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 Specific types of compensation agreements Fixed price compensation arrangements: Firm fixed price contracts Fixed price with economic adjustment contracts Fixed price redetermination contracts Incentive arrangements Fixed price incentive Cost plus incentive fee arrangements Cost-type arrangements: Cost reimbursement Cost sharing Time and materials Cost plus fixed fee arrangements Cost plus award fee arrangements Cost without fee Considerations when selecting contract types

1. Chapter 15
Methods of
Compensation
15-1

2. 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

3. Key Concepts
• Specific types of compensation agreements
» Fixed price compensation arrangements:
– Firm fixed price contracts
– Fixed price with economic adjustment contracts
– Fixed price redetermination contracts
» Incentive arrangements
– Fixed price incentive
– Cost plus incentive fee arrangements
» Cost-type arrangements:
– Cost reimbursement
– Cost sharing
– Time and materials
– Cost plus fixed fee arrangements
– Cost plus award fee arrangements
– Cost without fee
• Considerations when selecting contract types
15-3

4. 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

5. 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

6. 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

7. 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

8. 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

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 1,050,000 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. Firm Fixed Price Contract Example
Figure 19-3
15-15

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. Fixed Price Incentive Fee Example
15-22

23. 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

24. 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

25. 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

26. Cost Plus Incentive Fee Arrangements
• Cost savings = target cost - final cost
• Supplier’s share of cost savings = cost
savings × supplier share
• Computed fee = savings fee + target fee
• Final price = final cost + maximum fee
15-26

27. Cost Plus Incentive Fee Example
15-27

28. Cost-type Arrangements
• Used when:
» Research and development increases technical risk
» Project completion is in doubt
» Product specifications are incomplete
» High-dollar, highly uncertain procurements are involved
• Common types are:
» Cost reimbursement
» Cost plus fixed fee
» Cost plus award fee
» Cost without fee
» Cost sharing
» Time and materials
15-28

29. Cost Plus Fixed Fee Arrangements (CPFF)
• Buying firm pays a fixed fee and all costs
beyond fee
• Fee is for specified scope of work
• Supplier has no incentive to control costs
• Characterized by low supplier profit
• A total liability limit is usually established
Optimistic Most likely Pessimistic
Final cost $800 $1,000 $1,200
Fixed fee 50 50 50
Price $850 $1,050 $1,250
CPFF Example
(not in text)
15-29

30. Cost Plus Award Fee (CPAF)
• The award fee is a pool of money
established by the buyer to reward the
supplier in meeting the buyer’s stated
needs
• Receipt of the fee is based on the buying
firm’s subjective evaluation
• CPAF works as a flexible tool
15-30

31. Cost Without Fee
• Used primarily by nonprofit institutions
• Used for research work without the
objective of making a profit
• Institutions recover all overhead costs
• In recent years, high-technology firms
have increased their use of this contract
type
15-31

32. Cost Sharing
• In some situations, a firm doing research
under a cost type of contract stands to
benefit if the product developed can be
used in its own product line
• Under such circumstances, the buyer and
the seller agree on what they consider to
be a fair basis to share the costs (most
often it is 50-50)
• The electronics industry has found this
type of contract especially useful
15-32

33. Considerations When Selecting Contract Types
• Unstable labor conditions
• Unstable market conditions
• Improvement in production is required
• Complexity of product or service
• Product or service requires development
• Design is not completed or may change
• Learning must take place
• Short time to prepare for a bid or negotiation
• Short delivery period
» Which may require additional resources to meet
deadlines
15-33

34. Concluding Remarks
• Sound application of the compensation
methods presented will significantly
reduce expenditures when cost risk is
present
• Compensation agreements must result in
a reasonable allocation of the cost risk
• Agreements should also provide adequate
motivation to the supplier to assure
effective performance
15-34