On March 4, 2016, we posted a blog, “The Inherently Evil Cost-Type Contracts” which discussed the Government view of cost type contracts. More specifically, the risks to the Government when using a cost-type contract (typically cost-plus fixed-fee, but also including cost-plus incentive fee or CPIF). From a contractor risk perspective, the evil-twin of the CPIF contract is a Fixed-Price Incentive Firm Target (FPIF) contract because of the major difference in contractor obligations to perform as a function of costs incurred. Typically cost type contracts only require contractor performance up to the contract limitation of funds (LOF); as noted in FAR 16.307(d)(1), the completion form of a cost-type contract requires the contractor to complete and deliver the specified end product within the estimated cost (LOF). However, if the specified end product can’t be performed/delivered within the estimated cost, the government can require more effort provided the Government increases the estimated cost. A contractor is no longer required to perform once costs incurred equal the LOF; hence, the Government assumes the risk of cost overruns if the Government wants to compel delivery of the end-product.
Although FPIF contracts have most of the administrative requirements of a CPFF contract (i.e. the requirement for an adequate accounting system which measures allowable contract costs using FAR Part 31 Cost Principles), FPIF contracts are categorically a fixed-price contract type wherein the risks of cost overruns shift to the contractor. In particular, and in stark contrast to a cost-type contract, a FPIF contract requires the contractor to deliver the end-product regardless of the cost to meet the contractual requirements. FPIF contracts provide some contractor-risk buffer by establishing a target cost, target profit, and target price along with contractual share-ratios for cost underruns and cost overruns; hence, some protection from performing at a loss when actual costs exceed original estimates. However, that protection stops at the point that contractor costs incurred equal the ceiling price (an amount which is stated as a percentage of the target cost).
From a historical perspective, one notable FPI contract (involving huge cost overruns) involved a Navy contract with a ceiling price (including certain options) of approximately $24 million. To deliver the end-product, the contractor incurred approximately $81 million, and the contractor sought relief by unsuccessfully challenging the legality of the contract type (at the time, there was a $10 million limitation on fixed price research and development contracts). Had this been a cost-type contract, the contractor would have stopped performing once its actual (allowable) costs hit $24 million; unfortunately, that was not the case, and the contractor absorbed a $57 million loss along with its unallowable legal costs (challenging the contract type).
More recently, and somewhat widely published in the media, the contractor’s financial statements, and in two GAO (Government Accountability Office) reports, the KC-46 Tanker Program is another reminder of the contractor risks on an FPIF contract involving development costs and low rate of initial production (LRIP). In GAO-13-258, February 27, 2013, it was reported that the KC-46 tanker modernization contract (in development to convert a commercial derivative aircraft into an aerial refueling tanker) could be very illustrative to help guide and improve future defense acquisition since it involved an FPIF development contract. The 2011 FPIF contract provided contractor incentives to control costs while limiting the government’s financial liability (i.e. the FPIF ceiling price of $4.9 billion). Defense officials believe that a fixed price development contract is appropriate because the KC-46 development is considered relatively low risk mostly mature military technologies onto a well-defined commercial derivative aircraft. Further, the 2013 GAO report stated that the KC-46 program was running very close to its budget and schedule; however, there was a concern that both the government and the contractor estimated that the development cost would exceed the $4.9 billion FPIF ceiling.
Fast-forward to April 2016, report GAO-16-346, “Challenging Testing and Delivery Schedules Lie Ahead”. At this point in time the government estimates total development cost of $6.324 billion whereas the contractor estimate is $5.59 billion; in any case, measured against the FPIF ceiling price of $4.9 billion, the contractor will be absorbing a financial loss ranging from $766 million to $1.5 billion. Additionally, per the government, failures to achieve delivery schedules could result in other financial penalties including withholding progress payments and downgrading the contractor performance assessment ratings. Less than amusing, the government continues to down-play its financial risk, almost gloating over the fact that it negotiated a FPIF contract which will ultimately save the government as much as $1.5 billion. Unfortunately, that savings is nothing more than a contractor absorbing the increased development costs on a “relatively low-risk development contract”.
It should be obvious to all government contractors that risk is a matter of perspective. Lastly, proceed with caution when contemplating a fixed price development contract where there is far too much history, which shows that the financial winner is always the government.
Mike Steen is a Emeritus Advisor with Redstone Government Consulting, Inc. and a specialist in complex compliance issues to include major contractor cost accounting & business system regulations, financial compliance, resolution of DCAA audit issues, Cost Accounting Standards application, litigation support, and claims preparation. Prior to joining Redstone Government Consulting, Mike served in a number of capacities with DCAA for over thirty years, and upon his retirement, he was one of the top seven senior executives with DCAA. Mike Served as a Regional Director for two DCAA regions, and during that time was responsible for audits of approximately $25B and 800 employees. In October 2001, he was selected for the Senior Executive Service and in 2006 he received the Presidential Rank Award. During Mike’s tenure with DCAA, he was involved in conducting or managing a variety of compliance audits, to include cost proposals, billing systems, Cost Accounting Standards, claims, defective pricing, and then-evolving programs such as restructuring, financial capability and agreed-upon procedures. He directly supported the government litigation team on significant contract disputes and has prepared and presented various lectures and seminars to DCAA staff and business community leaders. Since joining Redstone Government Consulting in June 2007, Mike has developed and presented training and seminars on Government Contracts Compliance to NCMA, Federal Publications Seminars and various clients. Mike also is a prolific contributor of written articles to government contracting publications, as well as to our own Government Insights Newsletter. Mike also serves as the director of our training service offerings, with responsibilities for preparing and developing course content as well as instructing our seminars to clients and general audiences throughout the U.S. Mike also serves as a faculty instructor for the Federal Publications Seminars organization. Education Mike has a BS Degree in Business Administration from Wichita State University. He is also a graduate of the DCAA Director’s Fellowship Program in Management, and has a Masters Degree in Administration from Central Michigan University. Mr. Steen also completed a number of OPM’s management and executive development courses.