When determining FPIF geometry, does the product office need to set aside the entire award fee in case the contractor underruns? If we a 80/20 split and the contractor keeps 80% of the underrun, do we need to have that amount set aside or a percentage? Thanks.
The Background and Question portions of this Ask-a Professor (AAP) Question seem just a little confusing, so we will start by quickly ensuring that we are discussing the same things.
First, we need to recognize that Fixed Price Incentive Firm Target (FPIF) contracts do not have a fee associated with them. Fees are the domain of cost-type contracts only. The fixed price family of contracts, both Firm Fixed Price (FFP) and FPIF, have a profit, not a fee, component.
Second, while FPIF contracts fall within the fixed price family of contracts, there is nothing fixed about the price until the contractor overruns the cost enough to reach the contract’s ceiling price. That ceiling is the maximum price that the product office would contractually pay for the effort. In this forum we will not discuss the impact to the contractor’s profit once the Point of Total Assumption (PTA) is reached on the FPIF contract.
Short of the ceiling, the amount of profit that the product office would pay on the FPIF is dependent on the share ratio used on the contract and the estimated cost to complete the effort. A share ratio is expressed as a set of any two numbers that when added together equal one hundred (i.e. 80/20, 74/36, 50/50, etc.). The first number is the government’s share and the second number is always the contractor’s share. Therefore, if the FPIF has a share ratio of 80/20, for each dollar of cost overrun on the effort, the contractor’s profit would be reduced by 20 cents. Conversely, for each dollar of cost underrun on the effort, the contractor’s profit would be increased by 20 cents.
Finally, we need to consider why we are determining the FPIF geometry in the first place. The geometry of a FPIF contract is all about incentivizing the contractor to control their costs for the effort. The ultimate goal is to have the contractor’s cost come in at, or below, the target cost and thereby have the contractor receive the target profit (or more in the case of an underrun). Clearly, the steeper the share ratio (i.e. the higher the contractor’s share) the more the contractor will be incentivized to keep the effort’s costs lower. With a steeper share ratio, the contractor gets more profit when they underrun, but they also lose more profit if they overrun, than they would with a shallower share ratio. It must be remembered that it is totally acceptable to have two share ratios for a single FPIF contract. One for underrunning the target cost (e.g. 80/20) and a separate, steeper share ratio for overrunning the target cost (e.g. 65/35).
When the share ratio, or ratios, has been determined, the last piece of the FPIF geometry to discuss is the contract’s ceiling price. Routinely, the ceiling price is determined by multiplying the effort’s target cost by 110% - 130%. How much to multiply by is a function of the risk associated with the work to be done on the effort. If the effort has more risk, multiplying by a higher percentage would be appropriate. Conversely, lower risk would warrant the use of a lower percentage to determine the contract’s ceiling price. Some people would argue that the “sweet spot” for a ceiling percentage is 115% - 125%.
At the following URL: https://www.dau.edu/tools/t/FPIF-CPIF there is a very useful FPIF/CPIF calculator that allows the user to input various share ratios and ceiling percentages, along with the target cost as the allowable cost near the bottom, to see what the geometry, and target price, would look like.
Now that we have leveled the playing field with regard to discussing FPIF contracts, let’s turn our attention to how the product office would budget and fund one. The product office will utilize the Planning, Programming, Budgeting, and Execution (PPBE) process to request the funds necessary for the effort. Unfortunately, this process starts 2-5 years before the FPIF contract is ready to be awarded. Therefore, the product office will request the amount that the cost estimators have determine is the most likely price of the effort, which normally will include some level of “risk” funding. The most likely price is the combination of the target cost plus the target profit.
At the time of the FPIF contract award, the product office will fund the contract (i.e. obligate funds) at the amount of the contract’s target price as determined through negotiation of the contract’s target cost and target profit by the contractor and government contracting officers. Any extra funding, above the amount obligated on the contract, which the product office acquires through the PPBE process for the effort will either be committed in an administrative reservation of funds, used for another project within the product office, or given back.
During contract execution, an underrun will always be covered, as long as the contractor’s share of the share ratio is lower than the government’s. For example, if the share ratio is 80/20, the government saves 80 cents for every dollar of lower cost and the contractor’s profit would only increase by the remaining 20 cents.
The harder scenario is a cost overrun on a FPIF. As the cost goes up, the amount of profit will go down but not by as much as the cost increase. Therefore, some government contracting offices assert that the product office has to budget for and administratively reserve enough funds to cover all the way up to the contract’s ceiling price in order to avoid a potential Anti-Deficiency Act violation. There are three problems with that line of thinking: 1.) There are not enough funds in the entire DoD budget to cover every FPIF contract to its ceiling, 2.) requiring funding to the ceiling is a tacit admission that the incentives of the FPIF will be completely ineffective in their goal of getting the contractor to contain costs, and 3.) if the FPIF does not overrun to ceiling, there will be excess funds that will not be utilized and will be lost to both the product office and the service as they cancel while sitting in the administrative reservation.
The DoD Financial Management Regulation 7000.14-R, Volume 3, Chapter 8, paragraph 080203, section A.1 talks about the difference between the most likely price and the ceiling price establishing a Contingent Liability. Both FAR and DFARS are clear that contingent liabilities cannot have funds obligated on a contract to cover them since they may, or may not, materialize. When discussing commitments, the DoD Financial Management Regulation 7000.14-R, Volume 3, Chapter 8, paragraph 080203, section B states, “The amounts of such contingent liabilities, however, need not be recorded at the maximum or ceiling prices under the contracts. Rather, amounts should be committed that are estimated conservatively to be sufficient to cover the additional obligations that probably will materialize, based upon judgement and experience.” Therefore, we see that the product office is not allowed to budget for and administratively reserve funds to cover this contingent liability if they belief that there is a chance that the contingent liability will not materialize. However, as soon as it is recognized that the contractor will overrun the FPIF target cost, it is the product office’s responsibility to either obtain the additional funding, through a re-alignment of funds, a Below Threshold Reprogramming (BTR) or a Congressional Prior Approval Reprogramming (commonly called an ATR), or to de-scope the contract to within the funding limits available. That timely recognition of a FPIF overrun is the reason that Earned Value Management (EVM) data can be so beneficial to the product office.
Conclusion: In the case where the contractor underruns, there will be sufficient funds from the cost savings to cover the increased profit amount that the contractor has earned, as long as the contractor’s share of the share ratio is lower than the government’s. As discussed earlier, funding of contract overruns can be slightly more problematic, but not insurmountable by any stretch of the imagination.
Suggestions: Read DoD Financial Management Regulation 7000.14-R, Volume 3, Chapter 8, paying particular attention to paragraph 080203. In addition, it is most strongly recommended that you contact the product office, your local comptroller organization, and legal counsel for more information and their policy interpretation of this issue.