1. McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter 15 Methods of Compensation 15-2

3. Key Concepts Introduction to compensation agreements Contract cost risk appraisal »Technical risk »Contract schedule risk General types of contract compensation agreements »Fixed price contracts »Incentive contracts »Cost-type contracts 15-3

4. Key Concepts Specific types of compensation agreements »Firm fixed price contracts »Fixed price with economic adjustment contracts »Fixed price redetermination contracts »Incentive arrangements »Cost plus incentive fee arrangements »Cost plus fixed fee arrangements »Cost plus award fee »Cost without fee »Cost sharing »Time and materials »Letter contracts and letters of intent Considerations when selecting contract types 15-4

5. Introduction to Compensation Agreements The compensation arrangement determines: »Degree and timing of the cost responsibility assumed by the supplier »Amount of profit or fee available to the supplier »Motivational implications of the fee portion of the compensation arrangements 15-5

6. Example 1: Low Level of Uncertainty Potential OutcomesSellers CostSellers PriceSellers Profit Low$950,000$1,100,000$150,000 Most Likely1,000,0001,100,000100,000 High1,050,0001,100,00050,000 Firm Fixed Price Contract 15-6

7. Example 2: High Level of Uncertainty Potential OutcomesSellers CostSellers PriceSellers Profit Low$500,000$1,100,000$600,000 Most Likely1,000,0001,100,000100,000 High1,500,0001,100,000(-400,000) Same FFP Contract as 19-1 15-7

8. Example 2: Continued Most sellers are unwilling to large risks »The supplier will not want to offer the contract at $1,100,000 due to this additional uncertainty In this case, the seller studies the distribution of likely cost outcomes and concludes that, 9 times out of 10, the actual cost will be $1,400,000 or less Based on the risk aversion, the seller may demand a firm fixed price of $1,540,000 »$1,400,000 plus $140,000 (10 percent profit on this cost) »The supplier will not lose money on the contract 15-8

9. Example 2: Continued Potential OutcomesSellers CostSellers PriceSellers Profit Low$500,000$1,540,000$1,040,000 Most Likely1,000,0001,540,000540,000 90% Level 1,400,0001,540,000140,000 High1,500,0001,540,00040,000 Firm Fixed Price Contract 15-9

10. Example 2: Continued Potential OutcomesSellers CostSellers PriceSellers Profit Low$500,000$550,000$50,000 Most Likely1,000,0001,050,00050,000 90% Level 1,400,0001,450,00050,000 High1,500,0001,550,00050,000 Cost Plus $50,000 Fixed Fee 15-10

11. Example 2: Continued Potential OutcomesSellers CostSellers PriceSellers Profit Low$500,000$550,000$50,000 Most Likely1,000,0001,100,000100,000 90% Level 1,400,0001,540,000140,000 High1,500,0001,650,000150,000 Cost Plus Fixed 10% Fee 15-11

12. Contract Cost Risk Appraisal Technical Risk »Risk associated with the nature of the item »Technical risk appraisal: –Type and complexity of the item or service –Stability of design specifications or statement of work –Availability of historical pricing data –Prior production experience Contract Schedule Risk »Anticipate material and labor cost increases –Forward pricing is common »Anticipate possible schedule slippages 15-12

13. General Types of Contract Compensation Arrangements Fixed Price Contracts Incentive Contracts Cost-Type Contracts Buyer Risk Supplier Risk Low High Low Fixed Price Contracts Cost Type Contracts Incentive Contracts 15-13

14. Firm Fixed Price Contracts A firm fixed price (FFP) contract is an agreement to pay a specified price when the items (services) specified by the contract have been delivered (completed) and accepted Common types: »Firm fixed price »Fixed price with economic price adjustment »Fixed price redetermination 15-14

15. When to Use FFP Specifications are well defined Cost risk is low Schedule risk is low Technical risk is low Competition has established pricing 15-15

16. Firm Fixed Price Contract Example Figure 19-3 15-16

17. Reasons Why Firm Fixed Price Contracts Do Not Always Remained Fixed A supplier losing money may request relief if: »Customer contributed to the loss »Customer badly needs the items –Assumes other suppliers are not available »Supplier has unique facilities and time is short »Customers representatives do not employ sound supply management practices 15-17

18. Fixed Price and Economic Price Adjustment Contracts (FPEPA) (FPEPA) contracts are used to recognize economic contingencies, such as unstable labor or market conditions FPEPA is an FFP contract that includes economic price adjustment clauses »Escalator clauses are for price increases »De-escalator clauses are for price decreases 15-18

19. Rules for Selecting Indexes for Price Adjustment Clauses Select from the appropriate Bureau of Labor Statistics category Avoid broad indexes; use the lowest-level classification Develop a weighted index for materials in a product Select labor rate indexes by type and location Define energy indexes by fuel type and location Analyze the past history of each index versus actual price change of the item being indexed 15-19

20. Fixed Price Redetermination Contracts (FPR) A FFP is set for an initial contract period A redetermination (upward or downward) occurs at a stated time during the contract FPR prospective »Occurs at a stated time during the contract »Used where a fair and reasonable price can be developed for initial periods but not subsequent periods FPR retroactive »Occurs at the end of the contract »Used when uncertainty exists as in the prospective, but the amount of the contract is small and/or the performance period is short 15-20

21. Incentive Arrangements Used to motivate the supplier to: »Control costs »Encourage good supplier performance Contract price will usually be higher Ceiling price is usually fixed during negotiations Cost responsibility is shared Two primary types: »Fixed price incentive »Cost plus incentive fee 15-21

22. Elements of a Simplified Incentive Contract Target cost »Cost outcome both buyer and supplier feel is the most likely outcome Target profit »Amount considered fair and reasonable Allocating costs above or below target »Recognizes the target most likely will not be met »A sharing arrangement is agreed upon that reflects the sharing of the cost responsibility 15-22

23. Fixed Price Incentive Fee Example 15-23

24. Cost Plus Incentive Fee Arrangements Combine the incentive arrangement and the cost plus fixed fee arrangement Under a CPIF arrangement, an incentive applies over part of the range of cost outcomes The fee structure resembles a cost plus fixed fee contract at both the low-cost and high-cost ends of the range 15-24

25. Cost Plus Incentive Fee Example Target cost = $1,000,000 Target profit = $70,000 Optimistic cost = $800,000 Optimistic and maximum profit = $120,000 Pessimistic cost = $1,400,000 Pessimistic and minimum profit = $20,000 Sharing below target (customer/supplier) = 75/25 Sharing above target (cust./supplier) = 87.5/12.5 15-25

26. CPIF Contract Example Continued Target cost = $1,000,000 Target profit = $70,000 Maximum fee = $120,000 Minimum fee = $20,000 Cost savings = target cost - final cost »$300,000 = $1,000,000 - $700,000 Suppliers savings = cost savings × supplier share »75,000 = $300,000 × 0.25 Computed fee = savings fee + target fee »$145,000 = $75,000 + $70,000 Final price = final cost + maximum fee »$820,000 = $700,000 + $120,000 15-26

27. Cost Plus Incentive Fee Arrangements Cost savings = target cost - final cost Suppliers share of cost savings = cost savings × supplier share Computed fee = savings fee + target fee Final price = final cost + maximum fee 15-27

28. Cost Plus Incentive Fee Example 15-28

29. Cost-type Arrangements Used when: »Research and development increases technical risk »Project completion is in doubt »Product specifications are incomplete »High-dollar, highly uncertain procurements are involved Common types are: »Cost reimbursement »Cost plus fixed fee »Cost plus award fee »Cost without fee »Cost sharing »Time and materials 15-29

30. Cost Plus Fixed Fee Arrangements (CPFF) Buying firm pays a fixed fee and all costs beyond fee Fee is for specified scope of work Supplier has no incentive to control costs Characterized by low supplier profit A total liability limit is usually established Optimistic Most likely Pessimistic Final cost$800$1,000 $1,200 Fixed fee 50 50 50 Price$850$1,050 $1,250 CPFF Example (not in text) 15-30

31. Cost Plus Award Fee (CPAF) The award fee is a pool of money established by the buyer to reward the supplier in meeting the buyers stated needs Receipt of the fee is based on the buying firms subjective evaluation CPAF works as a flexible tool 15-31

32. Cost Without Fee Used primarily by nonprofit institutions Used for research work without the objective of making a profit Institutions recover all overhead costs In recent years, high-technology firms have increased their use of this contract type 15-32

33. Cost Sharing In some situations, a firm doing research under a cost type of contract stands to benefit if the product developed can be used in its own product line Under such circumstances, the buyer and the seller agree on what they consider to be a fair basis to share the costs (most often it is 50-50) The electronics industry has found this type of contract especially useful 15-33

34. Considerations When Selecting Contract Types Unstable labor conditions Unstable market conditions Improvement in production is required Complexity of product or service Product or service requires development Design is not completed or may change Learning must take place Short time to prepare for a bid or negotiation Short delivery period »Which may require additional resources to meet deadlines 15-34

35. Concluding Remarks Sound application of the compensation methods presented will significantly reduce expenditures when cost risk is present Compensation agreements must result in a reasonable allocation of the cost risk Agreements should also provide adequate motivation to the supplier to assure effective performance 15-35