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TRANSCRIPT
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McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter 15
Methods of Compensation
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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
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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 types15-4
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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
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Example 1: Low Level of Uncertainty
PotentialOutcomes Seller’s Cost Seller’s Price
Seller’s ProfitLow $950,000 $1,100,000
$150,000Most Likely 1,000,000 1,100,000
100,000High 1,050,000 1,100,000
50,000
Firm Fixed Price Contract
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Example 2: High Level of Uncertainty
PotentialOutcomes Seller’s Cost Seller’s Price
Seller’s ProfitLow $500,000 $1,100,000
$600,000Most Likely 1,000,000 1,100,000
100,000High 1,500,000 1,100,000
(-400,000)
Same FFP Contract as 19-1
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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
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Example 2: Continued
PotentialOutcomes Seller’s Cost Seller’s Price
Seller’s ProfitLow $500,000 $1,540,000
$1,040,000Most Likely 1,000,000 1,540,000
540,00090% Level 1,400,000 1,540,000
140,000High 1,500,000 1,540,000
40,000
Firm Fixed Price Contract
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Example 2: Continued
PotentialOutcomes Seller’s Cost Seller’s Price
Seller’s ProfitLow $500,000 $550,000
$50,000Most Likely 1,000,000 1,050,000
50,00090% Level 1,400,000 1,450,000
50,000High 1,500,000 1,550,000
50,000
Cost Plus $50,000 Fixed Fee
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Example 2: Continued
PotentialOutcomes Seller’s Cost Seller’s Price
Seller’s ProfitLow $500,000 $550,000
$50,000Most Likely 1,000,000 1,100,000
100,00090% Level 1,400,000 1,540,000
140,000High 1,500,000 1,650,000
150,000
Cost Plus Fixed 10% Fee
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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 slippages15-12
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General Types of Contract Compensation Arrangements
• Fixed Price Contracts
• Incentive Contracts
• Cost-Type Contracts
Buyer Risk
Supplier Risk
Low
High
High
Low
FixedPrice
Contracts
CostType
ContractsIncentive Contracts
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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
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When to Use FFP
• Specifications are well defined
• Cost risk is low
• Schedule risk is low
• Technical risk is low
• Competition has established pricing
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Firm Fixed Price Contract ExampleFigure 19-3Figure 19-3
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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
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Fixed Price and EconomicPrice 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
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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
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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
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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 fee15-21
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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
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Fixed Price Incentive Fee Example
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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
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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
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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» 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
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Cost Plus Incentive Fee Arrangements
• Cost savings = target cost - final cost
• Supplier’s share of cost savings = cost savings × supplier share
• Computed fee = savings fee + target fee
• Final price = final cost + maximum fee
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Cost Plus Incentive Fee Example
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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
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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)
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Cost Plus Award Fee (CPAF)
• The award fee is a pool of money established by the buyer to reward the supplier in meeting the buyer’s stated needs
• Receipt of the fee is based on the buying firm’s subjective evaluation
• CPAF works as a flexible tool
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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
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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
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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
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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
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