1.5 Contract StructuresContract Type Selection

Don Shannon

Basic Contract Types Three basic types

Fixed Price Cost Reimbursement Time and Materials

Each type has characteristics that make it applicable for a type of procurement Risk (Cost, Schedule, Quality) are

primary consideration Completeness /detail of

specifications will often determine risk

Cost Risk and Contract Type Risk must be viewed from each parties

perspective Buyer (Often the Government) Seller

Both parties seek to minimize their risk Cost risk Technical risk / Performance risk

Contract type is negotiable (FAR 16.103) Selecting the contract type is generally a

matter for negotiation and requires the exercise of sound judgment.

Negotiating the contract type and negotiating prices are closely related and should be considered together.

Contract Risk and Contract Type

Cost Risk High Low

Requirement Definition

Poorly- defined WellDefined Defined

Production Stages

Concept Studies & Basic Research

Exploratory Develop

Full-scale Deployment

Follow-on Production

Contract Type Various types of Cost Reimbursement

CPFF CPIF, FFIF, or FFP

FFP, FPIF, or FPEA

Risk ElementsBuyer Risks

Price will exceed established ‘budget’

Work will not meet customer requirements Poor quality

Inferior workmanship Substandard materials

Late delivery

Seller Risks

Specifications incomplete or missing

Differing Site Conditions

Changing business conditions Material Prices Labor concerns Laws / regulations Weather

“Force Majeure” .. Unforeseen events Acts of God War Performance failures by failures outside of either

parties control

Fixed Price Contracts Buyer and Seller agree to a price

Generally the price is not changed (i.e., it is “fixed”)

Offers buyer lowest risk by transferring risk to seller

Does NOT immunize buyer from all cost risks Differing Site conditions Imperfect specifications Seller agrees to do all work / deliver all

goods for one price

Seller assumes most risks and has little recourse for cost variations

Preferred contract type for most Government agencies.

Firm Fixed Price Price is not subject to adjustments

Sometimes called “lump sum”

Strong incentive for seller to control costs

Buyer must be able to accurately state requirements and estimate costs.

Applicable to: Construction Commercial purchases

Fixed Price – Economic Adjustment Allows upward and downward

revision of contract price

Revisions are keyed one or more factors Established prices Actual cost of labor or material Published indexes

Fixed Price - Redetermination Fixed price for part of the contract with

Redetermination of future prices at some point during performance (Prospective) Especially useful if prices are

subject to large swings such as oil or currency exchange rates.

Retroactive adjustment after completion Fixed ceiling price at start Retroactive adjustments can not

exceed ceiling

Fixed Price – Level of Effort Fixed sum paid over time

Contractor provides a ‘level of effort’ Can be based on labor hours (e.g., Full

Time Equivalent (FTE)

Contractor not obligated to continue performance beyond that limit

Used when exact requirements can not be accurately stated but buyer wishes to cap total cost.

Fixed price is invoiced over time as percentage of Period of Performance (1/12 per month etc.)

Cost Reimbursement Contracts Contractor is paid (reimbursed) for

actual costs

Ceiling cost is established Contractor may not exceed ceiling

except at own risk Contract shall make ‘best efforts’ to

complete work within ceiling

Types of Cost Reimbursement Contracts Cost Contract Cost Sharing Cost Plus Fixed Fee

Cost Contract Contractor is reimbursed for their costs

Must be “allowable” (i.e., not specifically prohibited)

Must be allocable to the “final cost objective”

Must be “reasonable” Arms-length dealing What would be normally paid by a

prudent buyer in the normal course of business

No profit or fee is paid Often to non-profit institutes,

colleges, universities, etc.

Cost Sharing Contracts Both the buyer ad the seller share in

the actual costs

Benefits to both parties Often used for developing

intellectual property shared by both

One gets ownership and sales rights

Other benefits from a paid-up license to use the technology

Cost Plus Fixed Fee Contracts Most commonly used form of cost contract

Fee is calculated as a fixed value based on estimated costs

“Best Effort” of seller to complete work for estimated cost

Stop performance when the cost is reached

If costs exceed estimate buyer may be provide added funds with or without additional fee No fee if costs are determined to be

‘overrun’

Incentive Contracts Applicable to both Cost and fixed price contracts

Provide additional motivation for seller to control a specific risk e.g., cost, schedule, quality.

Cost Incentive Permits adjusting final contract price using a

formula based on Final negotiated cost Target cost

Performance (Quality) Incentive Bonus for exceeding certain performance goals

Delivery Incentive Bonus for early completion e.g., the Big I project. Penalty for late completion

Liquidated damages

Guidelines for Selecting Contract Type Contracting Officers consider a number of

factors when selecting contract type

Risk is the primary factor

Sellers should be rewarded for accepting increased risk

Incentives, adjustments and award fees can be used to share the risk Equity .. What is fair and reasonable for both

parties Buyer (Government) should never place itself

in a position to make or break a seller (offeror)

When … Select a …

The offeror can actually estimate cost(s) Firm Fixed Price Contract

Economic conditions that will likely affect cost significantly and are outside offeror’s control but otherwise offeror can accurately estimate costs

Fixed Price Economic Adjustment

There are substantial cost uncertainties but it should be possible to estimate/control costs

Fixed Price Incentive Fee

Cost uncertainties are so great that fixed price would force seller to accept unreasonable risk but reasonable targets and formulas for sharing costs can be negotiated

Cost Plus Incentive Fee

The Level of Effort is uncertain and it is not feasible to negotiate an adjustment formula but likelihood of meeting objectives can be enhanced by a clear subjective fee plan

Cost Plus Award Fee

Cost uncertainty is so great the establishment of predetermined targets and incentive arrangements could result in a final fee out of line with the real work

Cost Plus Fixed Fee

Other Contract Devices Basic Agreement – Pre-negotiated agreement.

Includes Offer and Acceptance of terms but has no value

Basic Ordering Agreement (BOA) – Similar to above except may include pre-negotiated prices for standard items – again no value

Letter Contract – Temporary agreement pending negotiation of key terms and conditions – undefinitized contract actions

Indefinite Delivery / Indefinite Quantity (ID/IQ) – Establishes ordering framework as with BOA but includes assurance of some minimum value. Items are typically stated but quantity to be delivered and date for delivery need not be stated.