Posted on 9/21/2011 11:01 AM

WELCOME BACK, FIXED PRICE INCENTIVE (FPI) CONTRACTS

Secretary of Defense Robert S. McNamara thought they were the cat's meow.  He ordered the military services to use incentive contracts instead of cost plus fixed fee contracts in 1962.  They are complicated.  Perhaps that is why they fell into disuse starting in the 1980's.  But they are back.  DOD has directed again that the military services use FPI firm target contracts instead of cost reimbursement contracts when it makes sense to do so.

This type of contracting is not for the faint of heart or brain.  The FPI firm target contract is the most complex of all contracts in FAR Part 16.  Contract managers and administrators need to know all they can about how the incentives operate.

Fortunately, there is a must read document on the subject which is still a great resource:  Ralph Nash's Government Contracts Monograph on "Incentive Contracting".  The paper can be downloaded free of charge from the Social Science Research Network at http://ssrn.com/abstract=1928629

In simple, general terms, FPI contracts predetermine profit based on certain variables.  The parties can tie profit to cost or to a combination of cost, delivery and technical performance.  Profit becomes a mathematical formula which depends upon how things turn out in performance of the contract.  The parties predetermine the formula upon which profit is based thereby objectively forecasting the ultimate profit position for the contractor.

The Monograph goes into considerable detail on how to negotiate and administer the geometry of the incentive structure.  Chapter 2 is an absolute must read.  Anyone who studies it carefully will be a master of the subject.

Welcome back, FPI contracting.  But follow Ralph's advice carefully.  These contracts only work if you work out the proper formulas.

A simple example:  Target cost $100, target profit $10, ceiling price $120, sharing 50/50.  If costs come in at $80, the contractor gets another $10 or a total of $20 profit (still within ceiling price).  If costs are $120, contractor share of overrun is $10 so contractor gets no profit.

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