Overview of Contract Types and What Government Contractors Need to Know

Have you ever thought about the different government contract types and how it impacts your company’s bottom line: profit? Does it really matter what type of government contract that you have? Do you know what oversight there may be required of a particular contract type? Knowing and preparing for each type of contract, prior to accepting any government contract, will directly impact your administrative cost and profitability as well as the amount of government oversight. In this article, I will discuss the contract types and how significantly different they are, and your risk associated with these contract types.

Government Contract Types

Although the Federal Acquisition Regulation (FAR) Part 16 (Types of Contracts) describes several separate contract types (see below), FAR 16.101(b), groups contracts into two broad categories:

1. Fixed-priced contracts (FAR Part 16.2), and

• Firm Fixed Price (FFP)
• Fixed Price Incentive Fee (FPIF)
• Fixed Price with Economic Price Adjustment (FP/EPA)
• Fixed Price Level of Effort Contract (FP-LOE)

2. Cost-reimbursement contracts (FAR Part16.3)

• Cost Plus Fixed Fee (CPFF)
• Cost Plus Award Fee (CPAF)
• Cost Plus Incentive Fee (CPIF)
• Cost Sharing (CS)

Other Contract Types are:

• FAR 16.4 – Incentive Contracts (applied to Fixed or Cost Type Contracts)
• FAR 16.5 – Indefinite Delivery Contracts (for making multiple fixed or cost type awards)
• FAR 16.6 – Time & Materials (fixed and cost-plus characteristics), Labor Hour (T&M variant), and Letter Contracts (preliminary contractual instruments)

Fixed-Priced (FP) Contracts

A FP contract provides for a firm price that is not subject to any adjustment based on the contractor’s cost experienced in performing the contract. FP contracts are required for acquiring commercial products/services or suitable when the contract performance risk is low (known service or product and the risk of unsuccessful contract performance is low). There is a minimum administrative/accounting burden placed upon the contracting parties. For example, there is no contractor requirement for having an “adequate” accounting system unless the contract requires progress payments. The government and contractor agree to a price; the government obligates funds; and after contract signing, is primarily concerned with the contractor’s performance and schedule. Contract billings are a result of service or product delivery or milestones, not the incurrence of contractor cost unless progress payments are applicable. If a contractor can legitimately reduce its costs during contract performance, the amount of profit increases. However, the opposite is true as well. If it takes more costs to complete contract performance, the amount of profit decreases. That is why the contractor has the maximum risk on a FP contract.

Cost-Reimbursement Contracts

Cost-reimbursement contracts are often referred to as “cost-plus” (CP) types of contracts that provide for payment of allowable incurred costs. CP contracts are suitable for efforts that have higher performance risk (work is to be defined and higher risk of unsuccessful contract performance) such as research and development, new technology. CP contracts establish an estimate of total cost for the purpose of obligating government agency funds and establishing a ceiling that the contractor may not exceed (except at its own risk) without the approval of the contracting officer. The government reimburses the contractor through monthly billings of the costs. CP contracts are deemed to be most advantageous to the contractor since the government reimburses for contractor allowable costs. One way to look at this is:

CP CONTRACT PRICE = ALLOWABLE COSTS + FEE

Since the government is bearing the higher performance risk where it is reimbursing contractor allowable costs, the negotiated fee is generally lower than that of a FP contracts. CP contracts come with more government oversight enforceable through contract clauses. CP contracts will have the government audit clause (FAR 52.215-2, Audit and Records-Negotiated) which will provide the government audit oversight of contractor records as well as the Allowable Cost and Payment clause (FAR 52.216-7) which requires final annual indirect costs rate submissions (FAR 52.216-7(d)(2)). Further, before a contractor can be awarded a CP contract, the contractor has a requirement of having an “adequate” accounting system (FAR 16.301-3(a)(3)). The result of being awarded CP contracts is that you need an accounting infrastructure and training to your employees throughout the organization prior to accepting this type of contract.

Government contracts can have FP and CP contract characteristics. For example, a time and materials (T&M) contract has a FP characteristic with a fixed rate for labor hours applied to the hours used in contract performance and CP characteristic in reimbursing materials at actual costs. There is government oversight on the T&M contract hours to verify actual hours in the contractor’s accounting system as well as evaluation of the actual material costs. Profit is built into the fixed labor rate. Since contractors are reimbursed actual contract costs on CP contracts, the resulting fee on these contracts is generally lower than FP contracts. At the other extreme, on FP contracts the contractor is assuming the risk and the profit is generally higher.

Contractors should understand the contract types, for what products or services they are typically used, and the requirements of each. By understanding the requirements for the contract type you can ensure you have the adequate policies procedures and controls in place at your organization prior to signing a government contract. Contract efforts can also evolve. What you may have at the start of one contract may transition into another contract type. For example, a CP contract evaluating new technology can transition in future contracts to a FP effort at implementation of that new technology. So, it really does matter what government contract type you have and understanding that is important, so you are not surprised by what it does to your bottom line.

Redstone Government Consulting, Inc, with its experienced compliance and accounting consultants can assist contractors through the maze of government regulations and by providing training. Make us part of your team!