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Kenneth R. Segel (Author)
Publication date: 04/01/2016
Kenneth R. Segel has 30 years’ experience in government and commercial contracting. He has worked as a senior director and a director of contracts for Fortune 500, medium-sized, and small firms, where he managed contracts, subcontracts, purchasing, and pricing departments. He is the author of The Government Subcontractor’s Guide to Terms and Conditions, also published by Management Concepts, which navigates through contractual terms and conditions as they relate to the Uniform Commercial Code and common law. Mr. Segel has a master’s degree in public administration from San Diego State University, where he graduated with honors.
Typically used to procure commercial items or other products or services containing an adequately defined specification, the firm-fixed-price (FFP) contract is the most widely used of government contract types. A specification is defined as “a detailed statement … of the measurements, quality, materials, or other items to be provided under a contract.”1 Products may include commercial off-the-shelf (COTS) hardware such as bolts and fasteners, a jet engine that has passed qualification testing, or a building for which the government provides a detailed blueprint or services such as program management support. An FFP contract is uniquely suited for procuring commercial or well-defined items or services.
COs typically administer numerous FFP contracts over the course of their careers. Accordingly, the CO should have a thorough understanding of its definition, use, purpose, applicability, performance requirements, financial elements, and risks.
An FFP contract is part of the family of fixed-price contracts that the government uses to procure supplies and services for a specified price. An FFP contract is not subject to adjustment on the basis of the contractor’s cost increases during contract performance. It can be modified, however, when there is a “constructive” change such as an alteration to the PWS or specification; when an economic price adjustment is in order; and after a defective pricing incident. The contractor assumes all risk under an FFP contract and is therefore incentivized to perform well. An FFP contract places minimal administrative burden on both parties.
FFP contracts are widely used under the following circumstances:
1. Full production and follow-on production. “Production” is defined as developing new or making improvements to materials, equipment, tools, processes, systems, techniques, methods, and tools used in products and services.
2. For commercial supplies and services. FAR 2.101 defines “commercial item” to mean:
(1) Any item, other than real property, that is of a type customarily used by the general public or by non-governmental entities for purposes other than governmental purposes, and –
(i) Has been sold, leased, or licensed to the general public; or
(ii) Has been offered for sale, lease, or license to the general public;
(2) Any item that evolved from an item described in paragraph (1) of this definition through advances in technology or performance and that is not yet available in the commercial marketplace, but will be available in the commercial marketplace in time to satisfy the delivery requirements under a Government solicitation;
(3) Any item that would satisfy a criterion expressed in paragraphs (1) or (2) of this definition, but for –
(i) Modifications of a type customarily available in the commercial marketplace; or
(ii) Minor modifications of a type not customarily available in the commercial marketplace made to meet Federal Government requirements. Minor modifications imply modifications that do not significantly alter the nongovernmental function or essential physical characteristics of an item or component, or change the purpose of a process. Factors to be considered in determining whether a modification is minor include the value and size of the modification and the comparative value and size of the final product. Dollar values and percentages may be used as guideposts, but are not conclusive evidence that a modification is minor;
(4) Any combination of items meeting the requirements of paragraphs (1), (2), (3), or (5) of this definition that are of a type customarily combined and sold in combination to the general public;
(5) Installation services, maintenance services, repair services, training services, and other services if –
(i) Such services are procured for support of an item referred to in paragraph (1), (2), (3), or (4) of this definition, regardless of whether such services are provided by the same source or at the same time as the item; and
(ii) The source of such services provides similar services contemporaneously to the general public under terms and conditions similar to those offered to the Federal Government;
(6) Services of a type offered and sold competitively in substantial quantities in the commercial marketplace based on established catalog or market prices for specific tasks performed or specific outcomes to be achieved and under standard commercial terms and conditions. For purposes of these services –
(i) ‘Catalog price’ means a price included in a catalog, price list, schedule, or other form that is regularly maintained by the manufacturer or vendor, is either published or otherwise available for inspection by customers, and states prices at which sales are currently, or were last, made to a significant number of buyers constituting the general public; and
(ii) ‘Market prices’ means current prices that are established in the course of ordinary trade between buyers and sellers free to bargain and that can be substantiated through competition or from sources independent of the offerors.
(7) Any item, combination of items, or service referred to in paragraphs (1) through (6) of this definition, notwithstanding the fact that the item, combination of items, or service is transferred between or among separate divisions, subsidiaries, or affiliates of a contractor; or
(8) A nondevelopmental item, if the procuring agency determines the item was developed exclusively at private expense and sold in substantial quantities, on a competitive basis, to multiple State and local governments.
3. “Procurement of supplies and services with a satisfactorily defined serviceable or detailed specification.” FAR 16.202-2.
4. When a fair and reasonable price can be established up front. A fair and reasonable price is one where the parties reach an amicable agreement built around conditions, quality, and timeliness of contract performance. Fair-and-reasonableness is defined as when the following conditions apply:
a. Ample price competition exists. FAR 16.202-2(a).
b. “There are reasonable price comparisons with prior purchases of the same or similar supplies or services made on a competitive basis or supported by valid cost or pricing data.” FAR 16.202-1(b).
c. “Available cost or pricing information permits realistic estimates of the probable costs of performance.” FAR 16.202-2(c).
d. “Performance uncertainties can be identified and reasonable estimates of their cost impact can be made.” FAR 16.202-2(d).
5. Market conditions are stable.
6. When risk is minimal or may be predicted with a high degree of certainty. FAR 16.103(b).
Contract financing, covered in FAR Part 32, is the method the government uses to pay the contractor prior to accepting products or services. Contract financing is available only for fixed-price contracts.
Given the importance of financing, it is necessary to understand the FAR requirements pertaining to (1) purpose and scope of contract financing, (2) order of preference, (3) private financing, (4) customary contract financing, and (5) limitation of funds.
Unless an audit or other financial review is required to ensure contract compliance, payments are typically due 30 days after receipt of a proper invoice. FAR 32.007. However, the government may consider alternate contract financing methods when “The value of the contract financing to the contractor is expected to be reflected in either (1) a bid or negotiated price that will be lower than such price would have been in the absence of the contract financing, or (2) contract terms and conditions, other than price, that are more beneficial to the Government than they would have been in the absence of the contract financing.” FAR 32.005.
The government’s preferred order for contracting financing methods is as follows:
1. Private financing without government guarantee. FAR 32.106.
2. Customary contract financing other than loan guarantees and certain advanced payments. FAR 32.113. These include:
• Progress payments. FAR 32.5.
• Performance based payments (PBP). FAR 32.10.
• Advanced payments. FAR 32.4.
• Guaranteed loans. FAR 32.3.
• Financing supplies or services through combining two or more of the following: advanced payments, guaranteed loans, and either PBPs or progress payments (but not both). FAR 32.113.
3. Loan guarantees. FAR 32.113.
4. Unusual contract financing. FAR 32.114.
5. Advanced payments. FAR 32.113106(e).
Payment at time of receipt or specified time after receipt is less costly and less risky to the government; it also motivates the contractor to deliver the product or perform the service expeditiously. Payment in advance is the least attractive payment method in that it does not incentivize the contractor to perform at its best.
Although private financing without government guarantee is preferred over customary contract financing, loan guarantees, unusual contract financing, and advanced payments the government provides contract financing in the majority of fixed-price, noncommercial contracts where delivery times extend six months or more. The rationale is that the government does not want to handicap a contractor by not authorizing advanced payments.
The contractor assumes responsibility for financing the effort. The government is obligated to compensate the contractor for compliant work only. FAR 32.106.
Customary contract financing is defined as “financing deemed by an agency to be available for routine use by COs. Most customary contract financing arrangements should be usable by COs without specific reviews or approvals by higher management.” FAR 32.001.
Progress payments are disbursements made to the contractor as costs are incurred during work performance. FAR 32.102(b). Progress payments reduce the need for working capital given that the CO need not secure money up front to pay for the project.
Progress payments also provide the CO the opportunity to monitor the contractor’s work. Segmented payments encourage the contractor to adhere to the stated work schedules. They also enable the CO to stop a project that is not progressing as planned.
FAR 32.503-8 establishes the ordinary method for liquidation rates. Liquidation rates are payments made when milestones are reached during contract performance. The milestones are established at contract inception. This payment method is derived by liquidating money from the total price as milestones are reached; this is referred to as the “liquidation rate.” (The liquidation rate is the same number as the progress payment rate.)
The alternate liquidation rate method found at FAR 32.503-9 establishes that the ordinary liquidation method addressed in FAR 32.503-8 applies unless the CO elects to alter it. The rationale for altering the liquidation rate is to permit the contractor to keep the profit earned for the completed items. Under FAR 32.503-9, the CO may reduce the liquidation rate under the following circumstances:
1. The contractor requests a reduction in the rate;
2. The rate has not been reduced in the preceding 12 months;
3. The contract delivery schedule extends at least 18 months from the contract award date;
4. Data on actual costs are available –
a. For the products delivered, or
b. If no deliveries have been made for a performance period of at least 12 months;
5. The reduced liquidation rate would result in the Government recouping under each invoice the full extent of the progress payments applicable to the costs allocable to that invoice;
6. The contractor would not be paid for more than the costs of items delivered and accepted (less allocable progress payments) and the earned profit on those items;
7. The unliquidated progress payments would not exceed the limit prescribed in paragraph (a)(5) of the Progress Payments clause;
8. The parties agree on an appropriate rate; and
9. The contractor agrees to certify annually, or more often if requested by the contracting officer, that the alternate rate continues to meet the conditions of subsections 5, 6, and 7 of this section. The certificate must be accompanied by adequate supporting information.
The alternate liquidation rate at FAR 32.503-9 establishes that the liquidation rate may be changed under the following circumstances:
1. If the profit rate during contract performance is less than the anticipated percentage of profit and liquidation rate at time of contract award, the liquidation rate will be increased for both previous and succeeding transactions. Subsequent progress payments will also be increased. FAR 32.503-9(b)(1).
2. “The rate shall be increased or decreased in keeping with the successive changes to the contract price or target profit [fee] when —
a. The target profit [fee] is changed under a fixed-price incentive contract with successive targets; or
b. A predetermined price involves a change in the profit element under a contract with prospective price redetermination at stated intervals.” FAR 32.503-9(b)(2)(i) and (ii).
3. When the liquidation rate is changed, a contract modification will be issued incorporating the new rate in the progress payment clause. Payments or the liquidation shall be promptly dispensed. FAR 32.503-9(c).
Performance-based payments (PBPs) are payments made upon predetermined events or accomplishments identified and defined in the contract. These payments are a normal method of contract financing and may be fully recovered in the event of termination for default. PBPs are not (1) payments for accepted goods or services, (2) payments for partial deliveries, or (3) an incentive arrangement.
FAR 32.1002 states that payments may be made “on any of the following bases: (1) Performance measured by objective, quantifiable methods. (2) Accomplishment of defined events. (3) Other quantifiable measures of results.” Performance-based payments may be associated with the entire contract or a specific line item. When the performance-based payment is associated with a single line item, it must be tied to that line item.
Progress payments and PBPs cannot be used interchangeably under an indefinite-delivery contract or individual line items. FAR 16.501-1 defines an indefinite-delivery contract as “a contract for supplies that does not procure or specify a firm quantity of services (other than a minimum or maximum quantity) and that provides for the issuance of orders for the performance of tasks during the period of the contract.” This also applies to individual line items on the ID contract: It is not permissible to have PBPs on one line item and progress payments on another. It is, however, permissible to modify a contract from progress payments to PBPs.
The following steps are required to establish PBPs:
1. Identify the PBP events. Choosing payment events requires some serious consideration. Each event need not be on the critical path, but it must represent a significant and essential step in the execution of significant work throughout the contract or line item’s period of performance. “The basis for performance-based payments may be either specifically described events (e.g., milestones) or on some measurable criterion of performance.” FAR 32.1004(a)(1). In other words, a PBP may not be predicated on an insignificant event. For example, a significant event early in a program may be associated with placing the parts on order while an insignificant event may be issuance of a contract modification or the passage of time.
The frequency of payment should depend on the contractor’s financial need. This will help determine the number of events to include in the program.
The two types of PBP are severable (stand-alone) and cumulative (dependent). Contracts will typically include both types. Severable events do not rely on the accomplishment of other events while cumulative events require the prior or concurrent completion of other events in order to be successfully accomplished. FAR 32.1004(a)(2).
Program schedules may show that some months contain performance-based payment events while others do not. Even if a single month includes the completion of several events, the contractor may not receive more than one PBP in a month.
2. Define the completion criteria for each event. A poorly defined completion event can create confusion, leaving the definition of “completion” to interpretation by the parties. It is therefore necessary to be precise in definition of a completion event. For example, it could be determined that payment will be made upon the contractor’s passing qualification testing. A less complex event may be in order, such as the completion of kitting parts. Regardless, completion must be well defined, leaving no room for interpretation.
3. Establish the expenditure profile. The purpose of PBPs is to assist in the payment of contract costs throughout the duration of the contract or contract line item. The PBPs are set up at the beginning of contract award. At that time, it is customary for the contractor to provide the government with an expenditure profile of anticipated monthly costs.
The expenditure profile addresses the contractor’s projected financial requirements over the lifecycle of the contract. Given that the government must determine the price reasonableness of the effort, the contractor must be able to justify its projected numbers. Nonetheless, projected costs are treated as estimates; progress payments are based on actual costs incurred each month.
4. Create the PBP event values. FAR 32.1004(b)(3)(ii) notes that PBPs “are not expected to result in an unreasonable low or negative level of contractor investment in the contract.” In essence, PBPs are not to be used like progress payments or structured like advanced payments, i.e., the government does not intend to fund all contract costs before or as they incur. Establishing PBP event values will keep this from happening. These values are established by comparing the evaluated expenditure profile to the schedule of PBPs by month, thereby ensuring that the event amounts are not unreasonably low or reach a negative value of contractor investment. For example, if a company is awarded a million dollar contract and the first event is completed in month 2, which is expected to equate to $70,000, the starting point for the event should be no more than $70,000, which represents the financial need at that point in time. The amount tied to an event can be less but not greater than the projected cost incurred.
5. Address the PBP arrangement in a special provision in the contract. Given that it is not mandatory for the parties to reach agreement on the expenditure profile, it is worthwhile to insert a clause in the contract precluding total payments from exceeding actual costs incurred at any given stage of the program. In the absence of cost limitation language, an advanced payment situation may arise if work is completed earlier than anticipated.
The total performance-based payment may not exceed 90 percent of the contract price if based on the contract as a whole or 90 percent of the line-item price if established on a line-item basis. Ninety percent is the maximum performance-based payment that can be issued. Performance-based financing is established by identifying and agreeing on the events that will be used to show progress on the contract, determination of accomplishment, and the financing value for each. The contract must clearly identify the events, completion criteria, and financing values. FAR 52.232-22.
If a price adjustment clause is not included in the contract, all financial and performance risks associated with a fixed-price contract are placed solely on the contractor. FAR 16.202-1. As a consequence, the contractor may lose a dollar of profit for every dollar spent in excess of the established cost. However, the contractor can reap rewards for completing the work under budget.
The government also bears risks, such as overpaying for goods and services or overestimating the cost of a program. When a contractor comes in under budget, the government may not seek a cost reduction as it would on a cost-reimbursement contract.2 In addition, the government may expend more money than it would have under a cost-reimbursement contract, may need to change the contract type to ensure completion of the effort, or may need to defend against a lawsuit when a contractor attempts to recoup escalations in performance costs by alleging that the government constructively modified the contract3 (i.e., modified the contract without issuing a formal change order).