Where should the reduction be applied? Cost, profit, or both? The guidebook and training slides are mute on this matter.
Special thanks to our subject matter expert (SME) from the DAU Midwest Region who was instrumental in providing this answer.
We’ll try to answer the easy part first, consideration should be applied to profit and yes it should be reduced. Getting there however may require some good negotiation skills. Hopefully the rest of this helps.
Any changes made to target cost depends on many factors, including:
- Is additional work (scope) being added or deleted from the contract?
- If yes, is the type of work being added or deleted different in technical or managerial nature? More risky, less risky?
- Is the contractor currently underrunning or overrunning?
Assumption: for the remainder of the answer, we’ll assume the only change to the contract is the finance payments going from PPs to PBPs for the remaining (undeliverable and unpaid) work.
At first glance it might seem the negotiated target profit (and target cost) would increase because, if you were using weighted guidelines to determine profit there is a higher normal value and designated range at DFARS 215.404-71-3(c) for PBP contract financing than PP. And, even though DFARS 215.404-71-3(c)(6) says do not compute a working capital cost adjustment if PBP, that would almost never be enough to offset the difference calculated.
However, in the DOD we're required to use the PBP analysis tool (rather than the weighted guidelines), which incorporates a slightly different method for determining profit. Using the PBP tool, profit percentage is computed by the tool for the PBP arrangement. The PBP tool uses NPV (net present value) to determine IRR (internal rate of return) and profit percentages of the PBP arrangement. The big benefit of a PBP arrangement is that the improved cash flows (payments) result in the contractor getting paid sooner and often at higher amounts than they would get through traditional PP. This improved cash flow results in higher IRRs which will put the contractor in a more favorable financial position.
The PBP tool does all the complicated NPV calculations on each event payment and incorporates a notional "cost of borrowing" rate and a few other factors to determine the overall position of the different financing options. Then, you can use the "win-win" function in the tool to "split the difference" and give each party a relatively equal benefit. The contractor gets a benefit of higher IRR and the Government gets a benefit of lower overall price. The Government recognizes this benefit through a reduced profit amount. So, using the PBP tool will result in lower profit percentage - contrary to what the WGL would indicate. However, even with the lower profit percentage, the contractor will be in a better financial position due to the higher IRR. Getting the contractor to recognize that higher IRR with PBPs is better than higher profit without... is the tough part sometimes.
As far as how to make the switch in the middle of a contract, you would most likely make the adjustment on the undelivered items - or, the "not yet paid CLINS" by lowering the CLIN price to make up for the reduced overall price.