• TABLE OF CONTENTS
HIDE
 Title Page
 Dedication
 Preface
 Table of Contents
 List of Tables
 List of Illustrations
 List of exhibits
 Introduction
 Incentive contracting instrume...
 Structuring multiple incentive...
 Profit under incentive contrac...
 Selection criteria for incentive...
 Delimitations of incentive...
 Summary and conclusion
 Appendix A: Sample CPAF contract...
 Appendix B: Sample LMI tabular...
 Appendix C: Chronic deficiencies...
 Bibliography
 Biographical sketch














Title: Management of Incentive contract models
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Permanent Link: http://ufdc.ufl.edu/UF00098210/00001
 Material Information
Title: Management of Incentive contract models
Alternate Title: Incentive contract models
Physical Description: xiii, 336 leaves : illus. ; 28 cm.
Language: English
Creator: Veiner, Martin Irwin
Publication Date: 1968
Copyright Date: 1968
 Subjects
Subject: Public contracts -- Mathematical models   ( lcsh )
Public contracts -- Management   ( lcsh )
Management thesis Ph. D   ( lcsh )
Dissertations, Academic -- Management -- UF   ( lcsh )
Genre: bibliography   ( marcgt )
non-fiction   ( marcgt )
 Notes
Thesis: Thesis - University of Florida.
Bibliography: Bibliography: leaves 332-336.
General Note: Manuscript copy.
General Note: Vita.
 Record Information
Bibliographic ID: UF00098210
Volume ID: VID00001
Source Institution: University of Florida
Holding Location: University of Florida
Rights Management: All rights reserved by the source institution and holding location.
Resource Identifier: alephbibnum - 000551369
oclc - 13323728
notis - ACX5844

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Table of Contents
    Title Page
        Page i
        Page i-a
        Page ii
    Dedication
        Page iii
    Preface
        Page iv
        Page v
        Page vi
    Table of Contents
        Page vii
    List of Tables
        Page viii
    List of Illustrations
        Page ix
        Page x
        Page xi
        Page xii
    List of exhibits
        Page xiii
    Introduction
        Page 1
        Page 2
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    Incentive contracting instruments
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    Structuring multiple incentive contracts -- the models
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    Profit under incentive contracts
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    Selection criteria for incentive parameters
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    Delimitations of incentive contracts
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    Summary and conclusion
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    Appendix A: Sample CPAF contract measurement methods
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    Appendix B: Sample LMI tabular model with reward/penalty multipliers
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    Appendix C: Chronic deficiencies in defense contracting
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    Bibliography
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    Biographical sketch
        Page 337
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Full Text














MANAGEMENT OF INCENTIVE CONTRACT
MODELS













By
MARTIN IRWIN VEINER














A DISSERTATION PRESENTED TO THE GRADUATE COUNCIL OF
THE UNIVERSITY OF FLORIDA
IN PARTIAL FULFILLMENT OF TIE REQUIREMENTS FOR THE
DEGREE OF DOCTOR OF PHILOSOPHY











UNIVERSITY OF FLORIDA





































COPYRIGHT 1968 BY M. I. VEINER






































TO DAVID, KENT, MARK, AND CRAIG













PREFACE


In the last five years the use of incentive con-

tracts in government procurements has risen dramatically.

The Department of Defense has stressed the superiority of

incentive contracts over cost-reimbursable contracts forcing

the transformation. In this case, the stake involved is

very high as claimed dollar savings have run into the hun-

dreds of millions.

During the elapsed period, much data became avail-

able for post-contract analysis. Contractors totally unfamil-

iar with incentive contracting techniques were rushed head-

long into acceptance and compliance with Department of De-

fense policy. The result was surprising; multiple incentive

contracts could be dysfunctional to the objectives of both

parties in a contract. Therefore, potential users of incen-

tive contracts should exercise extreme caution. Patient ex-

perimentation, testing, and evaluation of every incentive

contract arrangement should precede the signing of a defini-

tive contract. The incentive contract model is the vehicle

for simulating actual experience and conducting trade-off

analyses of the proscribed nature.








HYPOTHESIS: An incentive contract model which recog-

nizes and tests interdependency between elements will tend

to optimize goal congruence between the government and the

contractor.

Several models have been developed but their use is

limited because contracting parties do not know they exist

or are ignorant with respect to potential benefits. This

study investigates, analyzes, and compares different incen-

tive contracting techniques, or models. The purpose, then,

is to prove that incentive contracts structured with models

are superior to those structured by traditional methods.

The information presented to prove or disclaim the hypothe-

sis should find a wide audience with government and defense

contractors. Savings and greater efficiency are badly

needed in government contracting.

I would like to express my gratitude to many people

who gave me their assistance. My special thanks must go:

to former colleagues in ETOC, the Directorate of Contractor

Evaluation at Patrick AFB, who encouraged my initial re-

search on the subject of incentive contracts; to faculty

members and students at the Patrick AFB Graduate Center

(of Florida State University) who have contributed helpful

suggestions and ideas; to the Air Force and National Aero-

nautics and Space Administration students who helped locate








and on occasion provided obscure research monographs; to

Arthur Nolen of the Contract Management Institute who granted

my attendance to several excellent contract seminars; and

to Mrs. Patricia Anne Ropero, Mrs. Dianne Tersine, and Mrs.

Thelma Schneider for their indefatigable support in typing

the manuscript. Dr. W. V. Wilmot, Jr., has patiently super-

vised the completion of this project with great understanding

and consideration.

In spite of the tolerance and assistance rendered by

all these people, and many more too numerous to thank person-

ally, I alone accept all responsibility for errors of fact,

analysis, or judgment.


M. I. Veiner

Patrick AFB, Florida
March, 1968

















TABLE OF CONTENTS


PREFACE

LIST OF

LIST OF

LIST OF

Chapter


. . . . . . . . . .

TABLES. . . . . . . .

ILLUSTRATIONS . . . . . .

EXHIBITS. . . . . . . .


I. INTRODUCTION . . . . . .

II. INCENTIVE CONTRACTING INSTRUMENTS.

II. STRUCTURING MULTIPLE INCENTIVE
CONTRACTS THE MODELS . . .

IV. PROFIT UNDER INCENTIVE CONTRACTS

V. SELECTION CRITERIA FOR INCENTIVE
PARAMETERS . . . . . .


VI.

VII.

APPENDIX


DELIMITATIONS OF INCENTIVE CONTRACTS

SUMMARY AND CONCLUSION . . . .


A. SAMPLE CPAF CONTRACT MEASUREMENT
METHODS . . . . . . .

B. SAMPLE LMI TABULAR MODEL WITH REWARD/
PENALTY MULTIPLIERS. . . . .

C. CHRONIC DEFICIENCIES IN DEFENSE
CONTRACTING . . . . . .


Page
. . . iv

.....viii

. . . ix

. . .xiii



. . . 1

. . . 19



. . . 71

. . . 174



. . . 215


. 251

. . 287




. . 293


. . 314


. . 322


BIBLIOGRAPHY . . .. . . . . . .


332


BIOGRAPHICAL SKETCH . . . . . . . ... .337


I


.













LIST OF TABLES


Table Page

1.1 GNP Federal Administrative Budget and National
Defense Spending From 1956-1968 . . . 8

1.2 Awards by Type of Contract Pricing Provision
by Fiscal Year . . . .... . . . 11

2.1 Elements of Basic Contract Forms . . ... 69

3.1 Number of Alternative Reward and Penalty
Tradeoffs to be Considered in
Negotiations . . .... . . 79

3.2 Iso-Fee Points . . . .. . . . . 87

3.3 Critical MC Numbers . . . . . ... .169

4.1 Rate of Return on Stockholder's Equity for
Three Defense Oriented Industries and All
Manufacturing Corporations 1956-1960 . . 177

4.2 Weight Ranges of Profit Factors Weighted
Profit Guidelines . . . .... . . 183

4.3 Weighted Profit Guidelines Example FFP Contract
for Contractor-developed Military Item . 185

4.4 CPIF Contract at Minimum and Other Contract
Business . . ... . . . . . 198

4.5 CPIF Contract at Maximum and Other Contract
Business ...... . . . . . 199

4.6 Constant Overall Profit with High 36/64 Share
Ratio . . . . . .... . . . 203

4.7 Net Income of Three Defense Oriented Industries
Compared with all Industrial Groups ... 212

6.1 Percentage Factors Used to Determine CWAS . 278
viii















LIST OF ILLUSTRATIONS


Fi


3.1 Goalposted Multiple Incentive CPIF Contract .

3.2 Iso-Fee Chart Value Statement Analysis . .

3.3 Graphic Analysis Structuring Tool . . .

3.4 Profit Line Conversion from Dollars to Percent

3.5 Goalposted Multiple Incentives for Formula
Example . . . . . . . . .

3.6 Graphic Portrayals of "Trade-Off" Function
1.2X-Y-10Z=0 in Three Planes . . . .


ix


gure

2.1 Degree of Risk by Contract Form . .

2.2 Contract Relationship to be Displayed
Graphically . . . . . .

2.3 The CPFF Graph . . . . . .

2.4 The CPFF Share Ratio . . . . .

2.5 The Firm Fixed Price (FFP) Contract .

2.6 Share Ratios . . . . . . .

2.7 Constructing a Share Line . . . .

2.8 Share Line Equation . . . . .

2.9 Basic Contract Types . . . . .

2.10 The Completed CPIF Contract . . .

2.11 Constructing the FPI Contract . . .

2.12 Final Constructed FPI Contract . .


Page

19


. . 24

. . 26

. . 28

. . 30

. . 35

S. 38

S. 40

. . 42

. . 47

. . 57

. 60









LIST OF ILLUSTRATIONS--Continued


Figure Page

3.7 PAA CPIF Contract Performance Incentive . 104

3.8 Share Line Combinations . . . . .. 112

3.9 Rate of Incentive Change Demonstrated . . 114

3.10 Share Line Transition . . . . ... 116

3.11 PIIM Incentive Fee Surface . . . .. 118

3.12 Iso-Fee Lines on PIIM Surface . . . .. 119

3.13 Alteration of PIIM Surface to Change Incentive
Raised Fee at Maximum Performance and
Cost. . . . . . . . . . 121

3.14 Alteration of PIIM Surface to Change Incentive
Decreased Fee at Maximum Performance and
Cost Increased Fee at Minimum Performance
and Cost . . . . . . . ... 122

3.15 Alteration of PIIM Incentive Over Cost
Range . . . . . . . . ... 124

3.16 Typical Hardware Used with PIIM Model . . 126

3.17 Lines of Constant Fee . . . . . .. 128

3.18 Lines of Constant Cost . . . . .. 129

3.19 Lines of Constant Performance . . . .. 130

3.20 Lines of Constant Share Ratio (3F/aC) . . 131

3.21 Lines of Constant 3F/.P . . . . .. 132

3.22 Lines of Constant Cost Equivalent (bC/3P) 133

3.23 Plane for Lines of Constant Cost . . .. 134

3.24 Plane for Lines of Constant Performance . 134









LIST OF ILLUSTRATIONS--Continued


Page


Figure

3.25


5.2 Elements of Incentive Models


5.3 Incentive Contract Development Process

6.1 CPIF Change: Dollar Versus Percentage
Adjustments . . . . . . . .

6.2 Cost/Performance Curve with Narrow Confidence
Limits . . . . . . . . .

6.3 Cost/Performance Curve with Broad Confidence
Limits . . . . . . . . .

6.4 Pressure Theory and Probability Impact .


xi


PIIM Gemini Spacecraft Model and 50 Percent
Outcome . . . . . . . ... 137

Trade-Off Curves Analysis . . . . .. 141

Fundamental STOIC . . . . . ... 145

Resources vs. Achievement . . . . .. 148

Marginal Utility . . . . . . .. 151

Dynamic Share Line . . . . . ... 154

Nomatic for Incentive Elements . . .. 157

Scaling the Incentive Nomatic . . . .. 158

Constructing the Nomatic . . . . .. 159

The Completed Nomatic . . . . . .. 161

MF Isofee Chart . . . . . . .. 165

Trade-Off Chart for Performance . . .. 166

Incentive Fee Calculation Based Upon Cost
Effectiveness . . . . . . .. 238


3.26

3.27

3.28

3.29

3.30

3.31

3.32

3.33

3.34

3.35

3.36

5.1


. . . . 240









LIST OF ILLUSTRATIONS--Continued


Figure Page

6.5 Effectiveness Value and Total Cost Effect
on Fee . . . . . . . . .. 272















LIST OF EXHIBITS


EXHIBIT Page

4.1 Method of Calculating Return on Assets. . 207

4.2 Evaluation of CPFF Contract Calculation
of Return on Assets . . . . ... .209

4.3 Calculation of Adjusted Return on Assets. . 210

5.1 RFP Segment for Instrumented Experimental
Payload Satellite . . . . . ... .223

5.2 Predictability Chart Used to Derive
Value Statement . . . . . ... .224

5.3 Six Proposals for the IEP Satellite ... .227

5.4 Derivation of PRICE Factor and its
Application . . . . . . . . 229

5.5 Six Bids Ranked According to Highest Score. 233


xiii














CHAPTER I


INTRODUCTION


Nature of the Problem

In 1961, Robert S. McNamara was appointed Secretary

of Defense. During his tenure in office, from 1961 to 1968,

McNamara is credited with having initiated many innovations

as part of a broad "management revolution" in the Department

of Defense (DOD). One of the more publicized changes insisted

upon by the new Secretary in 1961 was that the military ser-

vices reduce the then prevalent practice of writing cost-plus-

fixed-fee (CPFF) contracts. The use of this contract form had

escalated rapidly and with it came abuses and inefficiency in

contract performance. In an attempt to restore economy and

efficiency to the defense contracting process, government

agencies and defense contractors were encouraged to substitute

incentive contracts for less desirable CPFF contracts.

In the last few years, data collected from the comple-

tion of the first incentive contracts written suggest that

these arrangements may have been dysfunctional. Instead of

aiding the government, the incentive arrangement sometimes

resulted in a procurement that cost more than it should have

or perhaps lacked in performance ability. The possible un-

favorable consequences of an incentive arrangement suggest the





2

need for detailed explanation as to causes and effects. By

definition, an incentive contract is one in which the contrac-

tor and the government share any savings which result from

efficient management. The first assumptions with regard to

incentive contracts were that contractors would automatically

save dollars so that they might participate in the savings.

No thought was given to an examination of each contractual

element's effect on the incentive arrangement as a result of

cause and effect produced by changes in other elements in the

same incentive arrangement. Dysfunctional incentive contracts,

or those which work in reverse, are caused by the interaction

of the different elements which compose the incentive arrange-

ment, or structure. Dysfunctional incentive contracts which

might operate in reverse should be avoided by the government

and the contractor.

This study is an effort to find a better way to struc-

ture incentive contracts so that dysfunctional arrangements

may be avoided. The first incentive contracts were priced by

negotiating each incentive element separately, thereby creat-

ing minor contract alternatives within an existing contract

framework. The management decisions made separately as a re-

sult of alternatives arising during contract performance were

sometimes at odds with final contract goals. Contradictory

goals within the same contract were possible whenever this

pricing method was employed.

The existence of contradictory alternatives would be

erased by the both parties to a contract if they could be









foreseen at the time of negotiation and contract agreement.

However, contradictory goals are often obscured by the com-

plexity of the incentive arrangement. A description of addi-

tional considerations which must be negotiated in the incen-

tive contract will illustrate the complexity and its degree.

In the traditional commercial contract, the parties

satisfy the usual legal conventions of: agreement, consent,

consideration, and form. The traditional contract contains

an offer, and acceptance, which the performing party dis-

charges for consideration. Consideration, or payment is a

single amount, which is the price. In government contracts,

cost-reimbursable contracts divide the consideration into the

elements of cost and profit. Although this arrangement is one

step removed from the typical commercial contract which fea-

tures a single price, it is not overly complicated. However,

compare these simplified features to those encountered in the

incentive contract.

The underlying foundation of the incentive contract

is that the agreement is varying. The variations are a re-

quirement if different cost and fees are to prevail for dif-

ferent performance achievements. Thus, the parties must now

negotiate target cost, target fee, the share ratio, a maximum

fee, a minimum fee, and a range of incentive effectiveness.

These terms will be defined in greater detail in a following

chapter. They convey one theme clearly: incentive arrange-

ments are more complex because the parties must now agree on

price variations, which are composed of cost and profit









variations, all of which are tied to expected performance

variations.

Prior to signing and agreement, the parties to an in-

centive contract must examine all cost and performance prob-

abilities, and how imputed savings might be divided between

them. Some of the prior considerations are based on fact;

some are based on assumptions. The final agreement contains

both objective and subjective elements. For this reason, pre-

contract events are unlike those found in connection with con-

ventional contracts.

The additional requirements of negotiating an incen-

tive contract are described with one term--structuring. Struc-

turing an incentive contract consists of selecting from the

many alternatives available and combining in a final format

diverse elements of cost, performance, and schedule. This

process parallels that of arriving at one price in the con-

ventional contract, except that the incentive arrangement en-

compasses several prices for different performance outcomes.

The term structuring may be used interchangeably with the

term pricing. It conveys the significance of pricing a con-

tract which has varying schedules of compensation for varying

schedules of performance.

Price in the incentive contract is a function of per-

formance outcome, as determined by the incentive arrangement.

The incentive agreement can be structured to reward or pen-

alize the contractor. Above all, it should clearly define

goals for the contractor, and require him to focus all his









resources on achieving specified goals. Occasionally, goal

conflicts develop with incentive arrangements due to unfore-

seen circumstances when incentive elements interact with one

another. For example, a contractor might decide to stop all

work because the additional fee he would receive from the per-

formance and schedule incentives does not compensate him for

losses on the cost incentive portion. Thus, one more term is

required to describe an important phenomena of the incentive

contract: the interdependency effect, or the influence of one

incentive element to produce changes in another incentive ele-

ment. Goal conflicts can be minimized and dysfunctional in-

centive contracts can be avoided by testing the interdependency

effect which exists between incentive elements. The interde-

pendency effect should be tested prior to final contract agree-

ment during the negotiating stage by simulation with an incen-

tive contract model.


Hypothesis

An incentive contract model which recognizes and tests

interdependency between elements will tend to optimize goal

congruence between the government and the contractor.


Purpose of the Study

The United States is faced with ever-increasing de-

mands for its resources which are limited. In 1967, twenty-

two of every one hundred dollars expended in this country was

spent by federal, state, or local government. As recently as

1950, the ratio of government spending was as little as









thirteen out of every hundred dollars.1 The figures suggest

the expansion of goods and services purchased for the public

over the time period. At the federal level of spending alone,

new demands grow annually out of welfare programs, poverty

programs, support to education, the war in Vietnam, and other

critically needed services; faster than the sources with which

to finance them. They all compete for scarce dollars. Waste-

ful spending in one area, such as defense, can no longer be

tolerated as an isolated situation. It may deprive other

vital programs, causing them to either be discontinued or cur-

tailed.

The use of incentive contracts in defense contracting

can reduce waste and its undesirable side effects if incentive

techniques are applied properly. The DOD has already estab-

lished this concept with the mandate that incentive contracts

be utilized. No governmental agency was quite as well qual-

ified to judge the extent of waste in contracting. The de-

fense sector of the economy inherited a tradition of exces-

sive spending from World War II when the object of winning

the war at any cost was a national goal. The DOD rationalized

spending practices that supported a philosophy stating any

means justified the end. The first decade of the U.S.'s par-

ticipation in the race-for-space had similar overtones. When-

ever an emergency or national crisis exists, spending or cost

considerations become secondary, and waste in spending usually


1John O'Riley, An editorial in the Wall Street Journal,
March 25, 1968.








proliferates.

Artificial constraints must be incorporated into con-

tracts for projects which are deemed necessary at any cost to

prevent wasteful spending and exhaustion of scarce resources.

The government has continuously revised its procurement regu-

lations as one method of countering waste. Another method

has been to upgrade contracting practices, such as the trans-

ition to incentives. Recognition exists on the part of both

the government and defense contractors that efficiency is

essential to a healthy defense industry and also to the over-

all health of the economy. The figures for Gross National

Product, the Federal Administrative Budget, and spending for

National Defense suggest the total economic involvement of de-

fense spending. Over the last twelve years, defense spending

has consumed about 60 per cent of the Federal Administrative

Budget and has amounted to just under 10 per cent of this

country's GNP. Table 1.1 contains this information revised

and updated to include latest available estimates of spending

for each category.

The magnitude of current defense spending, which is

approaching an annual rate of $80 billion, is lost in the ex-

pression of a dollar figure on paper. A vastly different

mental picture results when $80 billion is converted into the

GNP of another country, or into goods and services that could

be purchased for use in this country exclusively. For example,

defense outlays in the U.S. are about double the total output

of goods and services (GNP) in India. Using product purchasing



















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power, it would buy the entire annual output of the auto in-

dustry's new cars and all new private residential construction

with funds to spare. Saving a small per cent of $80 billion

would completely fund lesser, but nevertheless vital programs.

The DOD policy to substitute contracts with incentives

for those with no incentives was admittedly adopted for ex-

pected financial savings. New weapon systems cost billions

of dollars and any savings prospects are apt to be attractive,

even a small percentage. However, all incentive contracting

benefits are not exclusively financial; there are several non-

monetary benefits. Government contract administrators are

charged with the responsibility of buying the best product at

the fairest price. Beyond price considerations, a plane or

missile must meet performance specifications. Quality may be

more essential than price. The government must use extensive

control techniques to ensure required quality, and to guide

the contractor towards essential areas of concentration. The

contractor should rightfully recognize and emphasize the gov-

ernment's objectives just as he voluntarily tries to please

his commercial customers. Fewer auditors and fewer inspectors

are required with incentive arrangements because the burden

to be efficient remains his responsibility. The contractor

accepts this because his profit depends upon it.

The defense industry must learn more about the pro-

cess by which incentive arrangements automatically motivate

contractors in essential performance areas by offering addi-

tional rewards for additional effort. The models that were





10

researched explain this process, but do not trace chain effects

through the contractors' organization. A contractor interested

in optimizing profit will, in turn, motivate his entire organi-

zation, focusing their attention on profit optimization which

will automatically occur if the customer's requirements are

satisfied. Knowing how the process just described functions

is one matter; understanding how and why it works is another

matter. Many studies similar to this one are required to de-

velop a body of knowledge concerning incentive contracts.

In the meantime, the defense industry must use incen-

tive contracts, and has adopted these instruments even though

a complete understanding concerning their operation does not

exist. For example, one needs only to look at the decline

of the CPFF contract form. The use of the CPFF contract had

grown rapidly in the late fifties until an all-time high of

36.8 percent of the total value of all contract procurements

were of this type by 1960. Shortly after this record achieve-

ment, the DOD and McNamara instituted the incentive policy

and began to reduce the number of dollars going into CPFF con-

tracts. Incentive contracts became the preferred substitutes

when firm-fixed price (FFP) contracts could not be negotiated.

Table 1.2 contains dollar amounts and percentage figures for

all government contract actions over $10,000. It clearly

demonstrates that by 1965, CPFF contracts declined to only

9.4 percent of the total and the experience of recent years

has been that a figure of less than 10 percent is being main-

tained. At the same time the CPFF contract was declining in





11


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usage, the fixed price contract and other incentive types

experienced increased utilization.

Finally, the role of incentives in contracting must

be explored. Without attempting to prove all the advantages

and disadvantages of incentive contracts, their potential

should be aired so that defense contractors can formulate

reasonable attitudes and policies. At present, many defense

contractors fear the incentive trend. There is no specific

reason for this other than fear of the unexpected or unknown.

They feel the incentive contract represents all stick and no

carrot in the hands of a government agency. Ideas presented

herein on profit under incentives should encourage these con-

tractors to become more receptive towards incentive contracts.

At the same time, they may be able to optimize profit while

contributing to the strength of their country.


Scope of Work

As a prerequisite to the discussion of incentive con-

tract models, a brief survey will cover the major contract

forms presently used by the DOD. The object will be to iden-

tify the degree of incentive and risk in different contract

forms. Essentially, the archtype of contracts with no incen-

tive is the CPFF form and it will be compared with the arch-

type that has greatest incentive, the FFP contract. This gen-

eral survey of contract forms is found in Chapter II, along

with an analysis of the opportunity to optimize profit under

different contract forms.








The cost-reimbursable contract is used as a norm or

frame of reference in this section, only because it is so in-

flexible and therefore provides a sharp contrast for other

contract forms. Included is a general foray into all contrac-

tual factors that might affect contractor motivation.

There are many ways to vary profit and they result in

basic differences within the incentive contract classifica-

tion. They are reviewed by illustrating how the contractor

determines, by his performance, the final total profit as a

result of decision making. Each unique technique or method

for structuring an incentive contract receives special analy-

sis in Chapter III, and examples of trade-offs, the technique

used to optimize profit, are simulated.

After a discussion on the methods of structuring and

pricing incentive contracts, there is a special treatment of

profit, and another section that investigates the method by

which incentive elements are chosen. These areas are contro-

versial but their inclusion is an integral part of understand-

ing contractor motivation and goal congruence. The section

on models establishes the interdependency effect, and also

that greater profit equals greater motivation. This study

must go one step further by revealing that profit restrictions

and artificial constraints against optimizing profits do

exist, and to suggest that conceptual conflicts between pro-

fit constraints and incentive profits must be resolved. Par-

ticular reference is made to the Renegotiation Board and sug-

gestions for curtailing its adverse affect on incentive









contractors.

Finally, in the interest of being objective, both

favorable and unfavorable aspects of incentive contracts are

explored. In a separate section, delimitations are discussed

to determine if the use of models can overcome some of the

drawbacks assumed to automatically be part of the incentive

contracting process. Another area, Appendix C, maintains

perspective by covering chronic deficiencies found in defense

contracting which one might expect to find regardless of

whether the study's hypothesis is true and models have been

applied.


Method of Research

The results of five continuous years of research effort

on incentive contracting are incorporated in this study. The

writer has chosen to emphasize the theoretical aspects of in-

centive contracts because of the need for a conceptual founda-

tion. To some extent, a theoretical, flexible treatment is

dictated because the DOD does not make completed incentive

contract figures available, contract by contract. Each model

is explained with simple illustrations and trade-offs. A

short example is developed for each model to illustrate the

method in which the parties to the contract test the inter-

dependency effect and simulate profit outcomes for different

cost/performance/schedule results.

The superiority of the incentive contract model as a

management decision making tool must be judged relative to

the old fashioned way of structuring the first incentive









contracts, which depended upon weighting factors exclusively

to obtain goal congruence. Thus, a general comparison between

the older technique and the methods advocated by a particular

model is presented. Although not involved with actual contract

figures, this study will relate the conditions under which an

incentive contract model might be appropriate, or specifically

give an example of a program in which the model was applied.

The extent of such reporting will depend upon information re-

leased to the public by the DOD. Generally, the discussion

will center upon the theoretical foundations for structuring

incentive contracts and will not involve testing validity

from empirical data because of the nonavailability of data.


Source of Information

Published literature on incentive contract models is

meager. Sources for incentive techniques are few by compari-

son with that for other subjects that exert a major impact on

the economy. The literature contains no major books or arti-

cles published prior to 1960. After this date, contract

specialists released some information to the public in maga-

zine articles directed towards major defense contractors. In

1962, the Division of Research at the Harvard Business School

published its first volume of the study, The Weapons Acquisi-

tion Process, by Peck and Scherer. In 1964, Scherer published

a second volume dealing with economic incentives exclusively,

which is quoted in this study. Another source has been the

Alfred P. Sloan School of Management at Massachusetts Institute









of Technology. M.I.T. has published numerous monographs

from the "Research Program on the Management of Science and

Technology." Articles have appeared at random in trade maga-

zines, such as Aerospace Technology, formerly Missiles and

Rockets, which are usually utilitarian, lack theoretical con-

tent, and only offer practical advice to contractors.

The best data on incentive contracts reside within

the Pentagon in the form of completed contract records and

that information is inaccessible to the average civilian.

Some information, however, does find its way to the public

through special studies. Various government agencies have

authorized studies by Arthur D. Little, Harbridge House, Lo-

gistics Management Institute, M.I.T., Rand Corporation, Stan-

ford Research Institute, and Booz, Allen and Hamilton, to

answer specific questions regarding incentive contracts. A

major coordinated research effort has never been undertaken

and is still required. A large scale effort would involve

greater numbers of people and dollars. These private research

efforts are noted because they have influenced DOD policy and

may have advocated changes similar to those found in this

study. Past studies on individual contracts do not comprise

a unified theory regarding the structuring and feasibility

of incentive contract models to prevent dysfunctional conse-

quences.

Finally, some of the ideas discussed were developed

in the field while the author performed contract evaluation

studies in 1964 and 1965. While no incentive contract model









has been singled out as being preferable or superior, a prag-

matic influence prevails for each model. The practical in-

fluence was extended as a result of having attended several

incentive contract seminars and from making observations from

comments and remarks rendered by those intimately familiar

with incentive contract problems on a first-hand basis.

Sources of this nature do not lend themselves to specific

identification at all times but their impact should not be

discounted.


Summary

There is a great need for better understanding as to

how to apply incentive contracts. Their use is inescapable

because the DOD has adopted the incentive philosophy with de-

termination. A defense contractor has the option of using in-

centive contracts or not bidding for work.

Incentive contracts have been known to operate in re-

verse, having resulted in just the opposite intent of that

desired by the contracting parties. In order to avoid dys-

functional consequences, and to ensure goal congruence be-

tween the parties to an incentive contract, the use of a mod-

el in structuring and pricing is recommended. The model,

used properly as a contract management tool, will simulate

problems before they occur, possibly preventing some problems.

At the least, a model can help the parties to a contract

avoid several problem areas.

Savings and greater efficiency are promised results









if trade-offs, or simulations, are conducted systematically.

Every justification exists to employ any tool in defense con-

tracting that will generate savings and lead to greater effi-

ciency in the use of scarce resources. Incentive profits can

contribute to the health of the defense industry and the econ-

omy as a whole by motivating improved performance. Incentive

profits depend upon varying compensation for varying perform-

ance. However, defense contractors generally fear varying

profit arrangements and do not understand the incentive con-

tract philosophy.

Providing contract managers for both sides of a con-

tract with the theoretical tools to simulate problems will

lessen fear of the unknown and remove doubt as an obstacle

to the further adoption of the very practical economic con-

cept that rewards motivate performance. Deductive processes

can be used to show, then, how profits can be optimized and

goal congruence will be ensured by using models that test the

interdependency effect.














CHAPTER II


INCENTIVE CONTRACTING INSTRUMENTS


Introduction

This section will discuss general characteristics

of various contract forms. One must have a knowledge of sev-

eral contract instruments, both incentive and otherwise, be-

fore the relative merits and flexibility of incentive con-

tracts may be appreciated. Following the definition and de-

scription of each contract type there will be a short refer-

ence to the environment in which that type has been used most

prominently by the DOD. The descriptions will note appropri-

ate contract usage. From this, it should become evident that

a perfect contract for all procurements does not exist. Like-

wise, there is no best incentive structure or model. Each

contract must be tailored to the situation.

Figure 2.1 shows the degree of incentive that can be

incorporated into two extreme contract forms.


FIGURE 2.1

DEGREE OF RISK BY CONTRACT FORM









A contractor under a CPFF contract is subject to far less

risk than a contractor on a FFP contract. To the left of

the fulcrum, a contractor may be under some form of cost

reimbursable contract; to the right of the fulcrum, he may

have some form of fixed price contract. Under a cost reim-

bursable contract, costs are paid for by the government; con-

sequently, business failure is unlikely with this contract

arrangement.

To the right of the fulcrum are the various fixed price

contracts. Here, for every dollar the contractor saves, he

earns an additional dollar of profit. Conversely, for every

dollar over the fixed target price, the contractor loses a

dollar because it is his dollar that is spent. Because there

are variations of both cost reimbursable and fixed price con-

tracts, contractors and the government have learned to shift

the risk by degree. It is possible to entirely rearrange the

risk load and the expected profit from its normally assumed

distribution. Risk shifting should not be a goal of the con-

tract form, but it is usually a result.

Under present economic laws in our society, one assumes

that the greater the risk involved in a market situation, the

greater the reward or profit. If risk is slight, then profit

should also be small. Statistics quoted in Chapter I indi-

cated low percentages of profit in recent years for CPFF con-








tractors. It was automatically assumed that contractors on

a cost reimbursable contract should be forced to accept lower

profits because the major risks of any contract were shifted

to the government. Abrupt realization that actual cost reim-

bursement supported inefficient practices resulted in the

development of contract variations that applied traditional

risk and reward rules as they once were taught.

In defense contracting risk has unusual origins. Since

risk is a major factor, its source should be carefully exam-

ined. Once a contract has been awarded, the usual source of

competition as a business risk factor is eliminated. A rather

common business risk, technical insolvency, is also minimized

because the government makes progress payments. Even the

vagaries of the business cycle have lessened impact on the

defense contractor. What, then, are the major risks?

In R & D contracts, developing hardware that advances

the state-of-the-art is considered a potential risk. Yet,

there are relatively few contracts to which this applies.

When a contractor sells nuts and bolts or a service to the

government, this risk is of no concern to either party. The

contractor's prime risk becomes the contract's target price

or the figure for which he agrees to do the job. If the

contractor has a cost reimbursable contract, even this major

risk is minimized. If the contractor has a fixed price contract,









the dollar amount becomes the focal point and whether he per-

forms the work for more than, or less than the target price.

Overshooting the target price represents lost money, while

remaining under the target represents additional profit.

The particular type of contract instrument selected

weighs heavily on the degree of risk associated with target

cost. If the contractor has great confidence (high proba-

bility) in performing the contract for the target price ne-

gotiated, he will try to freeze the arrangement with a fixed

price contract, having first allowed a markup for a fair pro-

fit. If however, the target is a nebulous one, and the pro-

bability of completing the contract at or near the target

cost is slight, the contractor will try to protect himself

with a cost reimbursable contract. Thus, the particular item

and circumstances surrounding a procurement situation dictate

the type of contract suitable for the parties. Other things

being equal, the government will always try to shift the risk

to the contractor, while the contractor will try to shift the

risk back to the government, and still make a profit. Con-

tracts have been developed which offer degrees of risk to the

contractor and which use various incentives to make the con-

tractor assume risk. The various contracts will be reviewed.

The order of discussion is not related to present rank by

dollar magnitude. See Table 1.2 for dollar amounts by









contract type.

The process of differentiating contracts can be stan-

dardized and limited by asking two prime questions: 1.) who

bears cost responsibility and, 2.) how do the parties share

profit or fee dollars? Additionally, graphics are used to

explain minor differences in contract arrangements, and even

to build or design hybrid forms. Subsequently and reversing

the usual analytic geometry of the process, we shall focus

on mathematical and non-mathematical explanations of contract

curves, hence the reason for "incentive contract models."

The price paid by the government for any and all ser-

vices performed by its contractors is equal to the cost of

performing the service plus some fee or profit for perform-

ing the service. Conventional practices have grown in which

these relationships are graphed in terms of cost and profit,

not price. See Figure 2.2.

Contract administrators derive great value from this

graphical tool even though it does not show total price.

However, total price is readily determined from the graph for

any contract. The user can find price at any cost outcome

by adding profit earned and cost for that level of contract

cost.

The X axis ordinatee) is reserved for contract cost or

target cost, while the Y axis abscissaa) shows fee or profit.


















C\j;








NJ



K3









A line or curve describes the functional amount of profit for

any cost outcome, and it is called the share line. Both cost

and profit axes are scaled in dollars, not percentages. Thus,

target cost and profit amounts are read directly.


Cost-Plus-Fixed-Fee (CPFF) Contracts

The CPFF contract is not an incentive contract and con-

tains no provisions for additional reward. However, descrip-

tion of the CPFF contract will permit a comparison of risk

degree and incentive provided by other share arrangements in

other contract forms. For example, under a CPFF contract,

the government assumes total cost responsibility, and the

contractor gets a flat fixed fee. If the contract overruns

or underruns the target, the government still pays the total

cost of the contract and the contractor still gets the same

fixed fee. The government's share responsibility is 100

percent and the contractor's share responsibility is 0 per-

cent. This is called a 100/0 share arrangement. The share

arrangement or share ratio describes the government's and

the contractor's portions in dividing underruns (savings) or

overruns (expenses). Its graphed product is the linear or

curvilinear share line.

Figure 2.3 shows a graph for a CPFF contract with an

estimated cost (EC) of $70 and a fixed fee (FF) of $6. A

uniform procedure is used to graph the share line whenever the



















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profit function is linear. Two points are located at two

different cost levels, and are connected with a straight

line. For the first point, construct a vertical line pass-

ing through the EC of $70 and a horizontal line passing through

the FF of $6. For the second point, assume the contractor

had a major overrun of allowable costs which brought the

contract cost up to $140, or $70 overrun. The fee at $140

would still be $6. Connecting the two points would give the

share line for a CPFF contract with an estimated target cost

of $70 and a FF of $6. Thus, the share line for a CPFF con-

tract is a horizontal line. This line is parallel to the cost

axis over the entire range of possible costs. All CPFF con-

tracts have the same profile. The government will reimburse

the contractor for all reasonable, allocable, and allowable

costs incurred under a CPFF contract. The share ratio is

100/0, and, therefore, the government bears the entire cost

of overruns and even pays the same fixed fee to the contrac-

tor whether he performs inefficiently or otherwise. Should

the contractor perform for less than the EC, the government

would save 100% of every dollar not spent.

Another way of expressing the sharing formula in this

same situation is presented in Figure 2.4. An overrun or

underrun can be stated as $X from target. The total alloca-

tion of an overrun or underrun must equal the combined






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government's and contractor's shares. Thus, the sum of the

numerator and denominator of the share ratio must always

equal 100 percent, and the sum of the two share ratios for

any sharing arrangement will show the disposition of the

total overrun, or total underrun. For this reason, the share

ratios are a prime feature of negotiations, as well as the

dollar level of profit itself for different contract cost

levels. The slope of the share line serves a similar purpose.

The mathematical relationship for the slope of the share line

will be developed after the same elements have been reviewed

for a FFP contract.


Firm-Fixed-Price (FFP) Contracts

The FFP contract is characterized by a sharply sloping,

almost vertical share line. It is the opposite of the hori-

zontal 100/0 share line found in a CPFF contract. The FFP

contractor bears all risk of cost overruns and enjoys all

benefit of cost underruns, or has a 0/100 share ratio. Slope

of the FFP share line is steepest for any type of contract

form presented, although it is never vertical. This is

shown in Figure 2.5.

Assume a negotiated FFP contract for a price of $120.

The contractor will automatically receive $120 for completing

the work regardless of costs incurred. If he provides the

















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service for actual costs of $116, his profit will be $4

($120 $116 = $4). If he is more successful and efficient,

and performs for a cost of $106, his profit will be $14

($120 $106 = $14). Regardless of cost outcome, the sum of

the cost outcome and the profit must always equal the fixed

price, $120. The contractor's share for any contract is

found by dividing the change in profit by the change in cost.

Let AH equal change in profit to prevent confusion with change

in price, and let AC profit equal change in cost; and the

equation becomes:

AY AH ($14 $4) $10
AX AC ($116 $106) $10 ~ 1 = 100%

Therefore, the share ratio is 0/100 for an FFP contract, the

exact opposite of the 100/0 for a CPFF contract. The FFP

share line can not be vertical in Figure 2.6 because AC is

always an absolute figure.

Since the contractor makes $1 in profit for every $1

he saves on cost, or loses it in the reverse situation, the

Armed Services Procurement Regulation (ASPR) states it is the

most preferred contract type.1 The FFP contract gives the

contractor maximum incentive to achieve cost reduction and

satisfy DOD goals because: 1) the government is able to

assume complete cost responsibility under this form of con-

tract, and 2) management is motivated to take positive steps


1Armed Service Procurement Regulation (ASPR), U.S.
Department of Defense, 3-402 (b)(1), 1963.








to avoid costs2. If both parties are equally competent in

contract negotiation, the FFP contract can satisfy both par-

ties. The objective and best interest of the government is

to get the procured item at the least cost and on schedule,

provided the item is of good quality and meets specifications.

The objective and best interest of the contractor is to make

a fair profit at a reasonable price while satisfying the cus-

tomer. Pricing complexity is avoided because the share for-

mula is simply 0/100. The contractor is rewarded proportion-

ally to his efficiency and he bears the burden of resolving

all problems. The government prefers to use this contract

whenever possible. However, lack of certainty with respect

to future costs, or unknown costs, may cause a contractor to

hesitate in accepting the binding arrangement of an FFP con-

tract. Under its terms both parties are bound by the nego-

tiated prices for the life of the contract and no price adjust-

ment is possible. Latest figures available (Table 1.2) indi-

cate that FFP contracts account for 58 percent of total pro-

curements, having reached this level along with the drive to

incorporate incentive contracts for DOD work.

The contractor's profit with FFP contracts stems from

his ability to control costs and he must manage efficiently

since all savings below target cost are retained as profit.



2Incentive Contracting Guide, Office of the Assistant
Secretary of Defense, (Installation and Logistics) DOD, AFP
70-1-5 1965. p. 29.









Benefits to the government are both direct and indirect in

nature. In the direct area, cost reductions on FFP contracts

suggest the most efficient production methods for future

follow-on contracts and also the most advantageous prices.

In the indirect areas, savings accrue because of the small

expense and workload involved in administering this contract

since there are no advisory audits and but one negotiation.

By contrast, CPFF contracts require constant supervision

and heavy audit attention.

The rigid contractual features of the FFP contract de-

mand fairly exact pricing information for success. Required

a prior knowledge of positive target cost restricts the use

of FFP contracts in most R & D work and service procurements

where this exact information is not available. In the latter,

for example, the work requirement may be stretched over a long

period of time and be non-definitive; or the work may be non-

repetitive even though the same service contract is negotiated

two years in a row. The FFP contract is not suitable in these

situations. It is most functional where products, not services,

are the procurement object. During World War II and the post

war era, the government bought large numbers of identical

planes from the same manufacturer. Despite this fact, FFP

contracts were not popular and not used.3 The FFP contract


3Miguel Angel Reguero, An Economic Study of the Mili-
tary Airframe Industry, Department of the Air Force, 1957,
p. 169.









is most suitable and is used for purchasing "off-the-shelf"

items, where reasonably close cost projections can be made at

minimal cost. Even though it is not always appropriate the

FFP contract is a standard against which all other contracts

may be evaluated.

In the two graphic situations presented, Figure 2.3 for

the CPFF contract and Figure 2.5 for the FFP contract, no slope

equaled no incentive and most slope equaled most incentive.

These extremes are the parameters of any incentive structuring

problem. Therefore, all salient features of the share line

have a bearing on this topic.

In Figure 2.6, a number of share ratios and their assoc-

iated share lines are plotted for a contract with a target

cost of $100. All the share lines pass through the target

fee of $7 (7 percent) and the target cost of $100. As the

contractor's share ratio increases from 0 to 100 percent, the

share line becomes steeper and steeper and the contractor ab-

sorbs or shares more and more heavily in any cost overruns or

underruns. Under actual contract conditions only one share

ratio would be applicable for any one contract cost outcome.

Thus a contractor would have negotiated either a 90/10 or a

75/25 share line with the government at target cost. Complex

contract forms which have varying share ratios, either due to

a stepped or curvilinear share line, will be introduced later.




















\Q \LN



1~ -'


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s ,I








A basic understanding of share line construction is a

prerequisite for incentive contract comprehension. The first

step in constructing a share line has already been covered;

it consists of locating the intersection of target cost and

target fee. It is one point of determination for the linear

share line. For the other, a second point must be selected

for an assumed cost outcome. If the parties negotiate an

80/20 share line and a TC of $100, should the contractor per-

form the work for $80, he will have succeeded in saving $20.

How is this $20 underrun divided and what is the associated

fee? The contractor's share of all cost underruns, or over-

runs, is 20 percent. For finding the associated fee connected

with an underrun of $20, one must increase fee equal to the

magnitude of the underrun multiplied by the contractor's share.

Since $20 x .20 equals $4, this is the contractor's share with

an 80/20 share line arrangement. The $4 is a reward, and it

is added to the target fee of $7, resulting in a total fee of

$11 paid to the contractor for performing the service for a

cost of $80. The second point is marked by coordinates for

$80 of cost and $11 of fee.

Once two points have been found, the share line is com-

pletely defined by connecting the two points and extending the

line. The sample 80/20 share line was completed by connecting

two points with a solid line extended in both increasing and





37

decreasing fee directions. Therefore, the second point de-

fining the share line could have been constructed by assum-

ing a cost overrun rather than a cost underrun. Any point

would have been sufficient provided that it was other than

at target cost and target fee. The share line described is

pictured in Figure 2.7.

A fee can be computed for any incentive arrangement

without graphic illustration as long as the share ratio is

known. Graphics assist critical negotiation of an incentive

contract, although fee can be figured independently, using

a share line equation. The contractor's fee is increased

by adding incentive fee to target fee as a result of a cost

underrun. The cost underrun times the contractor's share

is added to target fee to get total fee.



+ AF = AC x contractor's share, or


AY AF
AX AC and


AF
AC the contractor's share; and the slope of the
share line.



The share line equation may be used for constructing

the share line if it is not known, or also for solving for

fee at any given cost outcome at variance with target cost

and target fee. This can be proved by taking the same infor-

mation from the example used in Figure 2.7. Assume the share

line had not been labeled 80/20. By reading the cost and fee










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U
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ly


/


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o0 C


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information of the coordinates for $100 and $80 where they

intersected the share line, the reader would be able to de-

termine AF and AC thus:


AF = ($11 $7) = $4


AC = ($100 $80) = $20


AF 4 1
AC 20 5 20%; the contractor's share


In Figure 2.8, the government's share is automatically 80 per-

cent because (100% 20% contractor's share) equals 80 percent.

The two share ratios (80/20) must always equal 100 percent

by definition.

This information can be used to determine fee over any

cost range as follows:

Example I:
Target Cost $90
Target Fee $7
Share Ratio 70/30

What will be the contractor's fee if he accomplishes the work

for $80? This is a $10 underrun since,


AF
AC -30%


AF AF .30
(90-80) = 10 x 1 and


AF = $3.00 and

Total Fee = Target Fee ($7.00) + Delta Fee ($3.00) or $10.00



















z
0

:D
oo


(\jW
LIJ LL)
ZL


u r-
)
310









Example II:
Target Cost $90
Target Fee $7
Share Ratio 70/30

What will be the contractor's fee if he does the work and it

costs $110? This is a $20 overrun.

AF
Since AC = 30%

and AF AF .30
(90-110) -20 x and

AF = -6.00

Total Fee = Target Fee (7.00) + Delta Fee (-6.00) or $1.00

Note that the government saved $7.00 ($10 x 70%) in Example

I and lost $14 (20 x 70%) in Example II. While the government

had the lion's share, the contractor was forced to be cautious

and would ordinarily have preferred the first situation over

the second one.

This completes the basic indoctrination for share ratio

and share line understanding. This indoctrination was neces-

sary because share lines are incorporated into every contract.

By analyzing the share line, it is possible to identify and

partially analyze every contract. Proof of this statement

can be found in the illustrations of basic contract types in

Figure 2.9.

The CPFF and FFP contract graphs have already been ex-

plained. Their share lines were compared to show how opposite

















Ku

KS







NG


Lj


K





43
they appeared to be. Even the contract environments were

compared. The CPFF contract is used where target cost is

actually an unlikely estimate (low probability) while the

FFP contract attaches great weight to the target cost esti-

mate (high probability). These two contract forms in Figure

2.9, illustrations a. and d., have opposite share lines.

The essential element of the FFP contract is price.

It is ideal for formal competitive procurements. Since the

contractor agrees to provide the work or service at a specified

price, he, and he alone, is responsible for profit. He has

complete cost control and is responsible for allocating fac-

tors in their best mix. If he is more efficient than his

competitors, his profits will be higher than theirs. The

real incentive to avoid waste and devise better production

methods results in $1 of additional profit for each $1 saved.

The essential elements of the CPFF contract are: 1)

estimated cost, and 2) the fixed fee. Estimated cost, or the

cost the government will pay the contractor on this cost re-

imbursable form are for those costs that are true and allow-

able. Frequently, the Administrative Contracting Officer

(ACO) and his supplier are in disagreement as to whether a

cost is allowable and should be repaid by the government.

Therefore, this contract requires close audit supervision and

special accounting treatment by the contractor. Even with

close supervision, there is greater opportunity for the parties

to not have a meeting of the minds with the CPFF contract.









Section 15 of ASPR contains a statement of cost prin-

ciples now used as a basis for determining costs under cost-

reimbursement contracts and they are often incorporated into

contracts by reference. There still remains the possibility

that legitimate contractor costs may be disallowed or exces-

sive costs may be erroneously approved by the government's

auditor or the ACO. At the same time, Chapter I pointed to

the problem of low fees with CPFF contracts. Under the cir-

cumstances a contractor usually tries to get every penny he

can out of the government as an allowable cost. This tendency

causes massive overruns with cost reimbursable contracts rela-

tive to estimated target cost.

The CPFF contract allows no incentive for cost reduc-

tion. Nor can the contractor promise to hold the line on

costs if the government will give him an extra fee. Under

the provisions of 10 U.S.C. 2306(d), the maximum permissible

fee on CPFF contracts is limited to 10 percent of estimated

cost of the contract, exclusive of fees, on most types of

work.4

Returning to Figure 2.9, the share line in b., Cost-

Plus-Incentive-Fee (CPIF) and c., Fixed-Price-Incentive (FPI),

contracts offer compromises over the extremes afforded by the

share ratios under CPF (a) and FFP (d) contracts. These are


4Government Contracts AFM 110-9, Extension Course
Institute, Air University, DAF-DOD, 1964, p. 7-5. The limit
is fifteen percent on R & D work.








major contract forms in use today. Table 1.2 shows the rela-

tive importance of CPIF and FPI contracts in dollars and per-

centages. Table 1.3 shows impressive growth since 1960.


Cost-Plus-Incentive Fee (CPIF) Contracts

The essential elements of the CPIF contract are:

target cost, target fee, maximum fee, minimum fee, and the

share ratio.

The contractor's total fee on a CPIF contract is

limited to the range of fees defined by the maximum and min-

imum fee provisions of the contract. The maximum and mini-

mum fees are limits, and the share line in these regions

is a constant (horizontal). Therefore, the first step in

constructing a CPIF graph is to insert the horizontal share

lines that represent these two extremes of possible fee out-

come. The maximum and minimum fees are not derived algebra-

ically: they are the result of negotiation by the parties

to a CPIF contract. For example, given:


Target cost $100
Target fee 7
Maximum fee 12
Minimum fee 2
Share line 80/20

Clearly, fee cannot exceed $12, nor can it fall below $2.

Once either extreme has been reached, due to either a cost

underrun or a cost overrun, fee ceases to change as further









underrun or overrun is incurred. The possible numeric range

of fee variance is:



Maximum Target Minimum
Actual Cost $75 $100 $125
Target Cost 100 100 100
Underrun 25 0
Overrun 0 25
Target Fee 7 7 7
Reward +5 0 -5
Total Fee $12 $7 2



The contractor will probably perform for some cost within the

target area, so we will concentrate on this probable outcome

for the moment. For the construction example, the next step

after inserting the maximum and minimum fee lines or plateaus,

is to locate coordinates for target cost and target fee ($100

and $7). Another point is necessary to define the 80/20 share

line, therefore one other cost outcome other than target cost

is selected. Assume a cost of $90, then total fee would be

$9, because target fee ($7) and incentive reward ($2) combine

to make up the total.

The share line is constructed once these two points of

reference are located. It is extended until it intersects

the maximum ($12) and minimum ($2) fee lines. The construc-

tion of the CPIF contract is now completed. See Figure 2.10.

The parameters shown in Figure 2.10 suggest a contractor








K




r'4


t~i









would attempt to perform the contract for a cost of $75, be-

cause lowering the cost to this outcome, his total fee con-

tinues to rise. Once performance for $75 is reached, fee goes

no higher and the contractor no longer has additional incen-

tive to cut costs. In the regions where maximum and minimum

fees are applicable, and the share line is a constant or hori-

zontal, the contract switches from a CPIF form to a CPFF form.

The profit ceiling, maximum fee, and the profit floor, minimum

fee, convert the incentive contract to a fixed fee contract

and this may defeat the intentions of both parties. In the

early 1960's, when the parties to incentive procurements were

extremely cautious, many CPIF contracts had share lines which

were plateaus in the region of most probable outcome. Plateaus

are self-defeating and were quickly abandoned by sophisticated

contract negotiators as soon as experience was gained with in-

centive contract pitfalls.
Ay
Since the share line must have slope, -, over the cost

region for the contractor to make additional fee through re-

wards, the cost range becomes very significant. In the con-

tract illustrated, the operative cost range of the 80/20 share

line is defined as the range of incentive effectiveness (RIE).

The lower limit of the RIE is a cost of $75, and the upper

limit of the RIE is a cost of $125. At these cost outcomes,








fee has reached its maximum and minimum levels respectively.

Furthermore, the variance between maximum and minimum fee can

be defined as fee swing (FS), or fee pool. In Figure 2.10,

the FS is $10 (12-2), and the RIE is $50 (125-75).

In the CPIF contract, the general share line equation
AY
- for the contractor's share, is replaced by the specific

equation when the share line is a straight line, or:

S= $1 = = 20% (the Contractor's Share)


The difference between general and specific equations is more

apparent than real. The fee pool, FS, is nothing more than

the entire change in fee (AF) between maximum and minimum for

a specific CPIF contract with a constant contractor share line.

At the same time, RIE is nothing more than the entire range

in cost (AC) over which the share line operates. The general

equation is used to find the contractor's share ratio for any

cost outcome, while the specific equation is used with a CPIF

contract when the share line is a straight line.5 Regardless

of which equation is selected, whenever two CPIF contract ele-

ments are known, the third element can take on only one value.

Thus, as long as two of the variables are specified: FS, RIE,

or Contractor's Share, the third value can be derived.

In the CPIF contract illustration, the variables were

simplified for clarity. In practice, actual incentive contract


5Basic Graphics for Incentive Contracting, Boston:

Harbridge House Incorporated, 1965, p. 45.






50

arrangements are often more complex. Through hard and deter-

mined negotiations, the parties might agree to a broken share

line, or a series of separate share lines with different slopes

and different share ratios. For example, the government might

agree to split reward, 70/30, on the underrun side of target

cost, while taking more of the loss, 90/10, on the overrun side.

Contractors will frequently maneuver in order that they may

share profits to a greater extent and losses to a lesser extent.

Our typical example has a positive maximum and minimum

fee. It is quite possible to make the fee floor a zero fee, or

perhaps even a negative or minus fee. The intent, of course,

is to permit a contractor to make a small profit even if he

has done badly by incurring a major cost overrun, thus a mini-

mum fee will ordinarily be used to prevent a contractor from

experiencing an out-of-pocket loss6. However, to remind

the government and the contractor that incentive rewards are

a two-way street, ASPR states that: "Whenever this type of

contract, with or without the inclusion of performance in-

centives, is negotiated to provide incentive up to a high maxi-

mum fee, the contract also shall provide for a low minimum

fee, which may even be a 'zero' fee, or, in rare cases, a

'negative' fee."7 The minimum fee may be eliminated altogether



6U. S. Air Force, Department of Defense Incentive Con-
tracting Guide, Pamphlet 70-1-5, (Washington, D. C.: Office
of the Assistant Secretary of Defense-Installations and Logis-
tics) 1965, p. 5.

7ASPR, op. cit., 3-405.4.





51

and the sharing formula continued indefinitely on the over-

run side of target cost, whereby, the contract becomes "cost

sharing." A contractor faced with this alternative, would be

strongly motivated to stop excessive spending. While such

arrangements work favorably to the government's advantage, they

are admittedly difficult to negotiate with any contractor.

Finally the FS and range of costs over which the incen-

tive provision operates., (RIE), are completely non-standardized.

There is no one best incentive arrangement. Each time a new

contract is negotiated, the FS, RIE, and share ratios must be

worked out to the satisfaction of both parties based on the

degree of confidence they have in the target cost estimate.

Incentive contract models are valuable to parties looking for

alternatives at this vital negotiating stage.

The share line in Figure 2.10 is completely symmetrical

between FS and target fee; and between RIE and target cost.

In practice, the share line determined by multiple incentive

will not be symmetrical. There will be a skewed effect on

both FS and RIE targets. The Figure 2.10 example was symmetri-

cal because FS was + $5 from the target fee of $7; and because

RIE was + $25 from target cost of $100. They might have been

skewed by having unequal positive and negative FS's in terms

of dollar variance possible; or, the dollar difference between

target cost and the low.r limit of the cost RIE could vary

from the dollar difference between target cost and the upper









cost limit of the cost RIE. In any case, a contract which

has different dollar amounts TC is a skewed model and

is therefore called an asymmetric model. A majority of to-

day's multiple incentive contracts are asymmetrical models.

Nevertheless, the rules for structuring the symmetrical in-

centive contract model apply equally for the asymmetrical

model and the analytical processes are identical.

Why has this information been pursued in great detail?

The reason will manifest itself as more complex arrange-

ments of the CPIF and FPI are presented. The rules for de-

termining fee will not change as complexity increases. A

contractor is always interested in the total fee, which is

based on both target fee and marginal incentive fee. Fee

determination is complicated when it depends not only on

cost, but also on performance and schedule as well. The con-

tractor must manage by making trade-off decisions that al-

locate his factors in a mix designed to produce the highest

total fee possible. He can only solve the allocation pro-

blem based on a knowledge of the total reward. The key to

incentive performance lies in making the reward or total

fee, in actual dollars, visible to the contractor at every

moment. The problems created by combining several incen-

tives into one contract will be discussed in detail later.

Management must have knowledge of their impact on FS and RIE

before a decision-theory is possible.








Fixed-Price-Incentive (FPI) Contract

Contract form c, the fourth type illustrated in Figure

2.9 is an FPI contract. The essential elements structuring

an FPI contract are, 1) target cost, 2) target profit,

3) ceiling price, and 4) the share ratio.

The FPI contract is somewhat of a hybrid variety be-

tween the CPIF contract and the FFP contract. It is also

a relative of the older redeterminable contract used by

the DOD. Essentially, it provides for a flexible dollar

amount of profit based on a predetermined fixed profit pat-

tern. Target cost is a highly realistic prior estimate of

actual cost of performance as agreed to by contractor and

buyer. Target profit is the expected profit the contractor

will receive if his actual cost of performance equals tar-

get cost. The profit formula has a provision for decreas-

ing the contractor's profit as actual cost exceeds target

cost, and of increasing profit as actual cost is reduced

below target cost. The ceiling price (CP) is the maxi-

mum dollar amount the government will pay on an FPI con-

tract. Therefore, if the contractor's actual cost equals

the ceiling price, he just breaks even and earns no profit.

This is the contractor's break-even point. If actual cost

exceeds the CP, he must pay or absorb costs out of his own

pocket, and suffer losses accordingly.









The ideal situation for using the FPI contract would

specify a high degree of confidence in the maximum target

cost estimate, while involving substantial future oppor-

tunity for cost reduction. It would be appropriate, for ex-

ample, in a production procurement which involved large

quantities over an extended period of time. This situation

would possibly involve an improvement factor, or a learning-

curve effect. An FPI contract is not recommended for

industry or government unless costs can be estimated with

enough accuracy to assure realistic targets and profits

because a contractor can receive a reward for overestimating

his costs with an FPI arrangement.

The FPI contract may take two forms; one has a firm

initial target and the other has a series of firm targets.

The latter form is known as a fixed-price-incentive contract

with successive targets (FPIS). The FPI with a firm target

is used when contractor and government knowledge of probable

cost is indefinite though substantial, so that fair, firm

targets cannot be established at the outset. Resetting the

target with the FPIS must become possible at some early

point in the future performance of the contract, such as

just prior to delivery or shop completion of the first item.

The FPI contract can only be used after a written determina-

tion and finding is made setting forth that 1) this method of








contracting is likely to be less costly than other methods,

or 2) it is impractical to secure supplies or services of the

kind or quantity required without the use of such a contract8.

The FPI contract can be explained numerically or graph-

ically. As with the CPIF example, by starting with the num-

erical explanation and graphing the result both approaches can

be demonstrated simultaneously.

Given an FPI contract with: target cost (TC) equal to

$109; target profit (TTT) equal to $11; ceiling price (CP) equal

to $129; and a share line of 60/40, then:

LINE GREATER TARGET MINIMUM NO
(L) *-PROFIT PROFIT PROFIT PROFIT
1 ACTUAL COST 89 99 109 119 124
2 TARGET COST (TC) 109 109 109 109 109
3 TAR-ACT (L2-L1) 20 10 0 -10 -15
4 TARGET PROFIT (Tr) 11 11 11 11 11
5 REWARD/PENALTY 8 4 0 -4 -6
(40% of ,L3)
6 TOTAL PROFIT 19 15 11 7 5
(L4+L5)
7 PRICE (L1+L6) 108 114 109 126 129(CP)

The FPI differs from the CPIF in two very important re-

spects. First, there is no maximum fee limitation on the FPI

contractor. Therefore, with respect to cost underruns, each

time the contractor saves an additional $10 in cost, marginal

profit increases by $4 with a 60/40 share line. The govern-



8Government Contracts, op. cit. p. 7-3. Cited from
10 U.S.C. 2306 (c).








ment saves $6 or the remainder of the $10 saved by the con-

tractor. The second distinction of the FPI is the ceiling

price representing a dollar limit the government will pay to

the contractor. When actual cost reaches the contractually

stated ceiling price, the sharing ratio of 60/40 ceases to

apply. With respect to cost overruns, as the contractor

expends an additional $10, profit is decreased by $4. The

application of the 60/40 share line to additional expenditures

ceases once a cost outcome of $124 is reached because it would

result in a price paid that was greater than the $129 ceiling

price. Contract definition and agreement prohibit payment

over $129. Graphic analysis of the FPI will support the CP

position.

Figure 2.11 starts with the FPI assumptions just given.

The FPI must be structured in two distinct steps. First, a

point for locating a 60/40 share line is plotted for TC ($109)

and Tn ($11). Locating a second point for the 60/40 share

line is based on some assumed cost outcome and determining

the profit associated with that assumed cost. For example,

if TC is $89, a contractor would get a total profit of $11,

plus 40 percent of the $20 underrun, +$8, or $19 ($11+$8),

thus, the two sets of coordinates locate the 60/40 share

line and it is plotted.

There is a distinct break point in the share line due

to the impact of the ceiling price on the FPI contract. This




57







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I 5

^3 ^ ^>

$^i i / 4Q a


.ie /--









is the point at which, because of the contractual maximum

limit, CP, the contractor must absorb overrun costs himself.

Therefore, the contract goes from one with a 60/40 share

line, to one with a 0/100 share line. By definition, the

contract switches from an FPI to an FFP where the 0/100 share

line becomes operational. The contractor has an internal

cost ceiling which he should try to avoid and it is equally

important because opportunity cost or foregone profit results

before the external ceiling price is reached. The point at

which the share line becomes kinked and the share ratio

changes to 0/100 is called the point of total assumption

(PTA).9 In Figure 2.11, the intersection of the solid share

line with the broken share line originating at the CP marks

the PTA.

Finding the PTA geometrically, and constructing the

0/100 broken share line is an added problem of the FPI con-

tract. Two points will again serve the purpose. The first

is at the CP on the X axis. Its coordinates are 0 and 129.

The second point is found by assuming a cost outcome of $115

and the profit associated with that cost, assuming the CP

of $129 to be the price of an FFP contract in which the price

equals $129. The assumed cost $115 is subtracted from $129

resulting in a profit of $14. These two figures are the


9Basic Graphics, op. cit., pp. 60-65. This is a
handy term and is more useful than the cost ceiling phrase
found in the DOD Guide.








coordinates for the second point. The contractor with a

0/100 share line would make $14 on a $129 FFP contract if

he managed to perform the work for a cost of $115.

The final result, once the redundant portions of the

60/40 and 0/100 share lines have been eliminated, is given

in Figure 2.12. The completed FPI is characterized by a

PTA located at the point of intersection of both share lines.

Both numeric and graphic presentations make the CP and PTA

(no H) vividly clear. As a contractor expends cost dollars,

profit is reduced by the contractor cost share until suddenly

at the PTA cost point and beyond further expenditures will

be penalized at the rate of $1 of profit lost for each $1

of cost expended. In the specific example, the 60/40 share

line determines the relationship between cost and profit un-

til the 60/40 share line is intersected by the 0/100 share

line extended from the CP. There is strong motivation to

avoid spending additional cost dollars to complete a job

once the contractor's share has changed from 40 percent to

100 percent on the overrun side at the PTA. Needless to

say, spending beyond the CP is even less desirable and

should be avoided.

The point of total assumption is very significant to

the contractor. In the graphic example, the PTA was found

geometrically. It may also be precisely determined

algebraically, substituting in the following formula:




60











KV --





L: I
4J-'
N 54







t tO
'3 's









(TC + TH)
Ceiling Price Target Price + Target Cost
PTA = or,
Government's Share
C.P TP + TC

GS

(129 120) + 109
"6


PTA = $124


FPI contract data state either explicitly or implicitly four

contractual elements and incentive provisions. The CP, TC,

TH, and share ratios are stated explicitly. Target price is

implicitly understood and is simply the sum of TC and TH at

any cost outcome. The PTA cost point is implied although

the contractor devotes utmost attention to it for previously

stated reasons.

Finally, attention is drawn to the much steeper share

lines and share ratios in the FPI contract. The share ratio

is a response to "tight" or "loose" targets. Both parties

must ordinarily consider that target cost is reasonable.

Under certain circumstances, there may be little confidence

in the initial target. One party or the other will conclude

that target cost is too high or too low. At this point, they

will tailor the incentive contract to meet existing conditions.

In other words, to match the RIE, a loose target cost should

be accompanied by a low target profit objective and a tight

target cost should have greater associated target profit as









a reward.10 Since the terms of applicability stated for the

FPI called for a high degree of confidence in the estimate of

target cost, one must assume that the RIE is rather narrow

and because of this would create a steep share line effect.


Cost-Plus-Award Fee (CPAF) Contracts

Concluding this primer on incentive contracting instru-

ments, one finds a final form which is unlike the FFP, CPIF,

or FPI contracts. The CPAF contract has only emerged as a

useful contracting tool within the last few years. However,

its popularity with NASA, has drawn the attention of the DOD.

Both the Navy and the Air Force are presently experimenting

with CPAF contracts on a limited basis.

The subjective nature of the CPAF contract distinguishes

it from the traditional objective features of the incentive

contract. Yet there are attributes common to both types.

The CPAF contract is a marriage of the objective, before-the-

fact evaluation of conventional incentive agreements and the

subjective, after-the-fact performance evaluation of merit

systems for final profit determination.11 The CPAF contract,

in contrast to the other incentive forms is most often a "re-

wards only" agreement. A CPAF contractor's final profit is

determined by a board or panel after all work has been completed.

10DOD Incentive Contracting Guide, op. cit., p. 26.

11Ibid., p. 94.









A favorable decision by the board results in the award of

additional profit to the contractor over the usual target

profit.

A general description of the CPAF contract will have

to suffice. Examples of a numeric, geometric or even graphic

illustration do not exist because each contract is tailored

to an individual situation and total profit is based on sub-

jective after-the-fact evaluation. With a CPAF contract,

the contractor can increase his profit above a base fee,

providing the customer's subjective evaluation of his per-

formance under the contract is favorable.12 Trade-offs in

the usual sense are not stressed. Therefore, the CPAF con-

tract is also a combination of the CPFF and CPIF contracts.

At the outset of the contract, a CPFF contract base and min-

imum fee is established. In practice, the CPAF is managed

like the CPFF contract because fee does not prompt decisions.

Marginal profit is a bonus or reward-only fee added to base

fee.

The mechanics of the CPAF evaluation must be clearly

defined in the contract. Evaluation is performed on a quar-

terly basis, and ratings are compared with standard criteria

incorporated in the contract itself. The subjective rating

is particularly effective for non-personal service contracts



12Ibid., p. 93






64

relative to the difficulties raised by CPFF and CPIF con-

tracts for service procurements. Historically, level-of-

effort work has been purchased with straight cost reimbursable

contracts which give contractors no incentive to be efficient.

The CPAF contract introduces the possibility of making more

than a base fee, even if it is determined unilaterally by the

buyer. While the previous statement overemphasizes the sub-

jectiveness of the CPAF contract, in practice, both parties

have given it enthusiastic endorsement. If there is some

analogy with a human being's performance, psychologists

have proved the superiority of rewards versus the use of

penalties.13 The carrot works better than the stick for

some animals, and for some of the humans.

In a later chapter (VI), some of the potential problems

raised by incentive contracts are discussed in detail. Where

price estimates are little more than guesses, involving an

incentive structure may be futile. If a contract has many

changes and modifications, which is often the case with ser-

vice contracts, the incentive arrangement may lose its mean-

ing from dilution and also become burdensome in the process.

For these reasons the combined objective conventional incen-

tive and the subjective evaluation techniques make the CPAF

contract more suitable to contract problems where straight


13Neal E. Miller and John Dollard, Social Learning
and Imitation. (New Haven: Yale University Press), 1941.
p. 2, et passim.








incentive forms are unlikely to succeed. The NASA Guide

states unequivocally that, "formula type incentives cannot

be applied to nonpersonal services contracts because of the

difficulty of defining work to be performed precisely, and --

as a result -- accurate cost estimating."14

The essential elements of the CPAF contract are:

target cost, base fee, maximum fee, and criteria for

evaluating performance which results in additional fee paid

to the contractor. Additionally, the contract must specify

the methods and techniques to be used for assessing the

contractor's performance before beginning work.15 These

specifications are usually supplements to the contract and

are not in the main contract itself. With these elements as

a foundation, the NASA Guide exhibits a structuring technique

for a CPAF contract in steps similar to those used for

structuring and pricing a straight incentive contract.

The work statement spelling out the work to be performed

has heretofore been neglected. It is assumed that for each

contract situation, the work is always clearly defined.

While not always possible, it is definitely desirable for

any incentive contract, and even the CPAF contract. Major

areas of contractor effort should be set forth in a format



14NASA Incentive Contracting Guide, NPC 403, National
Aeronautics and Space Administration, 1965, p. 701.

15Ibid., p. 702.









that corresponds to the organizational structure intended

for use by the contractor. Objectives within each area should

be clearly stated in terms of end results desired. Performance

standards should be precisely stated and related to profit.

Specific performance demands enable the contractor to manage

his resources and make decisions based upon a knowledge of

the interaction taking place between cost, performance, and

his profit target.

The evaluation criteria, the most important feature

in shaping a CPAF contract, should be selected with extreme

caution. Every effort must be taken to select criteria which

stress areas of prime importance to the government and cause

contractor management to focus on critical areas. Evaluation

criteria should be organized to conform both with the work

statement, and with the organization intending to perform the

work itself.

Controlling cost should continue to be a major evalua-

tion area of the CPAF contract. This is very important and

when possible, the use of conventional incentives for cost

portions is recommended.16 Since both parties can predict,

with some accuracy, the number of man-hours the contractor

will require from the statement of work, a major segment of

the cost estimate should be valid.

Therefore, it is feasible to use a CPIF formula on

the cost portion, while applying CPAF subjective evaluation

techniques to the performance areas.


16Ibid., p.712.









A meaningful share line for cost only may be developed

which encourages the contractor to sacrifice cost and per-

formance alternately (trade-offs). NASA's preference for

incentive contracts is based on objective standards.7 Only

indefinite portions of the CPAF contract should be evaluated

by subjective techniques.

The NASA Guide continuously compares the CPAF and CPIF

contracts and finds them equally valuable. In Chapter III,

this writer takes exception and disagrees when using analy-

tical techniques. It is not possible to maximize profit

through managerial control and decision making if the exact

fee pool is unknown. In the CPAF contract, fee is inexact

and ill-defined. Conceptual similarities exist because every

CPAF contract has an RIE, from minimum acceptable performance

to outstanding performance like that found in the CPIF and FPI

contracts. However, the application of incentive evaluation

techniques to the CPAF's RIE and its measurement are impos-

sible. Neither exact measurement nor absolute quantification

is used. Indeed, the major problem with the CPAF contract is

the need for government representatives to judge the contrac-

tor fairly and consistently in a situation which usually

lacks objective, quantifiable data.18


1Ibid.
18Ibid., p. 703.
Ibid., p. 703.





68

Measurement problems raised by lack of quantification

can and have been overcome. The existence of the measurement

problems should not be ignored when designing evaluation

criteria which are subjective. NASA believes that CPAF

evaluation criteria do create an RIE, and that a contractor's

performance under CPAF receives "objective" evaluation.

Sample evaluation criteria used by NASA are given in

Appendix A. Its inclusion, with comments from the NASA

Incentive Contracting Guide is designed to show that even

though quantification is achieved in certain vital areas, the

calculation of a ratio does not guarantee concrete definition

of the RIE or objective measurement. The CPAF contractor is

promised a profit if his nebulous evaluation after-the-fact

is favorable.

SUMMARY

This section has reviewed several contracts currently

employed in the defense acquisition process. Major distinc-

tions between the various contracts were emphasized, moving

from the CPFF contract with no incentive to the FFP contract

which offers maximum incentive. The basic elements of each

contract form are compared in Table 2.1.

The rationale for introducing incentive contracts

was presented in Chapter I. Excessive dependence on CPFF

contracts caused the pendulum to swing in the other direction





69

TABLE 2.1

ELEMENTS OF BASIC CONTRACT FORMS


CPFF FFP CPIF FPI CPAF


1. Estimated 1. Price 1. Target 1. Target 1. Target
Cost Cost Cost Cost

2. Fixed Fee 2. Target 2. Target 2. Base
Fee Profit Fee

3. Maximum 3. Ceiling 3. Maximum
Fee Price Fee

4. Minimum 4. Share 4. Evalua-
Fee Ratio tion
Criteria
5. Share
Ratio




to avoid the mistakes of the past. There is an individual

procurement cycle for hardware and services, and the prefer-

able contract form is apt to change with time and/or the

level of confidence in the estimate of cost. The FFP

contract remains the best form of contract for most situa-

tions because of its competitive aspects. At the same time,

defense contractors are not prone to accept excessive risk.

Thus, there exists a need for a variety of contract forms.

The illustrations for pricing and structuring these

various contracts were purposely simplified for ease of

explanation. Total profit was determined by share ratios

over the RIE, and depended on one variable, cost. The next





70

chapter will deal with the real problems of structuring

multiple incentive contracts based on a variety of factors,

such as, cost, performance and schedule. The nonstructured

variety of problems caused by multiple incentives, and some

of the techniques which have been developed for their solution,

offer challenges to the disciplines of decision-making theory,

operations research, mathematics, statistics, micro-economics,

and even "Yankee ingenuity."













CHAPTER III


STRUCTURING MULTIPLE INCENTIVE CONTRACTS THE MODELS


Introduction

This section discusses several methods of structuring

and evaluating incentive contracts. Unlike Chapter II, it

deals with specific incentive contracts which have multiple

incentive elements.

A basic comparison of structuring techniques is possi-

ble by reviewing the mechanics of fee determination under dif-

ferent methods. Each contract structure technique, or model,

possesses unique characteristics. Continuity between models

is provided by common parts and terminology they share: TC,

TP, FS, RIE, and share ratio. However, greater concentration

will stress the differences that exist between models. Model

appropriateness will be judged by the reader from background

information; this study compares and contrasts models only.

Defense procurement history is replete with changes

in attitudes towards several contract forms. At one time,

the industry, taken to include both government and contractors,

was in favor of the CPFF contract. Real flaws concerning the

CPFF did not manifest themselves until experience and histori-

cal data had accumulated. A prediction for the future of

multiple incentive contracts is premature. The present will

become history. The incentive contract might yield in the






72
future to a far superior arrangement. Techniques must

evolve or even the sacred idol of today will become the

shibboleth of tomorrow. Those who do not learn the lesson of

history are doomed to repeat its mistakes. CPFF contract

abuses hastened the demise of this form. Likewise, the

future of the incentive contract depends upon a better under-

standing of the cost/performance/profit relationship. Models

offer a means to this end.

Within the last two years, a specific phenomenon of

the first multiple incentive contracts was discovered. The

first contracts were structured with what may be described as

traditional techniques. Lacking any foresight for specific

problems, early contracts were structured by individually

appraising cost, performance, and schedule areas separately.

Possible consequences were ignored by unwitting incentive

contract proponents. Results under a contract so designed

typically led to goal conflict. Contractors used trade-off

analysis to achieve highest total profit at the expense of

government objectives. In essence, functional relationships

of multiple incentive features, all of which are weighted in

the overall determination of profit, were ignored and were

assumed to be independent. The opposite is true. In the

multiple incentive contract, total fee determination makes

all elements interdependent.

The government gradually recognized the pitfalls of

separately negotiated incentive elements as results of the

first multiple incentive contracting experiences became

available. Research on the problem began in public and

private sectors. New theoretical structuring models were





73

suggested from various quarters. The common feature of

these is the interdependency relation. The most frequent

expression for a "better way" to test interdependency lies

in an interdisciplinary approach which considers not only

previously mentioned physical sciences but also economic

and behavioral theory. NASA, the DOD, and AEC, and even

the National Security Industrial Association are funding

intensive research to provide practical answers to the pro-

blems of utilizing incentives. Understanding and applying

models is one facet of incentive contracts. Extra-contrac-

tual and interpersonal relations are another. The scope of

this study is confined narrowly to the problem of suggesting

most appropriate contract structuring techniques.

The models and their order of discussion are (1) the

traditional approach; (2) the formula approach, Coleman and

Dellinger model; (3) tabular models matrix forms; (4)

Planned Interdependency Incentive Method (PIIM); (5) Trade-

off Curves Analysis, using constant fee; (6) Systematic Tech-

niques of Incentive Contracting (STOIC); and (7) the Logmill

System. Trade-off decisions are simulated for each of the

seven structuring techniques to demonstrate the interdependency

effect between incentive variables.

Furthermore, as in Chapter II, the models chosen have

no special advantage for hardware or service contracts. One

characteristic of service contracts and the application of

incentive methods to them is their numerous subdivisions on

the performance and schedule portions. For this reason,








service contracts are poor examples for illustrative purposes.

By using contract examples of airplane and missile procure-

ments, the number of performance and schedule incentive vari-

ables are minimized permitting explanation flexibility.



The Traditional Approach

The example discussed is a CPIF contract,although it

might just as easily have been an FPI contract. The contract

objective is successful performance which consists of com-

pleting a satisfactory end item or service at a reasonable

cost and within certain time limits.1 The incentive arrange-

ment is structured so that it motivates the contractor to

achieve outstanding results in every performance area, in

addition to the cost area. The incentive format must encour-

age the contractor to seek desirable alternatives in the max-

imizing process. The contractor should be compelled into

decisions between cost, performance and schedule that are in

consonance with the overall procurement objectives of the

government.2 The traditional method depends upon (1) RIE

and the profit pool, and (2) relative weights assigned to

each incentive, for goal achievement.

Preliminary work must precede the structuring of the

contract. Work to be performed must be carefully defined.

The contractor's proposal and trade-off studies must be


IDOD Incentive Contracting Guide, Op.cit., p. 47

2Ibid.





75

analyzed. Both parties must agree to a norm for the perfor-

mance incentive portion. With service contracts, historical

data and records often provide missing links essential for

contracting. Once records are complete, performance incen-

tive parameters can be selected and defined, and a norm

chosen. Target cost and performance are tied to the norm.

Target cost can be negotiated and delivery milestones set up

for a schedule incentive element. PERT and critical path

techniques are often utilized for the schedule section of

the contract.

Assume that the previous considerations had been exe-

cuted and the parties have a "meeting of the minds" for a

new aircraft with these targets:



Target Speed 1000 MPH
Performance Range 950 1050 MPH
Target Delivery 29 months
Delivery Range 27 to 33 months
Target Cost $100 million
Cost Range $80 to $130 million


The more effort devoted to precontract planning and

definition, the greater confidence both parties have in tar-

gets. To promote careful and often costly precontract studies

the government pays for Program and Project Definition.

Assume this has already been applied to the range of estimates

above so that targets selected are fairly valid. The work

has been precisely defined and priced, and cost outcome rests

on the contractor's ability to control cost while designing

a plane with a top speed of 1050 MPH. The performance target









should become the most important goal of the contract. The

contractor will manage so as to reach the highest performance

target level and possibly do so at the lowest cost level

possible.

The contractor should not be allowed the opportunity

to pick his own performance range. Nor when deciding between

minimum performance and maximum performance, should the con-

tractor have to provide additional or different services.

Performance incentive parameters should coincide with the

item the government ordered. Considering all these factors,

and additional ones such as overlap and trade-off which will

be defined, the parties must agree on target fee and the fee

pool.

Maximum fee, it is assumed, will be awarded if the

best cost, performance and delivery schedule are attained

by the contractor. Thus, he should get the greatest profit

the government is willing to pay if he produces a 1050 MPH

plane, in 27 months, at a cost of only $80 million. Minimum

fee will, likewise, be a function of the highest cost, the

slowest performance and the latest delivered date. Minimum

fee would occur if the plane cost $130 million, flew only

950 MPH, and took the contractor as long as 33 months for

delivery. Maximum fee and minimum fee can be looked upon

as a reward or penalty alternatively, thus for:








Incentive Element Outcome of Outcome of
Maximum Reward Maximum Penalty

Cost $80 million $130 million
Performance 1050 MPH 950 MPH
Schedule 27 months 33 months



These conditions determine the range of profit or the fee

swing (FS) or fee pool. Terminology is non-standardized,

but any phrase that denotes amount of fee available will

suffice.

However, fee pool is not the most important relation-

ship. The relative emphasis between incentive objectives

has not been established. Weighting the various incentives

is supposed to guarantee desirable results between cost, per-

formance and schedule. For this reason, the DOD Guide wants

the customer, i.e., the government to retain complete dis-

cretion in the weighing of various incentive elements. Many

individual contract factors must be considered for relative

weighing between incentives, such as, the state of the art,

confidence in targets, undetermined risk factors, etc. Once

relative weights have been discussed and tested by the par-

ties, specific weights must be negotiated. Herein lies a

major problem of the multiple incentive contract.

Via traditional, i.e., non-quantitative methods of

structuring multiple incentive contracts, the real impact

of weighing is not felt by parties concentrating on targets.

Distinct break points in the share line are inputed into the

contract by nonoperational segments, the point where a








performance incentive ceases to motivate. A contractor sets

his long range objectives on maximum profit but operates in

the short run on a basis designed to gain the highest profit

from the set of alternatives facing him. "The break-even

point between decisions to commit or not to commit further

time and money will be determined by the weights assigned

the three incentive areas."3

Just how specific is the incentive arrangement under

this traditional pricing method? Your author concludes that

while incentives continue to operate, they are indeterminate

over the entire range of cost and profit outcomes. To force

this point, that the parties do not know with any degree of

exactness how weighing will cause them to operate in the

short run situation, look at all possible tradeoffs shown in

Table 3.1. It shows the possibility of combining cost, per-

formance, and schedule (2.069 x 1015) different ways. The

only difference between the hypothetical CPIF contract situa-

tion described and that used to make up the table is that

the performance incentive is subdivided into four categories

instead of one. Complex service contracts may subdivide per-

formance incentive into fifteen smaller "cost centers".

Assume the negotiating parties ended up with an arrange-

ment permitting maximum fee of $18 million (18%), minimum

fee of $2 million (2%), and weighed as follows:



Ibid., p. 50.














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80
MINIMUM TARGET MAXIMUM FEE
WEIGHT FEE FEE FEE SWING

COST 50 $1.0 $5.0 $9.0 +

PERFORMANCE 25 .5 2.5 4.5 +

SCHEDULE 25 .5 2.5 4.5 +

TOTALS 100 $2.0 $10.0 $18.0

Only one set of conditions applies to yield the maxi-

mum fee (reward) and only one set of conditions applies to

yield the minimum fee (penalty). In the vernacular of con-

tract administrators, this contract is "compartmentalized."

There is a linear relationship for each incentive and it re-

mains constant throughout the range of cost/profit outcomes.

Most incentive contracts are constructed in this manner, al-

though occasionally and possibly on purpose, the design may

include an overlap.

Resorting to graphics, we now have an opportunity

to construct figures which would translate directly the

effect on total fee (ETOF) for any incentive element. The

arrangement is described as goalposting, because the graph

used, in the form of an H, resembles a football goalpost.

The X axis has the RIE for the particular incentive, while

the Y axis reads ETOF directly. Vertical ETOF axes are

erected at both the lower and upper extrems of the RIE

for each incentive element, and the horizontal cross member

is extended between the two ETOF axes. This line is actually

the target fee line for the weighted individual incentives.

However, the ETOF is 0 when all incentives have





81

target outcomes. Thus, the g ETOF point actually represents

a fee of $5.0 million for goalposted cost; $2.5 million for

goalposted performance; and $2.5 million for goalposted sche-

dule. See Figure 3.1.

The goalposts show that +$4 million FS for cost is

earned only if the cost outcome at the end of the development

equals $80 million. Should outcome be $100 million, the

contractor's fee will neither be increased nor decreased

because of cost performance. If, for some reason, the cost

outcome equals $140 million, the entire negative FS of -$4

million will be operative. The -$2 million fee for perfor-

mance is applied if, at the end of the development, the plane

flies only 950 MPH. Should performance outcome equal 1000

MPH, the contractor's fee will be neither increased nor de-

creased because of performance. Should performance equal

1050 MPH at the end of the development, all of the +$2

million FS for performance is earned. Delivery at 29 months

has no effect on fee. Early delivery at 27 months would put

the entire schedule incentive, +$2 million, into effect. Late

delivery, for example 33 months, would subtract $2 million.

The contractor's final fee is determined at the end

of the development by adding the sum of the three separate

ETOF's to TS. An infinite number of possible fees could be

earned, but only two fee outcomes are unique. Maximum fee

depends on coincidental satisfaction of the three goals

hardest to achieve, while minimum fee depends on lowest









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possible achievement. The final graphic solution would look

like the CPIF graph, Figure 2.10, illustrated in Chapter II.

The almost infinite number of possibilities raised in

Table 3.1 for a multiple incentive arrangement can now be

reexamined. In view of particular trade-off decisions creat-

ed by the contract, the contractor must evaluate each step

he intends to make. Hopefully, the relative weights assigned

will insure the government that the contractor will manage

his firm so that the desired objectives of both parties will

be met. If there is a divergence of objectives, improper

weighting is usually the fault. Tests should be made by

checking what happens when discrete changes are made in in-

dividual incentives.

What is the value of greater speed? For example, sup-

pose the contractor expends $80 million, finishes testing

the aircraft in 27 months and records a maximum speed of 975

MPH. He now estimates he can boost speed +25 MPH for a cost

of $10 million and three months additional work. Should he

do it?

At first glance, it looks as though the contractor

would pick up an extra $1 million by increasing speed from

975 MPH to 1000 MPH. However, he would lose $2 million

additionally on the schedule incentive. His preferred course

of action would be to deliver the plane and get final accept-

ance immediately.

There are several incentive contracting aids that can








be utilized with the conventional or traditional model. For

instance, it is possible to have a computer print out all

possible outcomes for a specific incentive matrix to have

alternatives available for making trade-off decisions. This

operation should not be confused with a computer program that

actually simulates and makes decisions for optimum achieve-

ments.

A simple T-Chart may be constructed to clarify incentive

element relationships. NASA has pioneered with an approach

called Value Statement Analysis.4 This approach calls for

weighing savings that accrue if a contractor achieves maxi-

mum rather than minimum acceptable on-target performance.

Any time cost and performance changes are tied together and

affect one another, they are analyzed in detail. The T-Chart

approach may be as simple as this.



A element A fee A element A fee

Performance +50 mph + $2 million Delivery 2 + $2 million

Cost $10 million $2 million Cost +$10 million $2 million

50 mph = $10 million 2 months = $10 million



T-Chart value statements are admittedly crude and do

not work with skewed share lines and many elements. In prac-

tice, contracts have curvilinear instead of linear share



4NASA Incentive Contracting Guide, Op. Cit., p. 506.





85

lines and too much complexity for decision-making with this

crude tool.



ISO-FEE CHARTS

A step advance over a matrix, table, or T-Chart is the

approach developed for more advanced models, but sometimes

used independently for value statements with conventional

contracts. The iso-fee charts are related indirectly to

indifference analysis in economics. An iso-fee chart is

prepared by graphing sets of outcomes in cost and performance

(or schedule) that result in the same fee (iso-fee) earned

for each pair of outcomes in the set.

The procedure for finding and graphing pairs is illus-

trated below using cost and performance from our CPIF model,

but simplified by exclusion of the schedule portion. Assume

delivery is on target at 29 months and will therefore have

no effect on FS. One slight additional change from previous

assumption is also necessary. Change the cost RIE from $80

120 million to make it symmetrical. Asymmetrical elements

contain breakpoints and thus require curvilinear solutions,

an unnecessary complication at this point. The same proce-

dure is applicable when breakpoints exist.

Table 3.2 is based on an 80/20 share line. (The CPIF

model presented would have had a FS ; 16 or 68/32 share
RIE 50
line, with a breakpoint because it was asymmetrical.) The

problem consists of finding three pairs of cost and performance





86

outcomes that will result in a fee outcome of $10 million.

Step 1, recognizes that a cost outcome of $100 million re-

presents a total change in fee equal to 0 on the $10 million

target fee. Step 2, assumes a performance outcome of 950

MPH. Step 3, requires finding the AF associated with that

performance outcome, $2 million. Step 4, requires finding

the AF for cost that when added to the AF for performance

would result in no change in A Fee Total. (For a net effect

of $0, a + $2 million reward must be added to the $2 million

penalty.) Step 5, requires finding the A cost that would

result in a + $2 million reward. Since the contractor is on

an 80/20 share line, cost savings of $10 million would re-

sult in + $2 million of profit. Step 6, is to add the A cost

(- $10 million) to the TC ($100 million), which results in

a cost outcome of $90 million. The first pair of cost and

performance outcomes leading to a fee of $10 million are

$90 million and 950 MPH; the next is $100 million and 1000

MPH; and the third pair is $110 million and 1050 MPH. The

procedure is repeated exactly for a $12 million fee.

Once a series of hypothetical cost and performance

combinations leading to the same fee have been found, pairs

of constant fee (iso-fee) can be plotted on a graph and a

connecting line drawn through the points. The connecting

line is an iso-fee or equal fee line, as constructed in

Figure 3.2.




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