RISK ALLOCATION AND MOTIVATION FUNCTIONS OF CONTRACTS IN
THE U.S.
The risk
allocation and motivation are two primary functions of contracts as well as the
evidentiary, administrative and payment functions. In today’s world, managing the acquisition
programs is getting harder as products and systems get more complex along with
the rapid technological developments.
Therefore, the acquisition programs involve more risk than ever and the
contractor motivation is the fundamental strategy to achieve the goals of a
successful acquisition program.
The
Federal Acquisition Regulation (FAR) is the principle document for the contract
management in the U.S. Government. FAR
enables the contracting officers (KO) and the agencies to select among
different contract types to allocate the risk efficiently between the
Government and the contractor. FAR also
increases the performance of the contractors with different incentives provided
by the contract type. Thus, risk
allocation and performance enhancement are strictly related to the contract
types.
Acquisition
programs always involve risk. Cost,
schedule and performance risks are the main concern of the contracting officers
in the Government programs. All these
risks may be allocated between the Government and the contractor with an
appropriate contract type. Furthermore,
the existing risks must be shouldered by the two parties, either solely by the
Government or solely by the contractor or must be shared by both.
The motivation function is the
fundamental part of the contractor performance and linked with the risk
allocation. Since all contracts include
a payment function and the primary goal of each contractor is making profit,
the motivation function will be performed by creating monetary incentives for
the contractors. Therefore, the
motivation function enables establishing a contract structure for mutual
satisfaction of the Government and the contractors.
Two
basic contract types are the “fixed price” and “cost” type contracts in the
U.S. Government. Generally, the fixed price contracts can be enhanced with the
price adjustments and the incentive fee.
On the other hand, the cost type contracts can be enhanced with various
types of fees. Fixed fee, award fee and
incentive fee are the available fee types.
Since
the contractor accepts to complete the job at a fixed price, fixed price
contracts mainly transfer all the risk to contractor. The fixed price contract types are
beneficial when the performance risk is low.
Mature technology acquisitions and commercial of the shelf (COTS) item
procurements are good examples where fixed price contract types can be
utilized. The contractor is incentivized
to reduce the cost since the cost savings will increase the profit margin for
the contractor and the cost overruns will reduce the profit or even may create
losses.
The cost type contracts hold the
risk mainly on the Government. The
Government accepts to pay all the costs incurred by the contractor to
accomplish the job successfully. The
major risk that challenges the Government is the contractor’s failure to
complete or deliver the product. The
cost type contracts are usually preferred when the performance risk is high. Cutting edge technology acquisitions,
unproven processes or innovative material procurements are examples of the
situations where the cost contracts may be utilized. Unlike fixed price, the cost savings will
basically return to the Government or cost overruns increase the Government
expenses on the contract.
“One
size fits all” strategy does not work well for the contract management. Therefore, selecting the appropriate contract
type is a crucial task for risk allocation and contractor motivation. The objectives of the contract type selection
process must be reducing the risk to a reasonable level for both parties and
creating incentives to increase the performance of the contractors.
The acquisition method is one of
the major considerations for selecting the contract type. Because some of the acquisition methods limit
the type of contracts applicable to a particular acquisition. For example, fixed price is the only contract
type that can be used when the Simplified Acquisition Procedures (SAP) is the
acquisition method. Another acquisition
method is Sealed Bidding that restricts the selection of contract types to Firm
Fixed Price (FFP) and Fixed Price with Economic Price Adjustment (FPEPA). The Negotiations is the other acquisition
method, however, any type of contracts specified in the FAR can be used with
this method.
Fixed
fee is the most basic type of contract fee that is used to increase the
contractor performance. This can only be
used with cost contracts and forms the Cost Plus Fixed Fee (CPFF) contract
type. In addition to cost reimbursed by
the Government, the CPFF guarantees a profit for the contractor equal to the
fixed fee determined in the contract initiation.
The
cost contract type including an award fee is called the Cost Plus Award Fee
(CPAF) contract. In the CPAF contracts,
the acquisition program is divided into periods and an award fee pool is
assigned to each period. The award fee
pool consists of a certain amount of fee, which will be available for the
contractor. First, an Award Fee Plan is
established to formulize the award fee payment.
The Award Fee Plan states the criteria that must be met by the
contractor to be eligible for getting certain percentages of the award fee
available at each period. A designated
Award Fee Board will evaluate the contractor and determine the percentage of
award fee to be released to the contractor.
Furthermore, the remaining portion of the fee pool not awarded during a
period can be added to the following periods to increase the incentive for the
contractor.
Incentive
fees can be used both with fixed price and cost type contracts: Cost Plus
Incentive Fee (CPIF) and Fixed Price Incentive (FPIF) contracts. The incentive fee is used to incentivize the
contractor to improve the cost, schedule and performance elements. Cost based incentive fee is stated as a share
ratio in percentages between the Government and the contractor for cost
savings. Each party will get its
designated percentage of the cost savings occurred. Changing the share ratio will affect the
incentives for the contractor. Thus,
determining the optimum percentages between the two parties is a critical task.
The
criteria for schedule based incentive fee is the early delivery of acceptable
product or early accomplishment of any major milestone. Performance based incentive fee must also be
based on measurable criteria such as exceeding the required limits stated in
the contract specifications. The amount
of incentive fee awarded to the contractor is determined through a calculation. The criteria for calculation is explained and
formulized in the contract initiation.
The fee is usually not a constant amount but increases as the contract
element improvements increase. However,
the maximum limit must always be specified and the minimum limit may also be
specified. An important point here is that
the contractor must meet all the contract element requirements to qualify for
the incentive fee.
As
stated before, fixed price contracts can also be enhanced with various methods:
Firm Fixed Price-Level of Effort (FFPLOE) is an enhanced method, which allows
flexibility in amount of work assigned to the contractor. Fixed Price with Economic Price Adjustments
(FPEPA) is another type that allows changing the price based on the
pre-specified economic indexes. Other
enhancements may be listed as Fixed Price with Price Re-determination (FPR) and
Fixed Price with Incentive Successive Targets (FPIS), which is a hybrid of
FPIF.
Finally,
the U.S.
Ugur Erdemir
Logistics and Acquisition Professional, Industrial Engineer
ugurerdemir1975@hotmail.com
Warehouse Site Selection Models
http://warehousesiteselection.blogspot.com/
Excess Inventory and Disposal
http://excessinventoryanddisposal.blogspot.com/
Reference: U.S.
