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  2. Fixed Price Incentive Firm Target (FPIF) Contract Type

Fixed Price Incentive Firm Target (FPIF) Contract Type

DAU GLOSSARY DEFINITION

Uses an incentive whereby the contractor's profit is increased or decreased by a predetermined share of an overrun or underrun. A firm target is established from which to later compute the overrun or underrun. A ceiling price is set as the maximum amount the government will pay. Necessary elements for this type of contract are: target cost—best estimate of expected cost; target profit—fair profit at target cost; share ratio(s)—to adjust profit after actual costs are documented; and ceiling price—limit the government will pay.

Alternate Definition

Pursuant to DFARS 216.403-1 and DFARS PGI 216.403-1, contracting officers are encouraged to evaluate an increased use of the Fixed Price Incentive Firm Target (FPIF) contract type. The FPIF contract type offers contractors a significant incentive to control costs. However, the FPIF is one of the more complex contract types to negotiate and execute. This article provides guidance for acquisition teams regarding the appropriate use of the FPIF contract type. First this article explains the elements of the FPIF contract and explains how FPIF contracts create incentives for cost control. In addition, this article explains the appropriate applications of FPIF contracts.

General Information

Elements

As stated in FAR 16.403-1, a fixed price incentive (firm target) contract specifies a target cost, a target profit, and a target price, which is the sum of the target cost and target profit. The contract also specifies a price ceiling (or ceiling price), but not a profit ceiling or floor, which is the maximum amount that may be paid to the contractor, except for any adjustment under other contract clauses. To illustrate, a price ceiling of $130 is represented by a dashed line shown below in Figure 1

 

FPI(FT)CT Fig1

The FPIF contract also specifies a profit adjustment formula. The profit adjustment formula is also known as the “share ratio” or “sharing arrangement,” and is graphically depicted by a “share line.” The profit adjustment formula is typically expressed as a ratio, with the “Government Share” in the numerator, and “Contractor Share” in the denominator. Figure 2 illustrates an “80/20” profit adjustment formula share line, and reflects how cost under runs (below target cost) and over runs (over target cost) will be shared between the parties.

The final FPIF element is the “Point of Total Assumption (PTA).” The PTA reveals where cost over run sharing ends, and the contractor totally assumes all cost overrun risk. At the PTA, the price calculated by the price adjustment formula is equal to the ceiling price (calculations for PTA are shown at the end of this article). Beyond the PTA, the share line price exceeds the price ceiling; therefore, the “price ceiling line” supersedes the share line. As illustrated in Figure 2, the price ceiling line and the share line intersect at the PTA.

FPI(FT)CT Fig2

These elements are all negotiated at the outset, before contract award. When the contractor completes performance, the parties assess all incurred direct and indirect costs, and negotiate the final cost. At that point, the parties apply the profit adjustment formula, and determine the final price. Figure 3 illustrates how FPI(F) contract profit and price are adjusted when actual costs incurred are below (under run) or above (over run) the original Target Cost.

FPI(FT)CT Fig3

FPI(FT)CT Fig4

In under run scenarios, the contractor earns all the target profit, plus the “contractor share” (20% in this example) of the under run according to the price adjustment formula. In over run scenarios up to the PTA, the contractor must subtract the “contractor share” (20% in this example) portion of the over run from the target profit. Beyond the PTA, the share line price exceeds the price ceiling; therefore, the price ceiling line takes effect, and the contractor’s profit is reduced by $1 for every $1 of over run--the FPI(F) contract essentially becomes a firm-fixed price contract. Subject to other contract terms, in no case will the Government pay more than the ceiling price.

Beyond the ceiling price, the contractor is still obligated to deliver in accordance with the contract. The FPI(F) is in the “fixed price” contract family, and therefore includes a “Default” clause (FAR 52.249-8 through -10). Pursuant to this clause, if the contractor fails to deliver, even beyond the ceiling price, the contractor faces the remedies of the Default clause, including termination for default.

By contrast, the Default clause is not included in cost-reimbursement contracts. Under cost reimbursement contracts, contractors are only obligated to execute their “best efforts” to deliver within the Total Estimated Cost (Limitation of Cost Clause, FAR 52.216-20). If a contractor does not deliver within the Total Estimated Cost, the contractor is allowed to revise their Total Estimated Cost to complete the effort, and the Government decides whether or not to provide additional funding.

In summary, the FPI(F) contract type provides significant profit incentive for the contractor to under run, allows the contractor to share some losses in an over run, yet still holds the contractor’s “feet to the fire” with respect to delivering in accordance with the contract. Because the profit varies inversely with the cost, this contract type provides a positive, calculable profit incentive for the contractor to control costs.

Application and Limitations

The FPI(F) contract is appropriate when the parties can negotiate at the outset a firm target cost, target profit, and profit adjustment formula that will provide a fair and reasonable incentive and a ceiling that provides for the contractor to assume an appropriate share of the risk. When the contractor assumes a considerable or major share of the cost responsibility under the adjustment formula, the target profit should reflect this responsibility.

Before employing a FPI(F) contract, the Contracting Officer should evaluate if the risk is within reasonable parameters for a firm-fixed priced contract, or if a cost-reimbursement incentive type contract would offer more appropriate incentives.

The FPI(F) is generally appropriate for production efforts when there is reasonable opportunity for the contractor to gain efficiency savings as more units are produced, and the Government is seeking to gain a share of those savings. Because of the objective, inverse relationship between costs incurred and profits gained, FPI(F) may not be the best incentive in situations when the Government’s desire is to incentivize the contractor to invest in pursuit of performance enhancing capabilities.

Per FAR 16.403-1(c), the FPI(F) contract type may be used only when

  • The contractor’s accounting system is adequate for providing data to support negotiation of final cost and incentive price revision; and,
  • Adequate cost or pricing information for establishing reasonable firm targets is available at the time of initial contract negotiation.

Other FPI(F) Considerations

Before selecting an FPI(F) contract type, Contracting Officers must understand the interrelationship between the share ratio and the PTA. Contracting Officers and Government acquisition team members should determine the requirement’s “Optimistic Cost” and “Pessimistic Cost” -- the Government’s estimates of the lowest and highest reasonable cost to complete the contract. To optimize FPI(F) effectiveness, the target cost should be set between the Optimistic and Pessimistic Cost estimates, and the Pessimistic Cost should be equal to or just below the Point of Total Assumption. This is the optimal range of FPI(F) incentive effectiveness.

It is permissible to negotiate separate share ratios for under run and over run scenarios. Before doing so, the government team must establish why separate ratios are in its best interest, and formally document the decision.

Based on the key risks of your program, determine how steep or flat the profit adjustment formula (“share line”) should be for under runs and over runs. Points to consider:

  • A steeper under run share line (for example, a 50/50 share line is “steeper” than a 80/20 share line) offers more profit to contractors for cost under runs, and a stronger incentive to keep costs down.
  • A steeper over run share line (50/50 instead of 80/20) takes more profit away from contractors as they over run. This adds risk to the contractor, and presents a strong incentive to avoid cost over runs.
  • A flatter over run share line (80/20 instead of 50/50) places more cost risk on the Government for over runs.
  • Though not illustrated in this article, it is permissible to establish different share lines for under runs and over runs.  For example, an FPIF contract could be established with an 80/20 under run share line, and a 50/50 over run share line.

The PTA is calculated as follows:  PTA cost = Target Cost ((Ceiling Price - Target Price) / Government Share)

Comparing the FPIF to a Cost Reimbursement Contract

Though the FPIF provides some shared risk with respect to cost over runs (similar to a cost reimbursement contract), the FPIF is still in the “fixed price” family of contracts. As such, the contractor must deliver on-time, or be subject to fixed price default contract remedies--including termination for default—even if total costs exceed the ceiling price. In contrast, under cost-reimbursement contracts, contractors are only obligated to execute their “best efforts” to deliver within the Total Estimated Cost (pursuant to FAR 52.216-20, or 52.232-22). Thus, if a contractor is putting forth its best efforts, but does not deliver within the Total Estimated Cost, the contractor is generally not subject to termination for default. Thus, an FPIF contract puts significantly more risk on the contractor than a cost reimbursement contract.

Conclusion

Overall, the FPIF contract type establishes objective incentives to complete work within target cost. Though a bit more complex to negotiate and execute, the reward is worthwhile to both government and contractor team members when used appropriately.

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