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Incentive Contracting - Incentives, Award Fee, Award Term

DAU GLOSSARY DEFINITION

Motivating the contractor in calculable monetary terms to turn out a product that meets significantly advanced performance goals to improve on the contract schedule up to and including final delivery, to substantially reduce costs of the work, or to complete the project under a weighted combination of some or all of these objectives.

Alternate Definition

Incentive contracting describes contracts, from either the cost reimbursement or fixed price families, that are structured to emphasize a specific acquisition objective(s) by tying it to a financial reward1. A portion of profit, fee, or the term of the contract is dependent upon criteria that further align Government and contractor interests. Award Fee and Incentives are the two categories of incentive contracting described in FAR 16.4, DFARS 216.4, and PGI 216.4. Although not discussed in those regulations, Award Term has also gained full acceptance as a type of incentive.

General Information

Incentive contracting is an integral part of a contract type discussion conducted during planning for many acquisitions. Section 401 of FAR Part 16 provides general instructions on the use of incentive contracting. For example, incentive contracting is only permitted when other contract types do not sufficiently focus contractor efforts and discourage waste. It is never the “default” selection. When appropriately used, an Incentive, Award Fee, or Award Term allow the Contracting Officer to further address risk concerns for key acquisition objectives. In recent additions to FAR 16.401, data collection and the sharing of best practices are required to support the effective application of incentives.

 

Another major condition for incentive contracting -- the anticipated benefit derived from the use of an incentive -- must outweigh the estimated cost. The true cost of an incentive is more than just the incremental profit/fee used to motivate a contractor. Each incentive type has its own administrative burden that drives cost. That is why the FAR also mandates that the Head of the Contracting Activity (HCA) must sign a Determination and Finding (D&F) to substantiate that incentive contracting is in the Government’s best interest. Three general rules for incentive contracting are:

 

  • Align incentive criteria to performance, cost, or scheduling results ;
  • Ensure the cost benefit equation justifies the incentive you’ve selected; and
  • Use a D&F to document your selection in the contract file.

 

Volume 4, Chapter 1 of the Contract Pricing Reference Guide provides practical guidelines and examples for structuring incentive contracts. This resource can be found on this DAU website or through a redirect from the Defense Pricinig and Contracting (DPC) website.

 

Incentives

 

Incentives contracts are distinguishable from Award Fee contracts because they utilize objective criteria. The objective criteria allow the incentive(s) to be communicated through a quantitative plan comprised of a target cost, target profit/fee, and profit/fee adjustment formula. The adjustment formula will also outline a ceiling price along with minimum/maximum profit parameters. There are a few primary guidelines specific to the use of incentives. FAR 16.402-1(a) prohibits use of performance or delivery incentives without a cost incentive. An incentive formula should also be tied to a target measurement rather than a threshold (minimum) requirement. For example, a troop carrier solicitation that specifies a fuel efficiency requirement of 8.0 miles per gallon (mpg) could establish an incentive at a target level of 10.5 mpg. Finally, because a component of every incentive plan is target cost, the contractor must have an adequate accounting system and adequate cost or pricing information to establish target cost.

 

Award Fee

 

Unlike Incentive type contracts, Award Fee contracts utilize subjective criteria. The criteria are not quantitative and cannot be translated into a formula. FAR 16.401(e)(1) outlines conditions that must be met when considering Award Fee contracts. Similarly, DFARS prohibits using a Cost Plus Award Fee (CPAF) as a means to avoid developing objective targets. Incentives are preferred because of the administrative burden associated with Award Fee contracts. As outlined in the Award Fee Plan, the Fee Determining Official (FDO), members of the evaluation board, and the Contracting Officer Representative (COR) are typically all engaged in evaluating contractor performance relative to the award fee criteria.

 

The award fee amount can be comprised of a guaranteed base fee amount and an award fee pool amount that is dependent on performance relative to the evaluation criteria. Because a large base fee amount could undercut the effectiveness of the incentive, the DFARS limits it to between 0% and 3%. Contractors that do not receive all of their award pool during one evaluation period cannot recover that fee in another evaluation period.

 

Award Term

 

Award Term is an incentive type that rewards contractors with an additional period(s) of performance. The administration and structure of Award Term mimic that of Award Fee. Similarly, the performance criteria are subjective, limiting this type of incentive to scenarios where objective targets are not practical. In the administrative process, the FDO is replaced with a Term Determining Official (TDO).

 

Although Award Term is similar to an option, there is a significant difference. The contractor legally earns the right to an extension instead of relying on the Government’s unilateral right to exercise an option. The FAR requires the Contracting Officer to ensure that an option is the most advantageous method of filling a need by evaluating price and other related factors. Because the term is awarded based on performance, the contract is not subject to analysis at each renewal point. The Government must terminate for convenience if there is no longer a need or additional funding is not available.

 

1An award term incentive is considered an indirect financial reward for the purposes of this article.

 

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