Previously, in our continuing series on selling to the government, we looked at contracting methods and the federal government's view of "fair and reasonable pricing." Let's now turn our attention to how the federal government deals with the financial and performance risks in contracting, which it addresses through contract type.
There are three main contract types: fixed-price, cost-reimbursable, and time-and-materials. The government can append incentives for good behavior to fixed-price and cost-reimbursable contracts, but not to time-and-materials contracts.
Fixed-price is the government's preferred contract type because it puts all the risk on the contractor. Fixed-price contracts are completion contracts, under which payment is contingent on delivery of a defined item or service. Because the price is fixed, the private sector takes full responsibility for all costs and the resulting profit or loss.
The government especially favors firm-fixed-price and fixed-price with economic price adjustment (FP-EPA) contracts when procuring commercial items. In theory, this works out great for everybody since commercial items should be the epitome of a well-defined item or service.
Contracting officers sometimes attempt to administer firm-fixed-price contracts as if they were level-of-effort contracts, which are meant for situations where vendors are paid for the amount of work they perform, as opposed to delivery of a specific good or well-defined service. The Department of Defense especially trains its acquisition workforce to favor fixed-price incentive and fixed-price redetermination contracts over cost-reimbursement or time-and-materials contracts wherever possible.
Cost-reimbursement contracts are level-of-effort contracts, mostly of the cost-plus variety -- that is, the government pays vendors their costs plus a "fee," which is how the government often refers to profit. Under level-of-effort contracts, the vendor is paid for work rendered irrespective of whether the intended goal gets accomplished.
The Federal Acquisition Regulation (FAR) bans cost-reimbursement contracts for acquisition of commercial items, so by definition these contracts are to be used when an agency cannot define its requirements with precision, or for when those requirements are out of the ordinary.
An inherent danger of even well-managed cost-reimbursement projects is "scope creep" -- an easy trap to fall into when requirements are inexact. And companies have an incentive to rack up costs despite the safeguards baked into the terms and conditions of cost-reimbursement contracts.
One such safeguard is a cap on vendor profit of no more than 10 percent of the contract's initial estimated cost, unless the work is for research and evaluation, in which case the margin is 15 percent, or for architect-engineer services, in which case it's 6 percent. It's illegal for the government to calculate a vendor's fee as a percentage of actual costs instead of initial estimated costs.
Yet safeguards can't control for some facts of life. Contracting officers extend contracts or raise contract ceilings, and rare is the company witnessing scope creep that does anything except go along or even encourage it.
NEXT: Cost Accounting