Documents
Resources
Learning Center
Upload
Plans & pricing Sign in
Sign Out

Samples of Types of Government Contracts

VIEWS: 1,285 PAGES: 4

									G OV E R N M E N T C O N T R AC T I N G

BY JOHN E. MCCORMICK

Do You Recognize the Differences Among Types of Government Contracts?
The contract type (e.g., fixed-price, cost-reimbursement) is a key consideration in any decision-making because the type of contract may determine the financial impact of the decision. For example, the financial effect of schedule changes varies widely, depending on the type of contract. This article focuses on how the type and attributes of government contracts must be considered to support successful financial performance for both the government and the contractor. Such information will be helpful to new project managers and others responsible for contract performance, as well as to more experienced managers who may benefit from a review of the basics of government contracting. The Federal Acquisition Regulation (FAR) allows a wide variety of contract types, based on the financial arrangement. Broadly speaking, these include fixed-price, cost-reimbursement, time-and-materials (T&M), and letter contracts. The various forms of fixed-price contracts and cost-reimbursement contracts are shown in the sidebars on page 45. According to FAR 16.104, the federal government professes a preference for firm-fixed-price type contracts. Contracts also may be distinguished on the basis of their ordering or execution. Under a traditional contract, the contractor performs a specific statement of work for a specified price or cost. More common today are indefinitedelivery types, which may be for definite or indefinite quantities or the requirements of the acquiring activity. Indefinite-delivery contracts are frequently awarded on a multiple-award basis, leading to continued competition at the task-order or delivery-order level. In addition, the government issues basic agreements and basic ordering agreements. These types of “contracts” or their orders are similar to fixed-price and cost-reimbursement types. A comparison of the outcomes in firm-fixed price, costplus-fixed fee, and T&M contracts will demonstrate how operational decisions or events affect the financial performance based on the financial type of contract. The selection of contract type requires the consideration of many factors, as detailed in FAR 16.104. According to FAR 16.102 (b), when necessary, it is permissible to combine contract types (i.e., firm-fixed price and cost-plus-fixed fee). The general financial arrangement
44 s Contract Management / July 2004

(e.g., fixed-price versus cost-reimbursement) should result in a fair distribution of the risk, considering various factors such as urgency, type, and complexity of the requirement. Other factors may influence the selection of contract; if a contract is to extend for a long term during a time of economic uncertainty, a fixed-price with economic price adjustment contract might be more appropriate than a firm-fixed-price contract (FAR 16.104 [f]). Analogously, indefinite-delivery contracts would be appropriate when the exact times or quantities of the supplies or services required are not known at the time of contract award (FAR 16.501–2[a]).

Considerations for Fixed-Price Contracts
Fixed-price contracting is an attempt, to the degree possible, to decouple costs from revenue. In a firm-fixed-price contract, the contractor’s costs of performance do not affect its revenue. The same is true to a lesser degree for the other types of fixed-price contracts. This means that the contractor must be very vigilant with respect to cost and schedule issues in its performance. For example, a delay may dramatically increase the costs of completion, even if the schedule slippage is caused by or excused by the customer. Such a delay may result from the customer’s inability to provide required materials or documentation in a timely manner, or a customer’s delayed approval of an interim deliverable that is needed before proceeding with performance. In the meantime, the contractor may incur expenses to maintain a temporarily unproductive labor force, as well as the facilities necessary for its performance. Conversely, if the contractor can successfully compress the schedule, it may dramatically improve the contract’s financial performance (i.e., profit) by being able to divert its labor force and facilities to other funded projects earlier than anticipated. Generally, payments are made in exchange for the delivery and acceptance of specific supply items or products of services (i.e., for deliverables rather than for effort expended or costs incurred during a period of time). Therefore, invoicing is generally event-driven rather than periodic. A deliverable need not necessarily be the “end item” of the contract. It may be a milestone on the way to the end

G O V E R N M E N T

C O N T R A C T I N G

item, for example, the delivery of a prototype under a contract for the development and implementation of an operational system. Milestones payments are ordinarily preferable to “progress payments” because they are payments earned in exchange for the acceptance of an item of value. In contrast, progress payments are made on the basis of incurred costs, which increase the administrative (reporting) burden and are provisional in nature. In a fixed-price environment, the contractor bears the greatest risk and has the maximum incentive to control costs: the profit motive. Although the fixed-price contract shifts the financial risks from the government to the contractor, the need for a successful outcome is not shifted. This risk is often overlooked. Although the contractor assumes some of this risk, the government and the government project manager retain the lion’s share of the risk for a successful outcome. Government managers, like their industry counterparts, do not advance their careers by presiding over failed projects. For a successful project, it is imperative that the government and the contractor have a clear and common understanding of the requirements. This requires a detailed statement of work. In the case of a performancebased contract, the performance-level and the service-level agreements should be clearly and specifically stated. A clear, shared understanding of the contract requirements will greatly reduce the dangers of “scope creep” for the contractor, as well as reduce the likelihood of disputes during the performance of the contract. In a fixed-price environment, scope creep may significantly erode the contractor’s profit. This is not just the contractor’s problem. An underperforming contract does not reflect positively on the contractor’s project manager. To assuage his superiors, the government project manager may begin to divert focus from delivering a quality product or service to improving the financial performance of the contract, for example, by reducing efforts in another area to offset the costs of the out-of-scope work. Such an event almost always has a negative effect on the government’s project manager because the business relationship shifts from being one of partners to one of adversaries. The administrative burden required by a fixed-price contract is normally minimal. Detailed reporting of costs or labor efforts should be avoided in fixed-price contracting unless there is some obvious need, such as under a fixed-price incentive. In a firm-fixed-price contract, the cost and labor expended are better left undisclosed because the disclosure of this information to the buyer is an invitation to help “manage” the process. In addition, the capture and reporting of the data will necessarily drive up costs to the contractor and the price to the government.

Fixed-Price Contracts
s s s s s

Firm-fixed price Fixed price with economic price adjustment Fixed-price incentive Fixed price with prospective price redetermination Fixed ceiling price with retroactive price redetermination Firm-fixed price, level of effort term

s

Cost-Reimbursement Contracts
s s s s s

Cost Cost sharing Cost-plus-incentive fee Cost-plus-award fee Cost-plus-fixed fee

Considering Cost-Reimbursement Contracts
In cost-reimbursement contracting, cost drives revenue. Invoicing is done on a periodic basis, for example, monthly

based on the costs incurred during the period. There is no revenue without cost. Cost reduction results directly in revenue reduction. Lost revenue may be recouped, of course, by adding tasking through contract modification. In a cost-plus-fixed-fee contract, the percentage of profit, but not the amount of fee, increases when the performance is accomplished at a reduced cost. In award-fee or incentive-fee contracts, the reduction of costs may increase the amount and percentage of fee or profit. In cost-reimbursement contracting, the financial risk is ordinarily limited to the fee. Caps on indirect expenses or other costs may expand this risk to cost items. Cost-plusfixed-fee contracts may be either “completion” or “term.” Under a completion type, the contractor must deliver and the customer must accept the delivery in accordance with the contract before the contractor is entitled to the stated fixed fee. Under a term type, the contractor must provide the stated level of effort during the period of performance to be entitled to the fixed fee. In either case, it is important to consider what the government is actually purchasing. The cost-reimbursement contract bears the heaviest administrative burden of the contract types. For example, the monthly reporting normally requires very detailed information with respect to costs and effort. The contractor will be required to propose the types and quantities of
July 2004 / Contract Management s 45

G O V E R N M E N T

C O N T R A C T I N G

labor intended with some degree of specificity. Absent some contract-specific requirement, the “labor mix” actually used in performance may vary, unlike the performance of a T&M contract. The contractor is confined to the contract’s cost limitation rather than to the particular number of hours of the labor categories specified in its proposal. Additionally, unlike T&M contracts, there is no prohibition of fee on materials or other direct costs (ODCs) in costreimbursement contracts. The contractor’s duty is to provide the labor and ODCs to accomplish the statement of work within the cost limitations of the contract. The statement of work in a cost-reimbursement contract is generally broader or more ambiguous than that of a fixed-price contract. This situation often leads to the accomplishment of work that is within the general scope of the contract but that is not contemplated in the contractor’s proposal. The contractor may include this effort in its monthly invoice and be compensated. The government and contractor must be aware of and sensitive to scope creep. It is possible that the project managers may gradually extend contract scope through a series of small steps, which may raise billing concerns. A more likely scenario is one in which the contract’s cost is expended on efforts never contemplated by the RFP or proposal but that are technically within the scope of the contract, to an extent that some essential work goes undone.

The T&M contract is low risk, similar to a cost-plusfixed-fee contact (FAR 15.404–4(d)(1)(ii)(C)). The financial risk is normally limited to the contractor’s ability to provide the requisite skills at the rated negotiated. Another risk that is often overlooked is unanticipated interruptions in the contractor’s performance during which it is unable to bill against the contract. This situation could be the result of inclement weather, lack of access to the government facility, or another factor outside the control of the contractor. Although these factors could justify an “excusable delay” in performance, they do not make up for the lost revenue. For this reason, the contractor should seek some flexibility in the contract terms that permits it to make up for lost time and that protect its revenue stream.

Profit vs. Fee
The terms profit and fee are not the same thing (FAR 15.404(a)(1)). Profit is the amount left after collecting revenue and paying all expenses (allowable and unallowable). The regulations do not limit the amount or percentage of profit that may be realized under a fixed-price contract. Fee is the amount negotiated in excess of allowable costs. It is not a percentage, although the finally negotiated amount may often be expressed as a percentage. Cost plus percentage of cost contracts are specifically prohibited by FAR 16.102(c). There are guidelines and statutory limitations on the amount of fee in cost-reimbursement contracts.

Considerations for Time and Materials Contracts
In T&M, or labor-hour, contracting, revenue is mostly driven by the direct labor hours expended in performance of the statement of work. Materials or ODCs may produce some revenue as well, but they may not bear any fee or profit (see FAR 16.601(a)(2), FAR 16.601 (b) (3) (iii)). All profit is realized from charges for direct labor. This type of contract should be used only when the contracting officer determines that it is not possible to estimate accurately the extent or duration of the work or to anticipate the costs with any reasonable degree of confidence [FAR 16.601(b)]. In a T&M contract, the government is buying the contractor’s direct labor rather than a specific deliverable or outcome. In effect, the “deliverables” are the direct hours. This allows invoicing to be done on a periodic basis, for example, monthly. Because the government is buying hours of labor, it normally issues the contract by ordering a specified number of hours of specific labor categories. Normally, the contractor is limited to the number of hours ordered for each labor category rather than being permitted to “mix and match” labor categories within the funded amount. This frequently requires repeated modifications in hours and dollars as the performance evolves. Some contracting shops have begun issuing contracts that allow the contractor and the government program manager to mix and match the hours as long as they stay within the funded dollar amount, thus providing greater flexibility to the operations personnel and reducing the administrative work load.
46 s Contract Management / July 2004

Risk Management and Mitigation
All contracting involves some risk. This article focuses on financial risk, but each of the following may involve business risks as well:
s s s

Inadequate specificity of the statement of work, Vagueness or flexibility in the schedule, and Undefined or vague acceptance criteria.

These conditions indicate higher risk in fixed-price contracting than in flexibly priced contracts. In a fixed-price environment, any one of these three conditions may lead to substantial schedule slippage and increased costs for the contractor, making it imperative that the contractor and government clearly commit on each. Often the contractor is content to get a comprehensive understanding of the statement of work but overlooks the schedule and acceptance criteria issues. Unfortunately, if the performance is delayed, the contractor may be required to maintain expensive personnel resources to ensure performance. Likewise, lack of clear acceptance criteria may lead to unexpected delays in the acceptance of deliverables, which drives up the contractor’s cost while delaying invoicing. These conditions can have a very negative effect on T&M and cost-based contracts as well. Although the

G O V E R N M E N T

C O N T R A C T I N G

contractor has no duty to continue work in the absence of sufficient funding and may access additional funds through modifications, these conditions can lead to significant customer satisfaction issues. Careful proposal preparation and a well-developed project plan can greatly mitigate the performance risk of the government and the contractor. It should also greatly reduce the contractor’s financial risk. The development and implementation of these two items will cause the contractor to have a more profound understanding of what is required by the contract. This will enable it to more easily achieve a common understanding with the customer (“buy-in”) and sensitize both to scope creep. Additionally, it will more readily expose any holes in the requirement or solution.

Revenue and Profitability Issues
That revenue and profitability are important issues to the contractor is self-evident. What may not be so obvious is their importance to the government. The FAR recognizes the importance of profit as a motivator for the contracting community (FAR 15.404–4(a) (2) and (3)). Under everincreasing budgetary constraints, the operational personnel may lose sight of this fact, but a financially underperforming contract substantially increases the risk of performance problems because the contractor personnel may lose some focus as they attempt to improve the financial performance. The contract provides the context for the performance. The type of contract affects the revenue and profit derived from the performance. For example, in a fixed-price environment, successfully compressing the schedule will result in realizing the same revenue but with lower expenses (e.g., labor, facilities, ODCs) thereby increasing profit. In the cost-reimbursement environment, however, compressing the schedule generally means lower expenses and therefore lower revenue. Under flexibly priced contracts, the contractor should strive to avoid unbillable time. For most government contractors, it is possible to manage vacation, holiday, and, to a lesser extent, sick time to minimize their negative effects on revenue. This may be done by preparing in advance for inclement weather or by making up missed hours. Wherever possible, negotiate unnecessary constraints on performance out of the contract. For example, a requirement that restricts the billable time to no more than eight hours a day and forty hours a week will severely limit the contractor’s ability to make up for lost time (and, therefore, revenue). If such a restriction is not essential, it should be removed from the contract. Every contract has limitations with respect to time (period of performance), work allowed (scope or statement of work), and funding (money). The effects of these limitations vary greatly with the type of contract. The project manager must always consider how the limitations of the contract will affect performance. For example, under a fixed-price contract, it may not make any difference if

some of the work was performed before the start of the period of performance, whereas under a T&M contract, such efforts are not billable. This is an example of why it is important to understand that the type of contract provides the context for the contractor’s performance. Remember, the contract type provides the context for any issue arising under it. The contract type should be a primary factor in any contractual analysis, performance assessment, or decision-making process. It is not too much to say, that the type of contract will frequently determine exactly what is being bought and sold. For example, the contractor’s duty under a cost-reimbursement contract is markedly different from its duty under a fixed-price contract, even though the specifications of the statements of work are identical. When confronted with an issue arising under a contract, a good first question is, “What’s the contract type?” CM
About the Author

JOHN E. MCCORMICK is counsel for federal contracts and contracts manager for Electronic Data Systems Corporation (EDS) in Herndon, Virginia. He is a member of the NCMA Tysons Corner Chapter. Send comments on this article to cm@ncmahq.org.

I Want Copies of That Article!
Want numerous articles reprinted from CM magazine in high-quality, full-color formats? It’s easy! Just call or e-mail The Reprint Department, a professional service CM offers to provide you top services. For pricing information, call Cheryl Keener at 717/481-8500, or fax your request to 717/481-7677.

July 2004 / Contract Management s 47


								
To top