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Problem of the Day--Pricing Contingencies

Don Mansfield

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Assume that you are pricing a firm-fixed-price contract using cost analysis. The prospective contractor has included a contingency of $100,000 in its cost proposal of the type described at FAR 31.205-7(c)(1):

Quote

Those that may arise from presently known and existing conditions, the effects of which are foreseeable within reasonable limits of accuracy; e.g.,anticipated costs of rejects and defective work. Contingencies of this category are to be included in the estimates of future costs so as to provide the best estimate of performance cost.

There is a 90% chance that this contingency will occur. If it occurs, there's a 100% chance it will cost $100,000.

The prospective contractor can take Precaution A, which will cost $50,000. If the contingency occurs, Precaution A would reduce the chance of the contingency costing $100,000 to 30% (there would be a 70% chance the contingency would cost $0).

The prospective contractor can take Precaution B, which will cost $75,000.  If the contingency occurs, Precaution B would reduce the chance of the contingency costing $100,000 to 10% (there would be a 90% chance the contingency would cost $0).

The prospective contractor is free to take Precaution A, Precaution B, or do nothing. 

What amount for this contingency would you allow in the contract price?

You may ask for more facts if you'd like or ask to make an assumption. Do not fight the hypothetical. Enjoy.



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It looks to me like an expected value problem.

In the scenario with no precaution the expected value is the chance of the contingency occurring, times the expected value if it does occur, so .9*(1*100,000)=90,000.

Precaution A gives an expected value of 50,000+(.9*(.3*100,000))=77,000

Precuation B gives an expected value of 75,000+(.9*(.1*100,000))=84,000

Since the scenario with the lowest expected value is Precaution A, I would allow the contractor to price the contingency at a maximum of $77,000.

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But wait. If the contractor did not price Precaution A or B into its FFP, then those hypothetical precautions are meaningless. Under Precaution A, you should allow $77,000 + $50,000 = $127,000. You need to allow the contractor to price in the cost of risk mitigation.

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The total of $77k includes the $50k to pay for Precaution A, plus the expected value of the contingency, which is $27k (90% x 30% x $100k). It is interesting that there is no single scenario in which the contractor will actually experience a cost of $77k. Either they will pay the $50k for precaution A and then contingency either won't occur, or will cost $0, in which case their total cost will be only $50k, or they will pay the $50k and have bad luck anyway and still experience the $100k contingency, in which case their cost is $150k. Only if they run the scenario multiple times will they all average out to $77k in the long run.

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Have any of ye land lubbers had experience using this method? Would a contractor actually be willin' to accept eatin' the $73k doubloons in Scenario A and $91k in Scenario B?  I may be cynical due to me sole-source encounters with dodgy contractors.

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5 hours ago, Contracting Pirate said:

Have any of ye land lubbers had experience using this method? Would a contractor actually be willin' to accept eatin' the $73k doubloons in Scenario A and $91k in Scenario B?  I may be cynical due to me sole-source encounters with dodgy contractors.

The contractor doesn't have to eat the loss. They could buy insurance, right? 

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On 12/4/2018 at 6:44 PM, Don Mansfield said:

Winner!

From the seller's perspective, at a 90% probability, I'd consider it a sure thing and price it assuming 100% of the costs would be incurred.

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21 hours ago, lotus said:

From the seller's perspective, at a 90% probability, I'd consider it a sure thing and price it assuming 100% of the costs would be incurred.

That's exactly what the seller did in the problem.

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