INCENTIVE CONTRACTS

1. INCENTIVE CONTRACTS David Dudley (ESC Pricing Chief) Paul Hovsepian (Raytheon VP, Contracts)

2. Incentive Contracts Changing Environment Incentivizing Acquisition Outcomes Understanding CPIF & FPIF Incentive Structures in Negotiations

3. Changing Environment • December 2005, GAO Report • “DOD Has Paid Billions in Award and Incentive Fees Regardless of Acquisition Outcomes” • 2007 National Defense Authorization Act (Sec 814) • “…award fees link such fees to acquisition outcomes (which shall be defined in terms of program cost, schedule, and performance)” • “…no award fee may be paid for contractor performance that is judged to be below satisfactory performance or performance that does not meet the basic requirements of the contract”

4. Changing Environment • April 2007, OSD AT&L Memo • “It is the policy of the Department that objective criteria will be utilized, whenever possible, to measure contract performance” • 2009 National Defense Authorization Act (Sec 867) • Substantially similar language as 2007 NDAA

5. Changing Environment • Award fee contracts (CPAF) became a popular contract type for efforts where Firm Fixed Price (FFP) was not suitable. CPAF provided a mechanism to incentivize many areas of performance – subjective and objective. • Traditional incentive contracts (CPIF / FPIF) have been used infrequently for many years.

6. Transitioning to IF Contracts • The transition from CPAF to CPIF and FPIF has been difficult for many. • How can the Government incentivize acquisition outcomes previously incentivized through the use of Award Fees?

7. Incentivizing Acquisition Outcomes • Gov’t program teams must decide on the behaviors they wish to motivate and incentivize contractors accordingly. • Cost, Schedule, Technical Performance, etc. • These should be clearly defined, objective criteria (i.e. easy to evaluate) that meet or exceed the requirement.

8. Motivating Contractors • A contractor wants to put a quality product in the warfighter’s hands at a fair and reasonable price. • A contractor wants to satisfy their customer. • The acquisition office • Good past performance ratings are important • Ability to meet schedule is critical

9. Contract Types • The contractor’s goal is to meet the requirements as efficiently and quickly as possible. • Cost and schedule often have a direct correlation • Programs that finish ahead of schedule are often under budget and vice versa

10. Multiple IncentivesProceed with Caution • Competing incentives and contractor behavior • Competing incentives often force trade-offs to maximize incentive $ earned • The contractor and the Government may not agree on the priority/importance of incentives

11. “All or Nothing” Incentives • “All or Nothing” incentives are powerful but can also have unintended consequences. If incentive becomes unattainable, all motivation for contractor is lost. • Instead consider a tiered/scaled approach.

12. “All or Nothing” Incentives • “All or Nothing” never makes sense for a cost incentive. • Example: • Contractor earns $1,000,000 incentive if he completes effort at or below a certain cost • The best financial outcome for the Govt is if the contractor misses the incentive by 1 dollar. (Govt pays $999,999 less) • Govt should never establish an incentive where it is not in Govt’s best interest for contractor to earn the entire incentive (i.e. rooting against the contractor)

13. Incentives • How does CPIF and FPIF work? • How and when are contractor’s are motivated in the IF environment? • Why do contractor’s like IF contracts?

14. Cost Incentive Graphs • Graphing Cost Incentives is critical in understanding how they work. • Graph becomes very important when comparing alternatives and offers and provide insight into the contractor’s thought process.

15. CPIFReview • Target Cost: The anticipated cost of the effort • Target Fee: The fee earned if the final cost equals the Target Cost • Share Ratio: The share of each dollar of overrun or underrun borne by the Gov’t/Contractor ratio • Min/Max Fee: The min or max fee the contractor receives regardless of the amount of cost overrun (min fee) or underrun (max fee) • Range of Incentive Effectiveness: Area under the curve where the contractor is most incentivized

16. Target Fee Target Cost Target Cost $100.00 Target Fee 9.00 (9.0%) Target Cost & Fee $109.00 Minimum Fee $ 4.00 Maximum Fee $ 14.00 Share Ratio: Over 80 /20 Under 80 / 20 100 / 0 Max Fee 80 / 20 (under) 80 / 20 (over) 100 / 0 Min Fee

17. Target Cost $100.00 Target Fee 9.00 (9.0%) Target Cost & Fee $109.00 Minimum Fee $ 4.00 Maximum Fee $ 14.00 Share Ratio: Over 80 /20 Under 80 / 20 100 / 0 Max Fee 80 / 20 (under) 80 / 20 (over) 100 / 0 Min Fee

18. Target Cost $100.00 Target Fee 9.00 (9.0%) Target Cost & Fee $109.00 Minimum Fee $ 4.00 Maximum Fee $ 14.00 Share Ratio: Over 80 /20 Under 80 / 20 100 / 0 Max Fee 80 / 20 (under) 50/50 Share Line 80 / 20 (over) 100 / 0 Min Fee

19. FPIFReview • Target Cost: The anticipated cost of the effort • Target Profit: The profit earned if the final cost equals the Target Cost • Ceiling Price: The max amount the Gov’t is obligated to pay the contractor • Share Ratio: Same as CPIF • Point of Total Assumption: The point on the cost overrun share line where cost plus profit equals Ceiling Price – share line becomes 0/100

20. Target Profit Target Cost PTA Target Cost $100.00 Target Profit 12.00 (12.0%) Target Price $112.00 Ceiling Price $130.00 (130%) Share Ratio: Over 70 / 30 Under 70 / 30 70 / 30 (under) 70 / 30 (over) 0/100

21. Cost Incentive Geometry • Cost Incentives are not one-size-fits-all • Each element of cost incentive structure is important • Don’t just focus on Target Cost & Target Fee or Profit • The geometry (Share Lines, Min & Max Fees, Ceiling Price) is what creates the incentive • The geometry can be a powerful tool in the reaching settlement

22. Incentive Geometry FPIF Financially, which offer is the best for the Govt?

23. Target Profit Target Cost Target Cost $100.00 Target Profit 12.00 (12.0%) Target Price $112.00 Ceiling Price $130.00 (130%) Share Ratio: Over 70 / 30 Under 70 / 30 70 / 30 (under) Offeror B Offeror A 70 / 30 (over) Offeror C 0/100 All three offers are financially identical

24. Incentive Geometry Understanding Share Lines • Any point along the same share line is financially equal as long as: • CPIF: Min & Max Fee $ are held constant • FPIF: Ceiling Price $ are held constant

25. Incentive Structures In Negotiations • Alternative Settlement Offers: Which would Contractor choose? Answer: It depends

26. Target Profit B Target Profit A Target Cost B Target Cost A Offer A Offer B Target Cost $10.00 $ 9.50 Target Profit 1.00 (10%) 1.14 (12%) Target Price $11.00 $10.64 Ceiling Price $12.50 (125%) $12.83 (135%) Share Ratio: Over 70 / 30 80 / 20 Under 70 / 30 80 / 20

27. Offer A Offer B Target Cost $10.00 $ 9.50 Target Profit 1.00 (10%) 1.14 (12%) Target Price $11.00 $10.64 Ceiling Price $12.50 (125%) $12.83 (135%) Share Ratio: Over 70 / 30 80 / 20 Under 70 / 30 80 / 20 If Ktr expects final cost to be more than $9.5M he should choose Offer B If Ktr expects final cost to be $9.5M or less he should choose Offer A

28. Incentive GeometryIn Source Selection • Competition can drive overly aggressive incentive geometry • Government should seriously consider specifying incentive geometry in RFP (except Target Cost). • Target Fee % / Profit % • Min & Max Fee % / Ceiling Price % • Share Ratios • Lessens risk of unrealistically: • narrow RIE or • low ceiling price

29. Summary • Select right contract type • Incentivize acquisition outcomes • Create arrangements that fairly reflect risk • Keep it as simple as possible