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Award Term:  The Newest Incentive

by Vernon J. Edwards

Special to Where in Federal Contracting?

October 30, 2000

  The Award Term Incentive—What It Is And How It Works

The award term incentive is a relatively new development in government contracting, one that was first used in 1997 and that is not yet described in government acquisition regulations. It is modeled after the award fee incentive described in Federal Acquisition Regulation (FAR) 16.405-2, but instead of rewarding a contractor for excellent performance with additional fee it rewards the contractor by extending the contract  period of performance without a new competition. Under an award term incentive the government monitors and evaluates the contractor’s performance, and if a government term determining official decides that the contractor’s performance was excellent, then the contractor earns an extension. The extension is (or should be) conditioned upon the government’s continuing need for the service and the availability of funds.

The award term incentive was the inspiration of Mr. Thomas Jordan, a senior Air Force civilian employee who was working at Kelly Air Force Base when he thought it up. Its first use was on a task order contract that the Air Force’s Aeronautical Systems Center awarded to the McDonnell Douglas Corporation in October of 1997, for simulation services for the F-15C aircraft. The contract has a seven year base period, which the contractor can extend to 15 years by rendering excellent service. Since that first use at least 25 acquisitions have included or plan to include award term incentives.

A true award term incentive rewards the contractor with legal entitlement to a contract extension, not an additional option. An option is a unilateral right of the Government; a contractor is not entitled to the exercise of an option. But under a true award term incentive, if the contractor’s performance meets the award term criteria stipulated in the contract and if any stipulated conditions such as continuing need and availability of funds are met, then the government must either extend the contract or terminate it for convenience or default. Many contracts have included incentives that have been labeled “award term,” but that should be called “award option” or “incentive option,” because the contractor’s reward is not an actual extension, but an option to extend, which entitles the contractor to nothing.

Agencies have used award term incentives in acquisitions for a variety of services, including technical and logistics support, laundry and dry-cleaning, depot-level maintenance, aircraft maintenance, grounds maintenance, janitorial services, real property maintenance and repair, and training. The incentives have been used in association with several different pricing and delivery arrangements—fixed-price, cost-reimbursement, indefinite-delivery-indefinite-quantity, and requirements. It has been used in combination with other incentives, such as cost-plus-incentive-fee and cost-plus-award-fee.

Most of the acquisitions that have included award term incentives have been conducted by the Air Force, but the National Aeronautics and Space Administration, the Naval Facilities Engineering Command, the Naval Sea Systems Command, the Army’s Ft. Drum in New York, and the General Services Administration have all conducted or announced plans to conduct acquisitions that include award term incentives. Those acquisitions include or plan to include provisions that will enable the contractor to extend its performance for periods ranging from a maximum of seven years (Naval Facilities Engineering Command) to a maximum of 20 years (Air Force Electronic Systems Center).

A More All-Encompassing Incentive Reward

The award term incentive may provide a solution to one of the most vexing shortcomings of contractual incentives—that they do not work as advertised. The standard contractual incentives described in FAR Part 16 are all profit incentives—they reward excellent performance by paying more money. Since the early 1960s, researchers have concluded that such profit incentives do not produce the results predicted by incentive theory. Studies conducted by Harvard University, the Rand Corporation, the Logistics Management Institute, the U.S. General Accounting Office (GAO), and a number of independent researchers have concluded that there is little evidence that incentives designed to motivate cost efficiency have been effective.

Perhaps the definitive assessment of contractual incentives was made by Harvard professor Frederic M. Scherer, in his classic study of their use in weapons development contracts. Writing in 1964 about fixed-price incentive and cost-plus-incentive-fee contracts, which he called “automatic contractual incentives,” he said:

The automatic contractual incentives applied to most advanced weapon system and major subsystem development and production efforts have not been powerful enough to compel the elimination of inefficiencies which companies were reluctant to eliminate. They have not been able to offset the inherent tendencies toward inefficiency propagated by weapons makers’ competition for survival in an environment of technological change. Nor is it likely, given the strategic role which contractors play in drawing up cost estimates and negotiating profit-cost correlation provisions, that the automatic contractual incentives approach can be greatly strengthened. 

[Scherer, F. M., The Weapons Acquisition Process: Economic Incentives (Boston: Harvard University, 1964), pp. 324-325.]

Later researchers have reached similar conclusions. In 1968, Rand Corporation researcher Irving N. Fisher describing his findings based on a comprehensive statistical analysis of cost outcomes under incentive contracts. He wrote: 

The statistical analysis presented here suggests that some of the advantages usually attributed to incentive contracts may be illusory. It is commonly believed that incentive contracts provide substantial entrepreneurial motivation for increased efficiency and tighter cost control. This belief is one of the stronger justifications for the current extensive use of cost-incentive contracts. The evidence presented here, however, implies that the incentive effect on contractors’ costs and efficiency may be weaker than is customarily believed. Rather, the evidence suggests that the cost underruns commonly observed for Air Force incentive contracts are the result of a general upward shift in target costs rather than improved cost control.

[Fisher, I. N., A Reappraisal of Incentive Contracting Experience, Memorandum RM-5700-PR (Santa Monica: The Rand Corporation, 1968), p.47.]

In 1974, Harvard professor and former defense official J. Ronald Fox wrote: “In the past few years there has been increasing evidence that incentive contracts do not accomplish the Government’s management objectives.” He cited, among others, a 1968 study by the Logistics Management Institute that concluded: “Incentives have not been significantly effective as protection against cost growth on programs.” [Fox, J. R., Arming America: How the U.S. Buys Weapons (Boston: Harvard University, 1974), pp. 240-241.]

Nearly 20 years after Irving Fisher’s Rand Corporation study, and 13 years after Ronald Fox’s analysis of the research on incentives, the U.S. General Accounting Office studied 573 Department of Defense fixed-price incentive contracts and found as follows:

If target prices are reasonably set we would expect to see final target prices both above and below, but clustering near, target prices. For the contracts we examined, however, there was no relationship between the cost-sharing ratio and achievement of a contract’s target price. For any particular sharing ratio, we found final contract prices both above and below target price by similar amounts. We did not find any apparent relationship between the cost-sharing ratio and attainment of ceiling prices. These findings do not support that part of incentive theory which holds that as the contractor’s share ratio increases the contractor has a greater incentive to meet or underrun target costs. Other research has also found that final contract costs and price seem unrelated to the sharing ratio.

[U.S. General Accounting Office, Incentive Contracts: Examination of Fixed-Price Incentive Contracts, GAO/NSIAD-88 (Washington, DC: 1987), pp. 3-4.]

If the standard cost incentives to do not work, the question is: Why not? J. Ronald Fox described the Logistics Management Institute’s 1968 findings as follows:

Extra-contractual considerations dominate over profit or fee. A contractor rarely seeks to maximize profit during the short run of a single contract. He is more interested in taking actions that will expand company operations, lead to increased future business, enhance company image and reputation, benefit his nondefense business, or relieve such immediate problems as loss of skilled personnel and a narrow base for fixed costs. 

[Logistics Management Institute, An Examination of the Foundations of Incentive Contracts, LMI Task 66-67, May 1968, cited by Fox, J. R. in Arming America: How the U.S. Buys Weapons (Boston: Harvard University, 1974), p. 241.] Frederic Scherer had reached similar conclusions in 1964. [Scherer, F. M., The Weapons Acquisition Process: Economic Incentives (Boston: Harvard University, 1964), pp. 159-162, 268-269, and 321-323.]

All of the above cited research looked at cost incentives. What about performance incentives? There appears to have been relatively little empirical research about performance incentives, probably because performance is so difficult to measure objectively. However, a 1978 article by Richard F. DeMong reported that several researchers considered performance incentives to be redundant, since most organizations were already motivated to provide quality performance. (Frederic Scherer came to the same conclusion in 1964.) DeMong also reported that one set of researchers could find no statistical relationship between contract type and performance in a study of 35 civil engineering service contracts. [DeMong, R. F., “The Effectiveness of Incentive Contracts: What Research Tells Us,” in National Contract Management Quarterly Journal, Vol. 12, No. 4 (1978), p.12.]

If the researchers are correct that contractual incentives have had little demonstrable effect on contract performance outcomes, and if that failure is due to the fact that short term profit rewards are not an adequate incentive, then the award term incentive is a promising development. That is because the award term incentive rewards a contractor with additional business, which satisfies four of the long term goals identified by Logistics Management Institute in its 1968 study: enhanced company image and reputation, increased future business, retention of skilled personnel, and the maintenance of an allocation base for fixed costs. The award term incentive gives a contractor a chance to earn a more all-encompassing reward than short term profit dollars.

The Advantages of Long-Term Business Relationships

Aside from the potential for motivating contractors to render excellent performance, there are at least two other advantages to the use of award term incentives to establish long term business relationships: (1) increased operational efficiency and effectiveness, and (2) reduced acquisition transaction costs.

Increased Operational Efficiency and Effectiveness.

Government service contracts are becoming more complex as government agencies outsource ever more of their internal functions. As service requirements become more complex (multifunctional and multitask) and require performance over an extended period of time (one year or longer), it becomes exceedingly difficult to write statements of work and contract clauses that fully describe all of the government’s requirements and that cover all of the contingencies that may affect performance. Such complex, long term contracts are referred to as relational contracts by legal scholars and incomplete contracts by economists, and a large body of legal and economic scholarship has developed concerning them.

Richard E. Speidel,  Beatrice Kuhn Professor of Law at the Northwestern University School of Law, has described relational contracts as follows:

Most commentators agree that relational contracts have at least three distinguishing characteristics. First, the exchange relationship extends over time. It is not a “spot” market deal. Rather, it is more like a long-term supply contract, a franchise or distribution arrangement, or a marriage. Second, because of the extended duration, parts of the exchange cannot be easily measured or precisely defined at the time of contracting. This dictates a planning strategy that favors open terms, reserves discretion in performance to one or both parties, and incorporates dispute resolution procedures, such a mediation or arbitration, into the contract. The inability of the parties to “presentiate” the terms of the bargain at the time of contracting shifts the focus to circumstances and conduct that occur ex post contract. Third, in the words of Lewis Kornhauser, in a relational contract the “interdependence of the parties to the exchange extends at any given moment beyond the single discrete transaction to a range of social interrelationships.” For example, a complex, cooperative relationship between the parties may expand over time to others who support or rely on the exchange relationship.

[Speidel, R. E., “The Characteristics and Challenges of Relational Contracts,” Northwestern University Law Review, Spring 2000, p. 823.]

Economist Bruce R. Lyons described the difficulties associated with planning complex, long term contracts as follows:

Human nature is assumed to be fundamentally opportunistic, so firms must make full allowance for adverse selection and moral hazard problems in their dealings. One way to insure against opportunistic behavior is to write a detailed contingent contract that specifies all possible eventualities and is watertight against all forms of opportunism. Unfortunately, because of bounded rationality, formal contracts have only limited value as a means of governing relationships. If the input is fairly standard and potential changes in circumstances are well understood, then contracts may be effective. Very often, however, it is beyond the practical capacity of man or woman to fully specify detail, predict all possible contingencies, and verify breaches in court.

[Lyons, B. R., “Contracts and Specific Investment: An Empirical Test of Transaction Cost Theory,” Journal of Economics and Management Strategy, Vol. 3, No. 2 (Summer 1994), p.258.]

So complex, long term contracts have gaps, and wise business-people know this. During the course of an cooperative long term relationship the parties will fill the gaps in their contract by adapting their expectations to emerging contingencies and prevailing conditions and making cooperative, ad hoc decisions. They will do so through formal contract modifications, to be sure, but also through informal, undocumented daily cooperation. As the parties fill the gaps in their contract, they develop a shared body of knowledge about the contract work and an informal protocol of cooperation that will enable them to respond to new conditions and solve new problems as they arise. The shared knowledge and the cooperative protocol becomes a part of the culture of the relationship. By consciously recognizing the fact that their contract is incomplete, by adapting their expectations to contingencies, and by adopting a cooperative approach to decision-making, the parties can satisfy their requirements and actually increase the efficiency and effectiveness of their joint endeavor. In short, a long-term, cooperative relationship facilitates team development and effectiveness. If the relationship works poorly, then a change in contractors may be necessary, but if it works well, a change in contractors may degrade performance, at least temporarily.

Reduced Acquisition Transaction Costs.

A second benefit of a long term relationship is a reduction in acquisition transaction costs. Government contract formation is often a long, tedious, and expensive process for both the government and competing offerors. New awards are expensive to plan, and proposals are expensive to solicit, prepare, and evaluate. And a source selection decision may be followed by a protest. So by reducing the frequency with which they must conduct new competitions for continuing requirements, agencies can reduce the transaction costs associated with the formation of new contracts. The Competition in Contracting Act (CICA) does not prohibit the use of award term incentives, no more than it prohibits the use of options. However, reducing the frequency of re-competitions for continuing service requirements can be justified on business grounds only if there is an overall net savings to the government.

The Disadvantages of Long-Term Relationships

A potential disadvantage of a long-term relationship is the possibility that the agents of the contracting parties will begin to conduct business on a personal basis instead of a proper professional basis. Contractual relationships are, after all, human relationships. People who have come to know and like one another in the course of time may relax their standards and overlook performance deficiencies for the sake of their personal relations; they may become reluctant to criticize or to take an action that could hurt the other person. On the other hand, a change in personnel may bring conflict as the parties try to adapt to new personalities and changes in long-standing ways of seeing, understanding, and doing. These sorts of developments are probably a natural and unavoidable byproduct of long-term business relationships.

Commercial Idea—Government Rules

The award term incentive is an attempt to use a commercial idea within a framework of government rules. The commercial idea is to dangle before a contractor the prospect of a long term business relationship and the sales that come with it in order to motivate it to provide excellent service. This is something that commercial organizations generally do implicitly and informally—i.e., without writing it into a contract. In the commercial sector, it usually goes without saying that a customer will generally stick with a contractor that performs well and charges reasonable prices. But unlike a commercial organization, a government agency cannot continue to give its business to a contractor just because the firm did well on the last job; it must conduct a new competition for each acquisition.

CICA and FAR Part 6 require agencies to promote and provide for “full and open competition” every time they acquire a service or product unless they can justify doing otherwise. Moreover, agencies must use the competitive procedures in FAR parts 12, 13, 14, or 15 when conducting those competitions. In order to avoid the necessity of conducting a new competition in order to extend a contract, a government agency must ensure that prospective award term extensions are included within the scope of the original competition. The GAO, in ruling on the use of options to extend the term of a contract, has long insisted that agencies meet three conditions: first, that the solicitation state that the contract will include options and the maximum length of the contract as extended by the options; second, that the government solicit prices for each option; and, third, that the government evaluate the option prices during the source selection for the original contract. The GAO will not go along with the use of unpriced options. [For a lengthy discussion of the GAO’s position on these matters, see the GAO’s 1986 letter: The Honorable Caspar W. Weinberger, The Secretary of Defense, GAO file number B-217655, April 23, 1986.]

Thus, in order to comply with the dictates of CICA and the GAO, government agencies must do something that commercial organizations do not have to do—they must make the award term incentive express and formal by writing it into their solicitations and resulting contracts. This is a task wherein lie many difficulties.

Problems Arising from the Need for Contractual Formality

The need for government agencies to make the award term incentive express and formal in order to include the award term extensions in the scope of the competition gives rise to problems that commercial firms do not have to face. No sensible business person would make an irrevocable legal commitment—enforceable in court—to a long term business relationship. Markets and organizations can change rapidly in today’s highly dynamic global market; it is very difficult to predict conditions even two years hence, and almost impossible to predict the state of a market or organization 10 to 15 years in the future. A deal that is highly advantageous today can be utterly worthless or bad business two years from now. Thus, one challenge for government agencies using an award term incentive is to find a way to write it into the contract so that the demands of CICA and the GAO are met and there is a real incentive, while providing enough ways out of the deal so that the parties do not become locked in a legal death grip. Failing to provide enough outs would be a serious mistake, but providing too many outs might undermine the incentive.

Aside from the conditions of continuing need and availability of funds, there may be many reasons why the government would want to renege on an award term. Inconsistent performance is one such reason. Many award term contracts have provided for a base year and four option years during which the contractor can earn a one-year award term extension in each of the first five years of performance. Suppose that a contractor renders excellent performance during the first year and earns an award term extension, but renders only marginally acceptable performance during the second year. Suppose that such inconsistent performance continues throughout the first five years, so that by the end of that time the contractor has earned only two of the five available award terms. Should the government remain in a relationship with such an inconsistent performer? What provision if any should the contract make for inconsistent performance?

Should an award term extension be contingent upon the continuing reasonableness of the award term prices? What if a price that was fair and reasonable at the time of the original source selection is no longer fair and reasonable 10 years later? What provision should the contract make for this possibility?

What provision should the contract make for the possibility that the contractor is no longer responsible—as defined by FAR 9.101—at the point in time that an award term is scheduled to begin? (What if it was debarred by another agency for reasons that have nothing to do with the contract?) Should the government be contractually obligated to continue to do business with such a firm? If the contract allows the government to get out of the award term in the event that the contractor is no longer responsible for some reason, and if the contractor is a small business, would the Small Business Administration’s Certificate of Competency Program apply?

Even if all of the conditions for an award term are met, the government can still get out of a bad deal by terminating the contract for its convenience. But it would seem that fairness demands that the contractor should have a way out as well. Remember that we are talking about relational contracts for services, not spot market contracts for goods. Contract law aside, is it good business to compel a contractor to perform an award term even though the contract no longer serves its interests, or is harmful to its interests? But what about the government’s notoriously long acquisition lead times? If the contract is to allow the contractor to opt out of an award term, how much notice should it require the contractor to give the government? Six months? A year? Two years?

These considerations pose two challenges to award term contract writers: First, they must include enough escape mechanisms to enable the government to respond to deal-wrecking organizational and market changes without including so many that they undermine the incentive. Second, they must allow the contractor to opt out the contract in a way that does not make the arrangement too risky for the government in light of its long acquisition lead times. They must insist on reasonable advance notice.

Yet another challenge has to do with contract pricing. In the commercial sector, firms do not have to negotiate prices far in advance. They can agree to negotiate them later, or they can agree on baseline prices and then renegotiate them as the need arises. But in light of the GAO’s position that agencies must obtain and evaluate prices for option periods, and evaluate those prices during source selection, it is likely to insist upon the same conditions for prospective award term extensions. Moreover, the GAO is also likely to object to any contract provision that would allow the parties to renegotiate the award term extension prices, since it has objected to the renegotiation of option prices, insisting that such renegotiations are sole source contract actions for which justification and approval are required in accordance with CICA. [See Magnavox Electronic Systems Co., Comp. Gen. Dec. B-231795, 88-2 CPD ¶ 431: “An agency is not permitted to negotiate with the awardee to reduce the option prices stated in the contract price if price competition for the option quantity is available.” See, also, Varian Associates, Inc., Comp. Gen. Dec. B-208281, February 16, 1983, 83-1 CPD ¶ 160; request for reconsideration denied, 83-2 CPD ¶ 78.] The GAO’s position on the renegotiation of option prices is reflected in FAR 17.207(f), which requires that options must be exercisable at prices that are “reasonably determinable” from the terms of the basic contract.

In light of the fact that most agencies that have used or that plan to use award term incentives have provided for as many as 10 to 15 years of performance, the GAO’s requirement to price those years at the time of initial contract award, and its objection to renegotiating those prices, confront agencies and contractors with a daunting problem. It is hard to imagine any business person making a firm commitment to prices 10 to 15 years in advance without some provision for price adjustment or escape from the deal. Economic price adjustment clauses, in the sense in which they are described in FAR 16.203, can help, but they usually do not cover all exigencies that could affect prices significantly. Thus, agencies that are contemplating the use of award term incentives must develop another solution, one that will meet with the approval of the GAO. One such solution may be for the parties to agree on ceiling prices that are subject to downward adjustment based on clearly stipulated terms and conditions. Upward adjustments of such ceilings could be based on economic price adjustment provisions or some other reasonable basis.


It is too soon to say whether the award term incentive is a good idea and will receive widespread acceptance within the acquisition community. One thing is clear: The effective use of an award term incentive demands a high level of contracting knowledge and skill during contract formation. It requires that acquisition planners effectively solve many complex incentive design problems. It requires that the contracting parties communicate clearly and work together effectively when negotiating contract terms and drafting contract language in order to ensure a common understanding of the nature of their undertaking. They must remember that they are thinking and writing for people who were not a part of the original negotiation. It requires a new approach to contract management, one in which the parties openly acknowledge that they cannot see or plan far into the future and that their contract is incomplete, and in which they agree to learn together, adjust their expectations when necessary, and engage in cooperative, ad hoc decision making during the course of performance in order to fill the gaps in their original agreement.

In light of the need to make award term incentives express and formal and subject to contract law enforcement, and in light of the fact that technology and the modern global economy sometimes seem to change with the speed of light, we must ask whether it is a good idea to enter into formal contracts of 10, 15, or 20 years duration. Does it make good business sense to do so?  The answer ultimately depends on how effectively award term incentives actually work to motivate contractors to provide and maintain a high level of service performance, and to reduce acquisition transaction costs. In short, the answer depends on the actual investment return to the taxpayers. The effectiveness of award term incentives will undoubtedly depend on the wisdom and skill with which agencies and their contractors plan, design, and manage them. All we can say for certain at this time is that the award term incentive is an interesting experiment.

  See the follow-up article published in February 2002, The Award Term Incentive:  A Status Report.  
  Vernon J. Edwards researches, writes, lectures, and consults about Federal acquisition.  From 1974 through 1986, he was a Federal acquisition official and worked for the U.S. Department of the Air Force, the U.S. Small Business Administration, and the U.S. Department of Energy.  From 1986 until 1998, he was a member of the faculties of The George Washington University's government contracts programs in the School of Business and Public Management and the Law School.
Copyright © 2000  Vernon J. Edwards  



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