive contract should establish a policy of contemporaneous documentation of all efforts made to improve performance and increase efficiency. Such information should be kept in a renegotiation file along with all other information which bears on the statutory renegotiation factors. Such a file can be invaluable when assembled during contract performance, and it is almost impossible to assemble such a file after the work is completed. In this regard it should be noted that documentation by the procuring activity can also be of much assistance to the contractor who is attempting to demonstrate his efficiency to the Board. The Department of Defense has taken steps to provide for better documentation of contract performance for use in the renegotiation process.

ssSee ASPR 1-319.

Judicial Review of Renegotiation


Since the final decision on renegotiation is made by the courts,^^ it is important to have some understanding of the position of the courts on profits flowing from incentive contracts. There have been two major cases which have dealt with this problem. In the first case, involving Boeing Airplane Co., the contractor appealed to the Tax Court a finding by the Renegotiation Board of excessive profit of $9,822,340 in 1952.90 One argument presented by the contractor in this appeal was that the decision was erroneous in that it did not give proper recognition to the fact that most of the work (80.8%) was done under incentive contracts and that much of the "excessive" profit was earned under the sharing formula of these contracts. (The contractor earned profits of $4,826,656 under the sharing formulas of incentive contracts during the year in question). The Court, however, did not give weight to the fact that the contracts contained the incentive features when it made its determination of excessive profits. Instead, it used the statutory factors in analyzing the profit made by the contractor. On the basis of these factors, giving heavy weight to the profit as a percentage of net worth factor, the Court found that the $13,000,000 profits were excessive in 1952. In its analysis of the effect of the incentive contracts in this case, the Court felt that the major effect of the incentive contract was to encourage the contractor to negotiate a high target cost.^^ There is no
89 Decisions of the Renegotiation Board may be appealed to the Tax Court where they are given a trial de novo. Renegotiation Act of 1951, 108, 50 U . S . C . App. 1218, 65 Stat. 7 (1951); as amended by P. L . 87-520, 76 Stat. 134 (1962). In 1962 the Act was amended to provide a limited appeal from Tax Court decisions to the Court of Appeals. This appeal may be on questions of law or findings of fact that are "arbitrary or capricious" with the stipulation that "in no case shall the question of the existence of excessive profits, or the extent thereof, be reviewed . . . " Renegotiation Act of 1951, 108A, 65 Stat. 7 (1951); 50 U . S . C . App. 1218a, as amended by P. L. 87-520, 76 Stat. 134 (1962). Boeing Airplane Co. v. The Renegotiation Board, 37 T. C. No. 64 (1962). 91 The language of the Court is confusing. It says: "Because the petitioner's real profit was not determinable until the incentive contracts had been fully performed, it follows that under those contracts such profits were finally fixed when actual costs were known. Actual costs being determinable when final profits were computed we see no justification for the payment to petitioner of more than that which would accrue to it by application of a reasonable percentage profit rate to actual as distinguished from estimated costs. Otherwise, with that rate applied to estimated firm target costs the very purpose of this type of contract is vitiated. "With the rate factor so applied it is obvious it will produce profits in direct ratio to the estimated cost, thereby creating a high estimated cost incentive rather than the contrary. Couple with the 20 per cent sharing of underruns of cost, the

evidence in the Court's opinion that it recognized the fact that the use of an incentive provision would give incentive to perform efficiently in spite of such a high target cost. However, the entire decision in this case is of questionable use as a precedent with regard to the interpretation of current types of incentive contracts since the court was looking at the "delayed firm target" type of contract which was deleted from the ASPR several years ago. Under this type of contract, the target cost was not established until a portion of the work on the contract had been performed. For instance, in the major contract being considered by the Tax Court in this case, the firm target was not established until November 1952. Thus, most of the work on this contract in 1952 was done prior to the setting of the target with the f u l l knowledge that the costs of the work would be used to establish the target cost. Such a situation creates a reverse incentivean incentive to increase costs. It may well be that these circumstances were instrumental in persuading the Court that the incentive contracts did not provide the proper type of incentive. In the other major case involving inventive contracts,^^ the same type of circumstances existed. The contractor's sales were 81% on incentive contracts in 1953 and 82% on incentive contracts in 1954. The contracts were primarily delayed firm target type contracts with the firm target costs being established after a substantial amount of performance. The contractor's costs usually decreased markedly after the establishment of the firm target cost with resulting incentive profits being earned.93 The Court did not discuss the effect of incentive contracts on the total profits earned but merely analyzed the amount of total profit in terms of the statutory factors. On the basis of its finding that the contractor had performed very well in several of the statutory areas, the Court reduced the amount of excessive profits that had been found by the Renegotiation Board from $6,000,000 to $4,000,000 for 1953 and from $14,000,000 to $12,500,000 for 1954. The major consideration in
high estimated cost tendency is enhanced. Only provided the profit rate factor is applied to actual cost and the firm target cost estimate used as a measure for under or overruns does the effect of the contract provide any incentive to lessen actual cost." ^'^ North American Aviation, Inc. v. The Renegotiation Board, 39 T. C. No. 19 (1962). 93 The opinion contains the following language: "The firm target price was arrived at by negotiations in which both the contractor and the Government were represented. Some of these negotiations lasted several days. The intervals between initial target and firm target were from less than a year to more than 3 years. The firm target price, usually, but not always, exceeded the initial target price. The final cost, that is, the average per imit cost over the entire contract, usually, was less than the firm target average per unit price."

finding such excessive profits again was the large percentage of profit compared to the net worth of the company. On the basis of these two cases, it is safe to predict that a contractor w i l l not be able to successfully argue that incentive contracts should be taken into consideration during the renegotiation decision in instances where the target cost has not been firmly established until much of the work has been performed. A current example of this type of contract is the case where a letter contract has been used initially and later converted to an incentive contract. On the other hand, where the target cost has been established before the performance of any work on the contract, the reasoning in these two cases woud not appear to apply and the contractor would therefore be able to argue that some consideration should be given to the fact that profits were incurred as a result of bettering the targets on the incentive contract. Even in such a case, however, the contractor will have to demonstrate that the improvements on the contract targets were the result of efficiency or some other effort on his part. Thus, in any event the statutory factors will be the major grounds for decision in these cases.

Chapter

VII

OTHER INCENTIVES
The incentive contracts being used by the Department of Defense at the present time use the profit motive in a rather stylized manner. In addition, they focus the profit motive in a narrow range of application on the profit to be earned on a single contract through the bettering of specific goals set forth in that contract. There are many procurement situations, however, where this technique does not create the necessary incentive or actually may misdirect the contractor's efforts. There is therefore a great need to devise other procurement techniques which create incentives for better performance and which can be used when the standard incentive contracting methods are not fully effective. It is the purpose of this chapter to analyze a few such techniques which have been proposed or used recently.

Program

Incentives

One of the major deficiencies of the present incentive techniques is that they deal only with a single contract instead of entire programs. They therefore place the emphasis on reducing costs or improving performance during a segment of the total program effort rather than on arriving at the lowest cost or best performance for the entire program. This tendency is particularly harmful to the Government when incentive contracts are used in the early stages of a programespecially during the development stage. There, the contract costs to which incentives are applied are largely design costs since manufacture of the product will take place on later contracts. The result is that a contractor can often maximize his profit on the development contract by choosing design alternatives which permit cost reduction during the design process but which increase the future cost of manufacture of the product. The performance incentive in the contract may have the same effect since design of an item that has high performance also frequently creates a high cost of manufacture. Such results have occurred frequently in the past and the increased use of incentive contracts in the development phase may increase the frequency of their occurrence. The solution to this problem, of course, is to devise a contracting technique which ties the cost of manufacture into the development effort. The easiest method of accomplishing this would be to issue a single

fixed price contract for the entire program. Such a contract would force the contractor to design an item that could be manufactured at a cost within the fixed price or take a loss on the entire contract. In almost all cases, however, this is not possible.^* Another, more limited method, would be to make the cost of manufacture one of the performance incentive targets in the development contract. If this were done, the contractor would have to focus his attention on the cost of manufacture during the design effort and the amount of emphasis to be placed on this factor could be regulated by the weight assigned to this factor in relation to the other performance goals. However, the development contractor would have to be awarded the manufacturing contract in order to determine if the incentive goals were met; and the time lag in determining the amount of incentive profit earned or lost on the development contract would be substantial. In many cases, therefore, this might not be an acceptable solution for either party to the contract. Another technique for focussing attention on the manufacturing cost during development is the use of options in the development contract covering the procurement of follow-on manufacturing quantities at a stated price.^s This technique is feasible for the Government to adopt and is being used with greater frequency at the present time. In such cases, the Government will solicit competitive proposals for a development effort and also for the manufacture of specified quantities of the product in the years following the completion of development. For instance, the contractor might be asked to propose a cost or price of development to be placed on contract immediately, a price for a quantity of 20 prototypes to be procured in the next year and the price of larger production quantities to be procured in succeeding years. The proposals will be evaluated in the price area on the basis of the total program
9* The major impediment to this type of contracting is the appropriation structure which, in most cases, provides funds on a year by year basis for major programs. Another impediment is the seemingly widespread fear that contracting for an entire program would be a means of avoiding the policy of obtaining maximum competition. On major programs, of course, this objection is unrealistic since the development contractor almost always is awarded the manufacturing effort. Even so, the regulations are extremely reticent when they discuss the connection of development and manufacturing contracts. See, e.g. ASPR 3-108. 95 A variation of this technique was suggested by P. E. Haggerty at the NSIA Joint Industry Defense Department Symposium on The Profit Motive and Cost Reduction (June 1961). Mr. Haggerty suggested that the development contract contain an option for the contractor to sell a specified quantity of the developed item at a fixed price. This would give the contractor an incentive to develop the item in such a way that it could be produced for the option price in order to obtain the future sales.

cost rather than the cost of the development effort only, and the contract will presumably be awarded to the contractor with the lowest overall price. Of course, the success of the technique depends on the use of competition to assure realistic price proposals. In this regard, it would also be expected that this technique would not be used unless there was sufficient technical knowledge about the requirements of the job and the state of the art to allow contractors to submit proposals with some confidence as to the accuracy of their cost estimates. However, when these conditions are present and realistic prices are obtained, this technique can be extremely beneficial to the Government since it forces the contractor to make every design decision with a f u l l awareness of its impact on the ultimate cost of manufacture of the product. Another advantage is that this technique provides the Government with full information of the ultimate cost of the program from its inception and also provides the parties with cost information on the full impact of changes to the program since the equitable adjustment for changes in such a contract would cover not only the design cost but also the option price. Thus, the more widespread use of this technique could provide substantial benefits to the Government. A similar technique has been used in the manufacturing area.^^ There the problem is often that prices are high because of the recurring short production runs which result from purchasing a single year's quantity of a product on each procurement followed by a competitive purchase of the following year's quantity. In such circumstances, no contractor can be assured of more than a one year quantity and therefore there is little incentive to undertake retooling or reengineering efforts that may reduce manufacturing costs. To counter this problem, the Army has developed a new procurement technique known as the "multi-year" procurement. Under this technique the procuring activity issues an Invitation for Bid or a Request for Proposal calling for alternate bids on the current one year quantity of the product and on the full requirement over two or three years. Since funds are not available for more than the first year portion of the total requirement, the Government also specifies in the IFB or RFP a cancellation ceiling covering non-recurring costs which are planned for amortization over the full period of the contract. The Government then evaluates the alternate bids and awards the contract on the multi-year basis unless it
96 See the proposed new provision, ASPR 1-322Multi-Year Procurement. See, also, Comp. Gen. Dec. B-152285, Aug. 27, 1963 affirming this procedure.

appears that there will be no price savings. In most cases, savings could be anticipated since this technique allows the contractor to plan his efforts over a longer period of time and institute cost saving programs with greater assurance that he will be able to benefit from such programs. This type of contract also will avoid breaks in production and should lead to reduced administrative cost. In the test procurements using this method, the Army has achieved cost savings of up to 9%.^^ The techniques discussed above are pioneering techniques to solve a problem in the incentive area that is constantly present and yet is not solved by the present incentive contracts. Since this is a real problem, additional techniques will undoubtedly appear as contracting officers search for better ways to tie the cost of future work to the present contract covering only a small part of the total program. It seems clear that much thought and experimentation is needed in this area.

Value Engineering
Another incentive technique which is closely related to the above discussion is value engineering. This technique also attempts to encourage design which will result in reduced cost of manufacture of the product. However, in this case the Government includes a clause in the contract either directing the contractor to undertake a value engineering effort as a part of the contract work^s or providing that the effort is optional but that the contractor will be paid a share of any savings which result from value engineering.^^ Thus, value engineering is treated as an additional effort to review the design of a product searching for changes to that design that will lead to reduced costs of manufacture. It is distinguished from the normal operation of an incentive contract in the fact that a contract change is required to implement a value engineering proposal whereas the cost reductions achieved under the incentive contract can be implemented without any approval of the Government.
97 Army brochure, Multi-Year Procurement of U . S. Army Material, Army Material Command. 98 This technique is called a Value Engineering Program Requirements clause. See ASPR 1-1703 for the regulations governing the use of such provisions and ASPR 1-1706 for the provisions of the clauses. A l l references to ASPR in this analysis of value engineering are to the regulations as revised by Revision 2 (15 August 1963) of the 1963 Edition of ASPR. 99 This technique is called a Value Engineering Incentives clause. See ASPR 1-1702 for the regulations governing the use of such provisions and ASPR 1-1705 for the provisions of the clauses.

The benefit of value engineering has been recognized by the Department of Defense which has required the inclusion of value engineering provisions in a large number of contracts.^oo This is evidently a recognition that in many cases cost savings can be as readily achieved by simplifying the design of a product as by improving methods within a contractor's operation to manufacture the product called for by the specifications. O f course, the nature of the product and the number of times it has been produced undoubtedly have much to do with the possibility of design simplification. However, there have been some outstanding examples of substantial cost reductions achieved by review of a design in order to achieve simplification and economy of manufacturing cost; and the use of value engineering would therefore appear to be a fertile field for cost reductions in Government procurement. The major problem in the present ASPR value engineering provisions is whether they provide sufficient incentive to encourage the contractor to pursue value engineering with real enthusiasm. The sharing arrangements established by the regulations call for contractors to share in the cost savings from a rate of 75% (on a firm fixed price contract with the Value Engineering Incentive clause) to 10% or less (on a CPFF contract with a Value Engineering Program Requirements clause). The percentages of sharing for incentive contracts would normally fall midway in this range. In general, these sharing percentages are as great as or greater than the percentages provided for cost reductions not involving value engineering. These percentages would therefore seem to provide substantial incentive in many cases if the contractor is sure that his proposals will be adopted soon after submission. However, this is an area of doubt in the present operation of value engineering. The regulations and the clauses provide that the Government has no obligation either to adopt the proposal or to process it in accordance with any schedule.ioi Since the sharing percentage applies only to costs saved
ASPR 1-1702.2(a) states that the Value Engineering Incentive clause "shall" be included in all advertised and negotiated procurements in excess of $100,000 unless the Value Engineering Program Requirements clause is included or the Head of the Procuring Activity determines that value engineering "offers no potential for cost reduction." ASPR 1-1703(a) states that the Value Engineering Program Requirements clause "shall" be included in each cost plus fixed fee contract in excess of $1,000,000 unless the Head of the Procuring Activity determines otherwise. These provisions also contain permission to use value engineering in other circumstances and discussion of other limitations on their use. 101 See paragraph (c) of the clauses set forth in ASPR 1-1705 and 1-1706. The regulations recognize this problem and state, "In order to realize the cost reduction potential of value engineering, it is imperative that value engineering change proposals be processed as expeditiously as possible." (ASPR 1-1701 ( b ) ) .

under the contract under which the proposal is submitted, the lack of expeditious processing can substantially reduce any additional profit which the contractor might earn under the value engineering provisions. One solution to this problem would be to apply the incentive share to future contracts but this has not been accepted as a viable technique at the present time. A further reduction of incentive in this area is in the data provisions which require that the Government get full rights to proprietary data in all value engineering proposals which are adopted and, in the case where the Value Engineering Program Requirements clause is used, in all submitted proposals. Some contractors have stated that this provision will lead to a reduced value engineering effort and the non-submission of proposals which include proprietary data. The problem, therefore, in value engineering is to determine the amount of incentive which must be given to motivate contractors to make a f u l l effort to achieve cost savings in this manner. This is especially true in the case where the Value Engineering Incentive clause is used. There the submission of proposals is completely optional and if the incentive is not sufiicient, the contractor may not undertake value engineering at all. It is interesting to note, in this respect, that the original ASPR provisions on value engineering issued in December 1962^^2 contained less incentive (or more risk) than the present provisions. The result of these regulations was a widespread refusal of contractors to accept the clauses and to participate in value engineering efforts. The new ASPR provisions contain less risk and, in some areas, more incentive. It is to be hoped that contractors will accept the present clauses and undertake value engineering in order that the potential costs savings from such efforts can be achieved.

Cost Plus Award Fee Contracts


Another problem that arises in incentive contracting when performance and delivery incentives are being used is the difficulty of establishing the total incentive formula at the beginning of contract per-, formance. In many development contracting situations, neither the Government nor the contractor are sufficiently aware of the total program requirements at the beginning of the contract to be able to accurately establish performance and delivery targets, ranges of acceptable performRevision 13 of the I960 Edition of ASPR. This revision inserted Section I, Part 17 into the ASPR for the first time.

ance and other aspects of the performance incentive contract. In addition, even if these targets are accurately established, there is a substantial possibility that program requirements will change thereby making the entire incentive formula obsolete. It has therefore been suggested that in lieu of the completely objective performance and delivery incentive contract, a subjective type of performance incentive could be used.103 Xhis subjective form of incentive contract has been called the cost plus award fee contract. In general, the cost plus award fee contract does not contain specific performance targets other than the normal specification requirements but provides that a board of experts are to review the contractor's performance after-the-fact and make adjustments to the profit or fee on the contract commensurate with the quality of that performance. Such a contract has been written by the National Aeronautics and Space Administration and the Atomic Energy Commission.^o^ This contract contains an award fee incentive arrangement covering a one year span of performance. During this year the Government project officers submit quarterly evaluations of the contractor's performance to the contractor for comment. The contractor may comment on the Government's evaluation of his performance or submit additional information reflecting on his efforts. A t the end of the year a Performance Evaluation Board screens all of this information including any presentation which the contractor desires to make and recommends a fee adjustment commensurate with the performance of the contractor. Based on this recommendation high officials of N A S A and A E G unilaterally adjust the contractor's fee. It should be noted that the contractor does not participate in this decision (all members of the Evaluation Board are Government employees) and that the decision on the fee is not subject to the disputes procedure. The fee adjustment, however, is made only within a range of approximately 1 . 1 % a measure of the fact that the parties were proceeding cautiously in this pioneering effort.^^^
Evidently this type of contract was first suggested in public by Thomas Morris, Assistant Secretary of Defense (Installations and Logistics) at the NSIA Joint IndustryDefense Department Symposium on The Profit Motive and Cost Reduction (1961). 104 This was the Nerva contract with Aerojet General Corp. The use of a cost plus award fee contract is an indication that N A S A is dissatisfied with contractor performance under CPFF contracts but is hesitant to adopt the D O D incentive contracts because of the research nature of the space programs. That agency is therefore engaged in a search for new contracting techniques at the present time. 105 In the succeeding year's contract, the contractor and the Government have agreed to substantially increase the spread of the incentive fee.

In this cost plus award fee contract the performance evaluation is made in broad areas which are agreed to by both parties at the outset. These criteria for evaluation are approximately as follows: 1. Technical Performance A . Technical management performance in program planning and organization, assignment and direction of skilled technical manpower, recognition of critical problem areas, sub-contract direction. B. Design. Approach in design concepts, design analyses, and detailed design execution. C. Development. Design of test specimens, models, and prototypes, and conception and execution of test plans. Correlation and an analyses of test results. D . Industrial Engineering. Application of modern industrial techniques including process development and control, and quality control. 2. Schedule Performance A . Completion of program tasks on schedule. B. Ability to recover from delays from any origin. 3. Administrative Performance A . Ability in budgeting, estimating, and cost control. B. Utilization of manpower. C. Utilization of materials. D . Cost minimization through study and use, when appropriate, of alternate arrangements, designs, methods, etc. It can be seen that while these criteria are rather general, a quarterly report covering each factor does serve the purpose of telling the contactor where performance weaknesses have appeared and thus allows him to correct mistakes and improve performance. In this sense, the procedure serves a very useful purpose of making information available at an early date. In a later cost plus award fee contract N A S A has made certain variations to the above described format.^^e this contract, covering a two year span of time, the target fee is set at a base rate of approximately 3% with a provision that a subjective incentive fee of approximately
This was an Overhaul and Maintenance contract on tracking stations with Bendix Corp.

y-fjo per quarter can be awarded to the contractor for good performance. In this case, the incentive only results in an increase in fee but the low target fee reflects this aspect of the arrangement. In addition, in this contract the fee adjustment is made quarterlynot at the end of the contract. Thus, at the end of each quarter the contractor can specifically ascertain his profit position. However, in this arrangement the contractor is not given the opportunity of commenting on the information that is submitted to the N A S A officials that make the decision on fee adjustmenthe is merely furnished a copy of the evaluation after the decision has been made so that he can take action in the future to improve performance in the areas where weaknesses have been pointed out. It appears that these differences in approach between the two contracts reflect the difference in the work to a large degreethe first contract being a research oriented effort whereas the second contract is a maintenance job requiring little original effort. The disadvantages of the cost plus award fee contract are immediately apparent. First, the contractor subjects himself to the discretion of a board of government personnel in the critical matter of the profit to be earned on a contract. This will inevitably raise a question with most contractors. However, the alternative of having a board partially composed of contractor representatives or third party representatives also seems to create difficulties. The protection of the contractor in this area therefore rests in the procedure used to review his performance and the fact that usually he is given an opportunity to make a presentation to the board. Second, this award fee technique might keep the contractor from knowing the amount of fee he will earn on a contract until after the work was completed. On a long contract, this could create difficult financial problems. N A S A has partially solved this problem by providing for incremental fee determination during contract performance and by placing a floor on the fee. Third, this type contract exposes the contractor to the risk that hindsight will be used to evaluate his performance. The N A S A technique of periodic review and written evaluation reports also partially solves this problem. In spite of the difficulties enumerated above, it would appear that the cost plus award fee concept contains enough advantages to both parties to make it a useful contracting technique. It does solve the major problem of the standard performance and delivery incentive contractthe problem of establishing a firm set of targets and performance criteria at a time when the parties can foresee the future only dimly. It there-

fore eliminates the substantial risk in such contracts that subsequent performance will show that the contract as written does not reflect the needs of the Government or the abilities of industry. The cost plus award fee contract therefore can serve as a protective device for both parties and, at the same time, enable them to introduce the profit motive with its incentives for better performance into the program at an early stage. It also has been suggested that the subjective and objective incentive contracts can be combined. For example, N A S A has recently issued a Request for Proposal with the following incentive provisions I^OT 1. Objective cost incentive90/10 sharing arrangement. 2. Objective delivery incentive$10,000 per day penalty for schedule delay up to a maximum fee reduction of $1,000,000. 3. Subjective performance incentive7% additional fee which can be awarded by N A S A for good performance on the five spacecraft to be delivered under the contract with the heavy weight assigned to the early spacecraft. 4. A t any time during performance either contracting party may propose an objective performance incentive formula which will convert any portion of the subjective performance incentive to a firm formula. In this contract it can be seen that N A S A intends to mix subjective and objective incentives in the same contract and also intends to provide a mechanism allowing the subjective incentive to be converted to an objective incentive during contract performance. Both of these procedures are clearly acceptable. Implicit in this procedure is the belief that subjective incentives are sometimes necessary but that they are definitely not as desirable as objective incentives. On the other hand, the small amount of existing experience on subjective incentives which N A S A
This was the N A S A procurement for the Lunar Orbiter. See N A S A press release of Sept. 27, 1963. This RFP has two other interesting aspects to it. First, N A S A has spelled the entire incentive formula out in the Request and has directed all contractors to submit proposals on that formula. (Alternate proposals are also acceptable.) Thus, all of the negotiation is removed from the incentive formula and the contractors can all be evaluated on the same basis. Second, the RFP calls for an option proposal for additional spacecraft based not on a firm price but on a pricing formula to be applied to the costs incurred in the manufacture of the last spaceaaft produced on the present contract. This is a very interesting technique for solving the problem of future pricing when the contractor is in a sole source position.

has had seems to indicate that they have worked quite well. The question might therefore be raised at the present time whether the subjective incentive is not a useful device in its own right rather than merely a mediocre alternative to the objective incentive.

Performance

Rating

Systems

The ultimate incentive might well be a performance rating system under which the contractor's performance on each contract was rated and that rating used for source selection and profit determination on future contracts. Such a system, if it were effective, would bring the future-business incentive (the incentive to obtain future sales and profits) into full play in the performance of current contracts. Thus, if a contractor knew that his opportunity to obtain future business would be decreased if he did not meet the performance, delivery and cost goals of a current contract, there would probably be no greater incentive to improve performance on current contracts. Such a system is in the future but the Department of Defense has taken the first steps to introduce such a system into the area of engineering development and operational system development.^^^ In analyzing such a technique, the functioning of the present incentive contracts in the area of the future-business incentive should be considered. It might be argued that the present incentives do not utilize this incentive or in some cases override it. It is certainly clear that the major incentive in the normal incentive contract is the profit-on-this-contract incentive. However, it would be inaccurate to say that this emphasis on current profit overrides the future-business incentive. W i t h almost all contractors this incentive to obtain future business and assure future profits is one of the major aspects of their corporate existence and one to which daily attention is paid. Thus, it is probably more accurate to say that in cases where the future-business incentive conflicts with the current-profit incentive, the future business incentive will prevail. For instance, if a contractor performing an incentive development contract
Department of Defense Directive No. 5126.38 (Aug. 1, 1963). This directive calls for performance evaluation reports from Government project officers every six months on major contracts. These reports are to be reviewed by agency or department review groups and then submitted to the contractor for comment. They will then be sent to the Department of Defense for central storage. Eventually their use will be mandatory for source selection. It should also be noted that the Department of Defense has already taken the first step in relating profit to past performance by providing in the new profit guidelines that from +2% to -2% points of profit be given to the contractor based on past performance. See ASPR 3-808.5(d).

finds he can earn additional profit by lowering his performance in a technical area, he will certainly consider the effect of such a decision on his chances of obtaining a follow-on contract for manufacture of the product and on his chances of obtaining future development contracts. In many cases, he will forego immediate profits to insure that his reputation with the customer remains untarnished. Thus, the future-business incentive will have prevailed over the present-profit incentive in spite of the fact that the contract puts special emphasis on the present-profit incentive. In this perspective it can be seen that a performance rating system which assured contractors that their present performance would be considered in all decisions on future contracts would be the ultimate incentive since it would clarify and strengthen an already existing aspect of the profit motive. O f course, this type of contractor evaluation has been present for years at the level of the individual Government employee or procuring agency. There, opinions on the relative merits of different contractors are frequently voiced and probably have some effect in source selection decisions. However, these opinions are usually informal and thus difi[icult to use as a major factor in source selection decisions. A Department of Defense or even Government-wide rating system established on a formal basis would therefore be much more powerful in bringing this type of incentive into play on a regular basis. This new technique also will serve the purpose of informing contractors of the Government opinion of their performance on a regular basis and will allow them an opportunity to protest the opinion if they feel it is unfair. This should have the effect of forcing much of the opinion on the relative merits of contractor performance out in the open rather than having it remain in the procuring activity where it has stayed in the past. In conclusion it can be seen that there are many possibilities of new techniques that can be used to create incentives for better performance in Government contracts. The need for such incentives is apparent. However, the problems of creating incentives are not easy to solve and there is a great tendency to impose incentive provisions without doing the necessary work to assure that they can be meaningfully applied during contract performance. This is therefore one of the most challenging areas in Government contracting and one which needs the effort and imagination of all who work i n this field.