Chapter 15
Methods of
Compensation
15-1
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
15-2
Key Concepts
•
Specific types of compensation agreements
»
Firm fixed price contracts
»
Fixed price with economic adjustment contracts
»

»
Motivational implications of the fee portion of
the compensation arrangements
15-4
Example 1: Low Level of Uncertainty
Potential
Outcomes Seller’s Cost Seller’s Price
Seller’s Profit
Low $950,000 $1,100,000
$150,000
Most Likely 1,000,000 1,100,000
100,000
High 1,050,000 1,100,000
50,000
Firm Fixed Price Contract
15-5
Example 2: High Level of Uncertainty
Potential
Outcomes Seller’s Cost Seller’s Price
Seller’s Profit
Low $500,000 $1,100,000
$600,000
Most Likely 1,000,000 1,100,000
100,000
High 1,500,000 1,100,000
(-400,000)
Same FFP Contract as 19-1
15-6
Example 2: Continued
•

Firm Fixed Price Contract
15-8
Example 2: Continued
Potential
Outcomes Seller’s Cost Seller’s Price
Seller’s Profit
Low $500,000 $550,000
$50,000
Most Likely 1,000,000 1,050,000
50,000
90% Level 1,400,000 1,450,000
50,000
High 1,500,000 1,550,000
50,000
Cost Plus $50,000 Fixed Fee
15-9
Example 2: Continued
Potential
Outcomes Seller’s Cost Seller’s Price
Seller’s Profit
Low $500,000 $550,000
$50,000
Most Likely 1,000,000 1,100,000
100,000
90% Level 1,400,000 1,540,000
140,000
High 1,500,000 1,650,000
150,000
Cost Plus Fixed 10% Fee
15-10

Incentive Contracts
•
Cost-Type Contracts
Buyer Risk
Supplier Risk
Low
High
High
Low
Fixed
Price
Contracts
Cost
Type
Contracts
Incentive Contracts
15-12
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

Supplier has unique facilities and time is short
»
Customers representatives do not employ
sound supply management practices
15-16
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
15-17
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

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
15-20
Elements of a Simplified Incentive Contract
•
Target cost
»
Cost outcome both buyer and supplier feel is
the most likely outcome
•
Target profit
»

•
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
15-24
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
•
Supplier’s savings = cost savings × supplier share