The Fixed-Price Incentive Firm Target Contract:  Not As Firm As the Name Suggests

By Robert Antonio

November 2003

The Rule Contract

Table 1 is the pricing structure that Gordon Rule was talking about during our meeting.  For the purpose of discussion in this article, it will be referred to as the "Rule Contract." 

Table 1: FPIF Structure on the Navy Contract Provided by Gordon Rule.

Someone familiar with an FPIF contract will notice what Gordon Rule was talking about.  For those who are not, the following discussion explains the mechanics of an FPIF contract pricing structure.

Mechanics of the FPIF Contract

The FPIF contract includes cost and price points, a ratio, and a formula. They include

• Target Cost (TC): The initially negotiated figure for estimated contract costs and the point at which profit pivots.
   
• Target Profit (TP): The initially negotiated profit at the target cost.
   
• Target Price: Target cost plus the target profit.
   
• Ceiling Price (CP): Stated as a percent of the target cost, this is the maximum price the government expects to pay.  Once this amount is reached, the contractor pays all remaining costs for the original work.
   
• Share Ratio (SR): The government/contractor sharing ratio for cost savings or cost overruns that will increase or decrease the actual profit. The government percentage is listed first and the terms used are "government share" and "contractor share."  For example, on an 80/20 share ratio, the government's share is 80 percent and the contractor's share is 20 percent.
   
• Point of Total Assumption (PTA): The point where cost increases that exceed the target cost are no longer shared by the government according to the share ratio. At this point, the contractor’s profit is reduced one dollar for every additional dollar of cost.  The PTA is calculated with the following formula.

PTA = (Ceiling Price - Target Price)/Government Share + Target Cost

All of these points and shares have an effect on costs, profit, and price.  However, two tools in the structure—the ceiling price and the share ratio—dramatically affect the potential costs, profits, and prices.

For the examples in tables 3, 4, and 5, I use the target cost, target profit, profit rate at target cost, and target price identified in Table 2.  The ceiling price and share ratio will vary according to example.

Table 2: FPIF Structure Used for Examples in Tables 3, 4, and 5.

Ceiling Price

At the ceiling price, the government's liability for cost within the terms of the original contract ends and the contractor pays for all costs above the ceiling price.  The setting of the ceiling price significantly affects the relationship between the government and the contractor once the target cost has been reached.  The example in Table 3 includes 4 different ceiling prices and the same 70/30 share ratio.  Remember, the ceiling price is stated as a percentage of the target cost. 

Table 3: FPIF Target Costs and Profit with Different Ceiling Prices and Constant 70/30 share ratio.

As can be seen, there is no difference in profit for any of the examples where costs are less than the target cost. This is because the ceiling price affects the cost and profit structure somewhere after the target cost is exceeded.  Since the ceiling price is used to determine the PTA, it also results in different PTAs.  Notice the PTAs for each ceiling price.  Prior to the PTA, but after the target cost is reached, the 70/30 share ratio is in effect and the government shares 70 percent of all overruns and the contractor shares 30 percent of all overruns.  Once the PTA is reached, the contractor’s profit will be reduced on a dollar-for-dollar basis up to the ceiling price.  Remember when Gordon Rule said "Look how flat it is?" He was referring to the incentive curve.  The incentive curve reflects the amount of potential profit for each cost level throughout the FPIF structure. The smaller the profit increment as costs increase, the flatter the incentive curve becomes.  The flatter the curve becomes, the closer it approaches a cost plus fixed-fee (CPFF) contract since the fixed-fee on a CPFF remains constant for all levels of costs.  By increasing the ceiling price on an FPIF contract, the government's share in cost overruns and the contractor's opportunity to recover costs is placed at a higher dollar level.  The higher the ceiling price, the flatter the FPIF incentive curve is because it is being stretched in length. 

Share Ratios

To compare the effect of share ratios on an FPIF structure, Table 4 includes 5 different share ratios ranging from 50/50 to 90/10.  As mentioned earlier, the government's share of savings or overruns is the first number in the share ratio.  In Table 4, a simple share ratio structure is used—one with the same share ratio throughout the structure— to analyze the effect of different share ratios.  Share ratios can be complex and can include more than one share ratio. However, to explain the effects of different share ratios, a simple structure is adequate.

Table 4: FPIF Target Costs and Profits with Different Share Ratios.

Prior to the target cost, the different share ratios provide profits based on the contractor’s share of saved costs alone.  Under the 50/50 share ratio, a contractor can increase its profit by $1 million when costs are $2 million less than the target cost because its share is 50 percent of any savings.  On the other hand, with the 90/10 share ratio, a contractor can increase its profit by only $200,000 when costs are $2 million less than the target cost because its share is only 10 percent of any savings.  The message is clear—there is less incentive to reduce costs as the government share increases. 

Once the target cost is exceeded, a contractor with a 50/50 share ratio has its profit reduced quickly below the PTA because it is sharing in half of the cost overruns above the target cost. On the other hand, the reduction in profit is less dramatic for the 90/10 ratio.  In effect, the incentive curve is being flattened below the PTA. Take another look at the overrun structure for the 50/50 and 90/10 share ratios. 

Ceiling Prices and Share Ratios Working Together

Now that you have seen the basics for different ceiling prices and different share ratios, it is time to see how they can work together.  Table 5 illustrates the effect of different share ratios coupled with different ceiling prices.  Compare a 50/50 share ratio with a 115 percent ceiling price structure to that of a 90/10 share ratio with a 135 percent ceiling price structure.  Quite a difference! 

Table 5:  FPIF Target Costs and Profits with Different Ceiling Prices and Share Ratios. 

The 50/50 share ratio and 115 percent ceiling price structure is referred to as a “tight structure” because it places a good deal of cost control incentive on the contractor.  On the other hand, the 90/10 share ratio and 135 percent ceiling price structure is referred to as a “loose structure” because there is less cost control incentive placed on the contractor.  With the combination of a high ceiling price and a high government share, we have flattened the incentive curve significantly. 

Now, with what we have seen so far, let's go back to the contract that Gordon Rule was complaining about in 1976.  To do this, we will compare a moderate FPIF structure with a 70/30 share ratio and 125 percent ceiling price to the Rule contract. 

Table 6:  Moderate FPIF Structure Compared to the Rule Contract.

 

As Table 6 shows, there is quite a difference between our moderate FPIF structure and the Rule contract.  Look at the $95 million dollar cost level.  Here the moderate FPIF results in no profit while the Rule Contract provides a 6.32 percent profit rate and a dollar profit of $6 million.  This difference is caused by the higher ceiling price and the higher government share of overruns on the Rule Contract.  Take a look at the profit rate on costs before the target cost is reached.  It increases more slowly on the Rule contract as costs are reduced below the target cost of $76 million.  Here, the flattening effect of the higher government share on any cost savings is evident.

What Was Gordon Rule Saying?

With the basic mechanics of an FPIF contract under your belt, we can go back to that day in 1976 when Gordon Rule said "What do you see?"  "What do you see?”  "Look how flat it is."  Well, a CPFF is a flat curve.  For example, on a CPFF contract, the share ratio is 100/0 because the government shares all of the cost savings and overruns within the original contract terms.  Additionally, the ceiling price could be infinite if the government wishes.  So, a CPFF contract has a 100/0 share ratio and whatever ceiling price the government is willing to accept. Gordon Rule was claiming that the FPIF example in the "Rule Contract" was, in fact, a CPFF contract.  Was he right?  In Table 7, a CPFF contract structure is compared to the structure of the Rule Contract.

Table 7:  CPFF Contract Structure Compared with the Rule Contract Structure

For the CPFF contract in Table 7, the fixed-fee is set at the same rate as the target profit on the Rule contract—$9.7 million at a cost of $76 million.  Remember that between $64,600,000 and $87,400,000, the share ratio on the Rule contract was 95/5.  So, the CPFF share ratio of 100/0 is quite close to that of the Rule contract at 95/5 between $64.6 million and $87.4 million.  After $87.4 million, the Rule contract converts to a 90/10 share ratio until the PTA which is between $92 and $93 million.  Notice how the percent of fee on costs closely parallels the percent of profit on the Rule contract.  As Gordon Rule emphasized, it is flat—it is nearly a CPFF contract.

Abuses of the FPIF

The Federal Acquisition Regulation (FAR) at 16.403-1 (b) explains that an FPIF contract is appropriate when a fair and reasonable incentive and a ceiling can be negotiated that provides the contractor with an appropriate share of the risk and the target profit should reflect this assumption of responsibility.  The FAR further points out that an FPIF is to be used only when there is adequate cost or pricing information for establishing reasonable firm targets at the time of initial contract negotiation.  Further, FAR 16.401 explains that incentives are designed to motivate contractors to meet government goals and objectives. 

The guidance in the FAR, although general, appears sound.  However, what happens when people and the survival of their programs or their organizations are involved?  Unfortunately, the FPIF can be manipulated and abused by government and/or industry.  It can be used to submit below anticipated cost offers, to hide huge anticipated overruns, or to deceive the uninitiated who only recognize the phrase "fixed-price." 

One Industry’s Experience with the FPIF

In the 1970s, 1980s, and into the 1990s, a series of General Accounting Office (GAO) reports discussed cost overruns on shipbuilding contracts.  For the most part, these reports discussed FPIF contracts.  Table 8 provides a summary of the anticipated cost overruns on most shipbuilding contracts during this period.

Table 8: Anticipated Cost Overruns and Savings Reported on Shipbuilding FPIF Contracts.

As we can see from the table, the majority of the contracts had cost estimates for completion that exceeded the original target costs.  Additionally, the amount of estimated cost overruns dwarfed the amount of estimated savings in each GAO report.  These numbers defy the law of averages.  If we simply look at these results without asking questions, we would declare the FPIF contract type as ineffective. However, there is more to it than that. 

During the 1970s and 1980s, the commercial shipbuilding market was shrinking for U. S. shipbuilders and the U. S. Navy became the “sole-customer” for their work.  At the same time, the Navy emphasized competition on its contracts and placed more emphasis on price in making decisions for contract awards.  Price became more important because of tight budgets.  The industry, recognizing that its commercial market had dried-up, placed survival above profit and cut prices in a frenzy of low-ball offers. Since the government was the sole customer, it had pricing power over its contractors.  According to the GAO

One shipbuilder said the Navy has sent a message that ship contracts will be awarded based on price and the response has been to bid aggressively. ¹

How aggressive was the bidding?  Here is one example.

Navy analyses indicate that both contracts were awarded at a substantial cost risk to the government based on comparisons of the proposed prices with the Navy's estimates.  In both of these awards, the Navy believes that there is a strong possibility that the contractors will exceed ceiling prices. ²

Yes, under these two contracts target cost was not the issue.  The Navy concluded that the contractors offered to work at a loss somewhere beyond the ceiling price.

Beware of the Hidden Target Cost

If an industry or a contractor is trying to survive in a competitive environment, how might it approach the FPIF.  As we have seen, contractors will bid below cost when they believe it is in their interest.  Does the FPIF provide an opportunity for a contractor to offer a very low price, expect a very large overrun, and hope for a small profit?  Yes, it does.  Table 9 provides a theoretical example that includes an FPIF with a 95/5 share ratio and a 135 percent ceiling price.  Included in the table is a "proposed target cost" which is the official offer amount that the contractor submits to the government.  In the second column, there are a range of the contractor's real goals for its target cost.

Table 9: Example of a Potential Contractor's View of a FPIF.

Assume that the contractor sets a goal of a 4 percent profit on costs.  From past experience, the contractor expects that the government will be willing to negotiate a 95/5 share ratio, a 135 percent ceiling price, and a 10 percent profit rate at target cost.  The contractor proposes a target cost of $100,000,000 but is really focusing on the 4 percent profit amount.  At that profit rate, the contractor's actual target cost goal is $129,807,000.  The government determines that the offer is fair and reasonable and negotiations are completed.  At the time of agreement on the pricing structure, $100,000,000 is the contractual target cost and the contractor's actual goal is $129,807,000 for a target cost.  In effect, the contract is negotiated with nearly a 30 percent cost overrun and a 4 percent profit.

A Government Incentive to Underestimate Costs

Does a government organization ever have an interest in understating the cost of an item?  The President's Blue Ribbon Commission on Defense Procurement, popularly known as the Packard Commission, gave us the following answer.

Once military requirements are defined, the next step is to assemble a small team whose job is to define a weapon system to meet these requirements, and "market" the system within the government, in order to get funding authorized for its development.  Such marketing takes place in a highly competitive environment, which is desirable because we want only the best ideas to survive and be funded.  It is quite clear, however, that this competitive environment for program approval does not encourage realistic estimates of cost and schedule.  So, all too often, when a program finally receives budget approval, it embodies not only overstated requirements but also understated costs. ³

If the government has an interest in underestimating the cost of a system, it can use an FPIF to its advantage by simply loosening the pricing structure of the FPIF contract.  Let's look at an actual example—the original contract for the Trident submarine awarded in 1974.

Table 10: Fixed-Price Incentive Pricing Structure for the Trident Submarine.⁴

As can be seen, the contract had a 95/5 share ratio and an incredible ceiling price of 152 percent of target cost.  Here is what Gordon Rule had to say about this pricing structure

When the Navy negotiates a 95/5 share above target cost for the first 26 million of overrun of target, the target cost figure is patently phoney.  Moreover, when the Navy negotiates a 95/5 share and then also a 152% ceiling, the target cost figure is patently ridiculous.  First priority for the future must be the negotiation of more reasonable target costs for our FPI shipbuilding contracts and if the budget has to be changed, then change it. ⁵

Once a system receives budget approval with an understated cost, the government must find a way to contract for it at that underestimated cost.  The FPIF provides the opportunity in two ways. First, it allows the government to hide expected overruns at the time the contract is awarded. Or, in Gordon Rule's words, it allows the government to include "an obvious overrun of target cost built in." ⁶  Second, the term "fixed-price" can be used to disguise a cost-reimbursement contract.  For example, in regard to the Trident contract, the Commander of the Naval Ship Systems Command, explained ⁷

People said, "That's a CPFF [cost-plus-fixed-fee] contract under another name," and I said, "Right.  You want to call it that, do what you like.  Call it what you please." ... I suppose it's a matter for some slight chagrin that what really ought to have been a CPFF contract turned out to be something else, or to have a different label on it, but I don't feel bad about it. ⁸

Some Final Thoughts

Does the FPIF contract have a place in federal contracting?  I think it does when it is used as it is intended.  However, it can and has been abused.  In testing an FPIF structure, there are a number of things I ask.  Here are several.

• Is the government's share of savings significantly lower below the target cost than its share of losses above the target cost.  For example, is there a 50/50 share ratio below the target cost while a 95/5 share ratio exists above target cost.  This alerts me to the possibility that the real target cost exceeds the negotiated target cost in the contract. 
   

• Is the ceiling price above 135 percent of target cost?  Although a 135 percent ceiling price is generous, anything above it is excessive.
   

• Does the share ratio flatten out around the target cost for an extended period?  For example, is there a share ratio of 95/5 or 100/0 from 10 percent below target cost to 10 percent above target cost?  This effectively converts the extended part of the FPIF structure to a cost plus fixed-fee contract. 

If I do identify a suspicious FPIF structure, I turn to the facts surrounding the negotiation of the target cost.  For example,

• Is the government's budget for the item unrealistically low? 
   

• Does the government have pricing power over the contractor?  In short, can the government dictate the contractor's price because of market conditions? 
   

• Is the contractor in survival mode or is the contractor trying to gain a foothold in a program area?
   

• If there was a final proposal revision, did the contractor's price drop substantially?

¹ Navy Contracting: Cost Overruns and Claims Potential on Navy Shipbuilding Contracts, GAO/NSIAD-88-15, October 16, 1987, p. 9
² Ibid
³ President's Blue Ribbon Commission on Defense Procurement, Final Report, June 30, 1986, p. 45.
⁴ J. Ronald Fox and Mary Schumacher, "Trident Contracting (C): Negotiating the Contract," John F. Kennedy School of Government, 1988, pps 6 and 7.
⁵ Hearings before the Committee on Armed Services, United States Senate, 94th Congress, Second Session, Part 8, Shipbuilding Cost Growth and Escalation, p. 4658.
⁶ Fox and Schumacher, p. 8.
⁷ In 1976, the Naval Ship Systems Command was renamed the Naval Sea Systems Command.