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Contract Types

ACON 021

DAU GLOSSARY DEFINITION

General Information

The contract type dictates the degree and timing of the responsibility assumed by the contractor for the costs of performance and the amount and nature of the profit incentive offered to the contractor for achieving or exceeding specified standards or goals. Most contract types fall into two general categories: fixed-price contracts and cost-reimbursement contracts. Fixed-price contracts place full responsibility on the contractor for performance costs and resulting profit (or loss). Cost-reimbursement contracts impose minimal responsibility onto the contractor for performance costs. The Government pays the contractor for allowable costs incurred in performance of the contract and fee (profit) is either fixed or based on a fee incentive arrangement.

The Contracting Officer must understand the differences between contract types before exercising sound business judgement. Fixed-price and cost-reimbursement contracts operate differently concerning the contractor’s profitability and cost control. Cost and performance risk allocation between the Government and contractor shifts depending upon the contract type selected. For example, the contractor bears the greatest risk for a firm-fixed-price contract because the contractor’s promise is that it shall deliver at the agreed-to price in the contract to receive the price. If the contractor incurs costs greater than the price without warranted price adjustments, the contractor will accept a monetary loss. Whereas under cost-plus-fixed-fee contracts, the Government bears the greatest risk because the contract obligates the contractor to provide its best effort to meet the needs within the estimated cost in the contract. Moreover, the nature of this arrangement limits the incentive for the contractor to control costs based on profit motive because the contractor will receive the same fee amount (although the percentage of fee earned will be lower, which offers the contractor some incentive to control costs) whether the contractor incurs cost at or below the estimated cost. In addition, the contract does not obligate the contractor to continue to perform if the contractor exceeds the estimated cost unless the Government issues a contract modification to obligate additional funds. The Government employs a fixed-price contract type when the cost risk to the Government is low, and the Government’s requirements are well-defined such as contracts for commercial items or full-on and follow-on production. The Government uses cost-reimbursement contract types in contracts for research and development, testing and demonstration, and initial production, or for requirements with uncertainties involved in contract performance that do not allow the Government and contractor to sufficiently estimate costs to use in any fixed-price arrangement which therefore would impose unreasonable and excessive performance and cost risk under a fixed-price arrangement.

FAR Part 16 provides for another category of contracts that contract for a level-of-effort. Contract types of this category include time-and-materials and labor-hours contracts. The Government bears the preponderance of cost and performance risk because the Government is contracting for a level-of-effort or labor hours rather than for a completed job, task, or project. The contracting officer must prepare a determination and findings and document that no other contract type is suitable before soliciting for a time-and-material or labor hours contract. In addition, DoD has strict determination and findings approval requirements provided in DFARS 216.604(d)(i)(A). Time-and-material and labor-hours contracts are among the least preferred contract types because the contractor is not incentivized to establish limitations for its incurred labor hours. The contractor’s profit and overhead increases as the contractor works and invoices for more labor hours. Time-and-materials and labor-hours contracts burden the Government with additional oversight responsibilities to ensure the contractor institutes efficient performance methods and sufficient cost controls.

The contracting officer’s discretion for selecting a contract type is not open-ended and without certain prohibitions and limitations. Under no circumstances is a cost-plus-percentage-of-cost contract type permitted, as this provides little incentive for the contractor to control contract costs. In addition, contract types available for use will depend on the nature of the supply, system, or service purchase and the contracting method used. Contracts for commercial items may only be issued under firm-fixed-price or fixed-price with economic-price-adjustment arrangements. FAR 12.207(b)(1) describes circumstances permitting the contracting officer to use a time-and-materials or labor-hours contract for the acquisition of commercial services. Similarly, contracts issued under FAR Part 14 Sealed Bidding procedures may use firm-fixed-price, or if authorized, fixed-price with economic price adjustments. Cost reimbursement contracts are prohibited from being used for commercial acquisitions and sealed bidding. The contracting officer’s greatest discretion comes from negotiated non-commercial procurements using FAR Part 15 procedures.

The contract type employed during an acquisition presents different benefits for both the Government and contractor. The most advantageous contract type from the Government’s perspective is firm-fixed price, as the contractor has full responsibility for the performance costs and resulting profit (or loss). Alternatively for the contractor, cost-plus-fixed-fee serves as the most advantageous contract type. Under this arrangement, the contractor bears minimal responsibility for performance costs, and the contract provides for a negotiated fee (profit) that is fixed. Between these two extremes are various incentive contracts in which the contractor's responsibility for the costs of performance and the profit or fee incentives are tailored to the uncertainties involved in contract performance. Please visit DAU’s Comparison of Major Contract Types Chart tool to learn more about the various contract types in the fixed-price, cost reimbursement, and level-of-effort families.

Selecting the contract type frequently occurs during contract negotiations. The objective is to negotiate a contract type and price (or estimated cost and fee) that will result in reasonable contractor risk and provide the contractor with the greatest incentive for efficient and economical performance. Highlights of consideration factors as prescribed in FAR 16.104 when selecting the appropriate contract type include the following:

  • Price competition. Effective price competition promotes realistic pricing; a fixed-price contract is ordinarily in the Government’s interest.
  • Combining contract types: A contract may use multiple contract types. While the Government’s desire is to issue firm-fixed-price contracts, not all requirements fit. However, the contracting officer should consider whether a portion of the contract could be issued under a firm-fixed-price. 
  • Price analysis. The accuracy of the price analysis can provide a basis for selecting the contract type.
  • Type and complexity of the requirement. Complex requirements, especially those unique to the Government, usually result in greater risk assumption by the Government.
  • Urgency of the requirement. If urgency is a primary factor, the Government may choose to assume a greater proportion of risk or offer incentives to ensure timely contract performance.
  • Period of performance. In times of economic uncertainty, contracts extending over a relatively prolonged period may require economic price adjustment terms.
  • Contractor’s technical capability and financial responsibility. If the contractor is well-positioned to control technical and financial uncertainties, explore shifting more contract type risk to the contractor.
  • Adequacy of the contractor’s accounting system. Before agreeing on a contract type other than firm-fixed-price, the Government contracting officer must ensure that the contractor’s accounting system will permit timely development of all necessary cost data in the form required by the proposed contract type.
  • Concurrent contracts. If performance under the proposed contract involves concurrent operations under other contracts, the impact of those contracts should be considered in the context of cost, schedule, and performance risk.
  • Extent and nature of proposed subcontracting. If the contractor proposes extensive subcontracting, a contract type reflecting the subcontracting risks to the prime contractor should be selected.
  • Acquisition history. Contractor risk usually decreases as the requirement is repetitively acquired, so more contract type risk can be assumed by the contractor.
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