Performance-Based Payments
DAU GLOSSARY DEFINITION
Method of providing financing to contractors performing under fixed-price contracts in which payments are based on achievement of specific events or accomplishments that are defined and valued in advance by the parties to the contract.
Performance-based payments (PBPs) are a customary method of contract financing that may be available under fixed-price contracts, except for contracts awarded using Sealed Bidding procedures. PBPs differ from the more traditional progress payments based on costs because these contract financing payments are made on the basis of the contractor’s achievement of objective, quantifiably measurable events, results or accomplishments that are defined and valued in the contract prior to performance.
A. Historical Perspective: Contract Suitability for PBPs
- PBPs are the preferred Government contract financing method when the contracting officer finds them practical, and the contractor agrees to their use. However, smaller contracts generally are not practical candidates for PBPs because the significant time and effort required to establish and administer this financing method will usually outweigh any financial benefits to be attained.
- The ideal candidate for PBPs is a production contract where: (a) the underlying item being acquired has a stable design, (b) the fabrication, assembly and test processes are well established, (c) the program plan and schedule are well defined, and (d) the expected outcomes are thoroughly understood by all parties, all of which permit PBP events and their timing to be more easily identified.
- It is much less likely that PBPs would be practical on fixed-price contracts for services. Unlike production contracts that normally provide opportunities for numerous objective events such as receipt of materials and completion of subassemblies or stages of manufacturing, service contracts usually involve fewer and less objective milestones and tend to involve primarily “level-of-effort” activities.
B. PBPs require considerable thought and effort on the part of both parties to negotiate the detailed PBP arrangement (i.e. good payment events and reasonable payment event values) to be set forth in the contract.
Features of Good Payment Events
- Represent integral and meaningful aspects of contract performance and signify true progress in completing the contract
- Are clearly and precisely defined by using objective metrics and criteria based on clearly identifiable indicators of performance that measure completion
Features of Reasonable Payment Event Values
- Do not result in payments that exceed the FAR limitation (90% of contract price)
- Do not result in payments exceeding the cumulative cost incurred during contract performance
- Reflect a realistic relationship to the amount of working capital needed to complete a given event
- Are not disproportionate to the approximate value of the progress the underlying events represent.
- Result from a discounted cash flow analysis that determines appropriate overall financing needs
C. The mandatory DoD PBP Analysis Tool [an Excel-based discounted cash flow model]
- The contractor’s funds required for working capital needs are most often obtained through short-term borrowing. The Government’s cost of raising funds is based on the lower rates that it costs the U.S. Treasury to borrow money. Because a contractor's time value of money is higher than the Government's time value of money, the accelerated funding provided by PBPs versus progress payments results in greater financial benefit to the contractor than the cost to the Government. This sets the stage for the negotiation of a mutually beneficial and lower contract price – a "Win-Win" financial arrangement. However with PBPs, a payment is only made when an event has been successfully accomplished. Therefore, the key is to negotiate a price that is lower than it would be with progress payments, that provides the contractor better financial value, and that recognizes the potential risk inherent in PBPs.
- The mandatory DoD PBP Analysis Tool allows the contracting officer to identify that “Win-Win” solution. It does this by comparing the expected monthly cash flow to the contractor when using PBPs versus progress payments. The tool calculates the final cost to the Government and the financial value to the contractor under both scenarios. The final cost to the Government is calculated by adding the cost of borrowing the financing payments made to the contractor to the contract price. The financial value to the contractor is based on calculating the Internal Rate of Return (IRR) and Net Present Value (NPV) value of the cash flows. The tool finds the solution that benefits both parties – lower final price to the Government and greater IRR and NPV for the contractor.