Chapter 15
Methods of
Compensation
15-1
Key Concepts
•
Introduction to compensation agreements
•
Contract cost risk appraisal
»
Technical risk
»
Contract schedule risk
•
General types of contract compensation
agreements
»
Fixed price contracts
»
Incentive contracts
»
Cost-type contracts
15-2
Key Concepts
•
Specific types of compensation agreements
»
Firm fixed price contracts
»
Fixed price with economic adjustment contracts
»
Fixed price redetermination contracts
»
Incentive arrangements
»
Cost plus incentive fee arrangements
»
Cost plus fixed fee arrangements
»
Cost plus award fee
»
Cost without fee
»
Cost sharing
»
Time and materials
»
Letter contracts and letters of intent
•
Considerations when selecting contract types
15-3
Introduction to Compensation Agreements
•
The compensation arrangement
determines:
»
Degree and timing of the cost responsibility
assumed by the supplier
»
Amount of profit or fee available to the
supplier
»
Motivational implications of the fee portion of
the compensation arrangements
15-4
Example 1: Low Level of Uncertainty
Potential
Outcomes Seller’s Cost Seller’s Price
Seller’s Profit
Low $950,000 $1,100,000
$150,000
Most Likely 1,000,000 1,100,000
100,000
High 1,050,000 1,100,000
50,000
Firm Fixed Price Contract
15-5
Example 2: High Level of Uncertainty
Potential
Outcomes Seller’s Cost Seller’s Price
Seller’s Profit
Low $500,000 $1,100,000
$600,000
Most Likely 1,000,000 1,100,000
100,000
High 1,500,000 1,100,000
(-400,000)
Same FFP Contract as 19-1
15-6
Example 2: Continued
•
Most sellers are unwilling to large risks
»
The supplier will not want to offer the contract at
$1,100,000 due to this additional uncertainty
•
In this case, the seller studies the
distribution of likely cost outcomes and
concludes that, 9 times out of 10, the actual
cost will be $1,400,000 or less
•
Based on the risk aversion, the seller may
demand a firm fixed price of $1,540,000
»
$1,400,000 plus $140,000 (10 percent profit on
this cost)
»
The supplier will not lose money on the contract
15-7
Example 2: Continued
Potential
Outcomes Seller’s Cost Seller’s Price
Seller’s Profit
Low $500,000 $1,540,000
$1,040,000
Most Likely 1,000,000 1,540,000
540,000
90% Level 1,400,000 1,540,000
140,000
High 1,500,000 1,540,000
40,000
Firm Fixed Price Contract
15-8
Example 2: Continued
Potential
Outcomes Seller’s Cost Seller’s Price
Seller’s Profit
Low $500,000 $550,000
$50,000
Most Likely 1,000,000 1,050,000
50,000
90% Level 1,400,000 1,450,000
50,000
High 1,500,000 1,550,000
50,000
Cost Plus $50,000 Fixed Fee
15-9
Example 2: Continued
Potential
Outcomes Seller’s Cost Seller’s Price
Seller’s Profit
Low $500,000 $550,000
$50,000
Most Likely 1,000,000 1,100,000
100,000
90% Level 1,400,000 1,540,000
140,000
High 1,500,000 1,650,000
150,000
Cost Plus Fixed 10% Fee
15-10
Contract Cost Risk Appraisal
•
Technical Risk
»
Risk associated with the nature of the item
»
Technical risk appraisal:
–
Type and complexity of the item or service
–
Stability of design specifications or statement of
work
–
Availability of historical pricing data
–
Prior production experience
•
Contract Schedule Risk
»
Anticipate material and labor cost increases
–
Forward pricing is common
»
Anticipate possible schedule slippages
15-11
General Types of Contract Compensation
Arrangements
•
Fixed Price Contracts
•
Incentive Contracts
•
Cost-Type Contracts
Buyer Risk
Supplier Risk
Low
High
High
Low
Fixed
Price
Contracts
Cost
Type
Contracts
Incentive Contracts
15-12
Firm Fixed Price Contracts
•
A firm fixed price (FFP) contract is an
agreement to pay a specified price when
the items (services) specified by the
contract have been delivered (completed)
and accepted
•
Common types:
»
Firm fixed price
»
Fixed price with economic price adjustment
»
Fixed price redetermination
15-13
When to Use FFP
•
Specifications are well defined
•
Cost risk is low
•
Schedule risk is low
•
Technical risk is low
•
Competition has established pricing
15-14
Firm Fixed Price Contract Example
Figure 19-3
15-15
Reasons Why Firm Fixed Price Contracts Do Not
Always Remained Fixed
•
A supplier losing money may request
relief if:
»
Customer contributed to the loss
»
Customer badly needs the items
–
Assumes other suppliers are not available
»
Supplier has unique facilities and time is short
»
Customers representatives do not employ
sound supply management practices
15-16
Fixed Price and Economic
Price Adjustment Contracts (FPEPA)
•
(FPEPA) contracts are used to recognize
economic contingencies, such as unstable
labor or market conditions
•
FPEPA is an FFP contract that includes
economic price adjustment clauses
»
Escalator clauses are for price increases
»
De-escalator clauses are for price decreases
15-17
Rules for Selecting Indexes for Price Adjustment
Clauses
•
Select from the appropriate Bureau of Labor
Statistics category
•
Avoid broad indexes; use the lowest-level
classification
•
Develop a weighted index for materials in a
product
•
Select labor rate indexes by type and location
•
Define energy indexes by fuel type and location
•
Analyze the past history of each index versus
actual price change of the item being indexed
15-18
Fixed Price Redetermination Contracts (FPR)
•
A FFP is set for an initial contract period
•
A redetermination (upward or downward)
occurs at a stated time during the contract
•
FPR prospective
»
Occurs at a stated time during the contract
»
Used where a fair and reasonable price can be
developed for initial periods but not subsequent periods
•
FPR retroactive
»
Occurs at the end of the contract
»
Used when uncertainty exists as in the prospective, but
the amount of the contract is small and/or the
performance period is short
15-19
Incentive Arrangements
•
Used to motivate the supplier to:
»
Control costs
»
Encourage good supplier performance
•
Contract price will usually be higher
•
Ceiling price is usually fixed during
negotiations
•
Cost responsibility is shared
•
Two primary types:
»
Fixed price incentive
»
Cost plus incentive fee
15-20
Elements of a Simplified Incentive Contract
•
Target cost
»
Cost outcome both buyer and supplier feel is
the most likely outcome
•
Target profit
»
Amount considered fair and reasonable
•
Allocating costs above or below target
»
Recognizes the target most likely will not be
met
»
A sharing arrangement is agreed upon that
reflects the sharing of the cost responsibility
15-21
Fixed Price Incentive Fee Example
15-22
Cost Plus Incentive Fee Arrangements
•
Combine the incentive arrangement and
the cost plus fixed fee arrangement
•
Under a CPIF arrangement, an incentive
applies over part of the range of cost
outcomes
•
The fee structure resembles a cost plus
fixed fee contract at both the low-cost and
high-cost ends of the range
15-23
Cost Plus Incentive Fee Example
•
Target cost = $1,000,000
•
Target profit = $70,000
•
Optimistic cost = $800,000
•
Optimistic and maximum profit = $120,000
•
Pessimistic cost = $1,400,000
•
Pessimistic and minimum profit = $20,000
•
Sharing below target (customer/supplier) =
75/25
•
Sharing above target (cust./supplier) =
87.5/12.5
15-24
CPIF Contract Example Continued
•
Target cost = $1,000,000
•
Target profit = $70,000
•
Maximum fee = $120,000
•
Minimum fee = $20,000
•
Cost savings = target cost - final cost
»
$300,000 = $1,000,000 - $700,000
•
Supplier’s savings = cost savings × supplier share
»
75,000 = $300,000 × 0.25
•
Computed fee = savings fee + target fee
»
$145,000 = $75,000 + $70,000
•
Final price = final cost + maximum fee
»
$820,000 = $700,000 + $120,000
15-25