Contributors:
John Ford, JD, Senior Consultant, Government Contracting Industry Practice
Susan Moser, CPA, CITP, Government Contracting Industry Practice Leader
The Federal Acquisition Regulation (FAR) describes several contract types and the circumstances in which each type may be used. In this article, we will briefly describe the most common types you may encounter and some of the advantages and disadvantages of those common contract types.
Contracts are generally defined by the way they are priced. In this regard, there are three ways contracts are priced, i.e., fixed price, cost reimbursement and time-and-material. There are various categories of fixed price and cost reimbursement contracts.
Focusing on fixed price contracts, the most commonly used variation is firm fixed price (FFP). As the name implies, the price of the contract is fixed at the time of contract award. What the government owes the contractor does not change based on the actual costs the contractor incurs in performing the contract. This contract type places all the cost risk on the contractor. For this reason, these types of contracts are frequently referred to as “bet the company” contracts. On the other hand, FFP contracts generally require less financial record keeping, and are generally not subject to audit. FFP contracts can be used when the government uses sealed bid procedures when awarding contracts, when the government is acquiring commercial products or services or when the work to be done is well defined so that the contractor can make an informed judgment as to what it will cost to perform the contract.
The second type of fixed price contracts that need to be discussed are fixed price incentive (FPI) contracts. There are two types of FPI contracts, firm target and successive target. We will focus on the firm target variety. When this contract type is used the profit the contractor receives is inversely related to the costs it incurs. There are certain terms that must be understood regarding a FPI firm target contract. These are target cost, target profit, target price and ceiling price. The target cost is the negotiated cost at which the contractor expects to be able to perform the contract. The target profit is the profit the contractor will receive if it performs at the target cost. The target price is the sum of the target cost and target profit. Finally, the ceiling price is the limit of the government’s liability under the contract. It frequently is, but is not required to be, equal to the target price.
Generally, when the contract is complete, the contractor’s actual allowable costs are determined. For these purposes, the cost principles from FAR Part 31 are used to determine the contractor’s costs that are eligible to be included in the final price. If the contractor’s actual costs are less than the target cost, the target profit will be adjusted upward in accordance with an adjustment formula stated in the contract. Conversely, if the contractor’s actual costs exceed the target cost, the target profit is reduced by the adjustment formula. There is no minimum or maximum profit a contractor can receive under a FPI contract.
The advantage of a FPI contract is that the contractor can receive more profit if it performs in an economical manner. Some drawbacks are that this contract type requires the contractor to keep more detailed cost records than an FFP contract and the costs the contractor incurs are subject to audit. This means there can be disputes concerning the allowability of the costs the contractor has incurred.
Turning to cost reimbursement contracts, the most commonly used variation of this contract type is the cost plus fixed fee (CPFF). Under this contract type, the contractor is reimbursed its actual allowable costs, as determined by the contracting officer using the cost principles of FAR Part 31, incurred up to the estimated cost of the contract. The government is not usually obligated to reimburse the contractor for costs incurred in excess of the estimated cost of the contract and the contractor is not obligated to continue performing once it reaches the estimated cost of the contract. The costs incurred by the contractor are subject to audit. Thus, contractors must maintain adequate records to demonstrate that the costs claimed on the contract are allowable costs. Further, this contract type requires the contractor to establish final indirect cost rates for each year in which some contract performance occurred. The contractor must submit a proposal for such rates. The contractor must certify that the proposal does not contain any unallowable costs. If the proposal contains expressly unallowable costs, the contractor may be subject to a penalty.
As the name implies, the fee under a CPFF contract is fixed at a specified dollar amount at the time of award. Thus, it does not change regardless of the costs the contractor incurs. If the contractor incurs more costs than anticipated, the effective profit rate on the contract will go down. Conversely, if the contractor’s costs are less than the estimated cost, the effective profit rate will go up. The government is required to withhold up to 15 percent of the fee pending completion of the contract. The exact amount of the withholding and the basis upon which the fee will be paid.
Like FPI contracts, there is a cost reimbursement incentive fee (CPIF) contract that works similar to the FPI. That is, the incentive fee is adjusted inversely to the allowable costs incurred by the contractor. However, unlike a FPI contract, when a CPIF contract is used, the contract must state a minimum and maximum fee that the contractor can receive.
Finally, there is a cost plus award fee (CPAF) contract. Under a CPAF contract, there usually is a base fee which is fixed and an award fee. The award fee is derived from an award fee pool from which the government awards the contractor a fee. This fee is based on the government’s judgment of how well the contractor performed the contract using criteria stated in an award fee plan. From the contractor’s perspective, a major drawback of a CPAF contract is that there is little a contractor can do to challenge the amount of the award fee because there are only two grounds on which the award fee can be challenged. First, the government did not follow the award fee plan in determining the award fee. Second, the government acted arbitrarily in making the award fee.
This is only a brief discussion of FAR contract types. If you wish more detailed information on this subject, please do not hesitate to contact us.
