COST-REIMBURSEMENT CONTRACTS

Cost-reimbursement contracts provide for payment of actual allowable costs, as governed by Part 31 of the FAR. Cost-reimbursement contracts establish estimates of total cost for the purpose of obligating funds. If a contractor exceeds the funds without contracting officer approval, such costs are incurred at the contractor’s risk.

A cost-reimbursement contract is used when the uncertainties of performance do not permit costs to be estimated with enough accuracy to use a fixed-price contract. Cost-reimbursement contracts entail minimal contractor financial responsibility. Under these contracts, the contractor is reimbursed for actual allowable costs up to the contract ceiling, plus the established fee. The contractor usually is not allowed to invoice for more than 85 percent of the fee until the contract is completed. The remaining 15 percent is held by the government as a reserve for contractual problems and/or final indirect rate adjustments.

Once awarded a cost-reimbursement contract, a contractor is subject to numerous federal regulations and contract clauses. One of the more troublesome clauses, the limitation of cost clause (LOCC), is found in FAR 52.232-20. This clause requires a contractor to notify the contracting officer in writing whenever he has reason to believe that: (1) the costs he expects to incur under the contract in the next 60 days (or an alternative number of days ranging from 30 to 90) when added to costs previously incurred, will exceed 75 percent (or an alternative percentage ranging from 75 to 85) of the estimated costs specified in the contract; or (2) the total cost for the performance of the contract, exclusive of any fee, will be either greater or substantially less than estimated.

The primary purpose of the LOCC is to protect the government from unauthorized and unexpected cost overruns. Once the contractor notifies the government of a potential overrun, the government must decide whether or not to extend the work and grant additional funding, or to revise the contract scope of work.

Several decisions by the Board of Contract Appeals (BCA) construed a pre-1966 LOCC liberally, allowing contractors to recover for cost overruns in a variety of situations. Since then a revised LOCC, adopted in October 1966, has made it extremely difficult for a contractor to be reimbursed for a cost overrun. If a contractor with an adequate accounting system can show that he could not reasonably foresee a cost overrun, he can be excepted from the requirement. In establishing this exception to the no-reimbursement for overrun rule, the Court of Claims has stated that it is an abuse of discretion for the contracting officer to refuse to fund the cost overrun because of the contractor’s failure to give notice when it was impossible to do so.

The best example of when a contractor may not be aware of a potential overrun is a contractor who had submitted indirect cost billing rates for audit. The government auditor challenged certain pension costs and reduced the billing rate substantially. The contract funds were substantially expended using this lower billing rate. When the government auditor performed the final indirect cost audit several years later, the auditor changed his mind and did not disallow any pension costs.

Another practical danger is the government’s unilateral removal of funds from a contract before final audited rates have been established. In some cases, funds expire after three or five years. In other cases, funds may simply not be available to cover increases because final indirect cost rates are more than the interim billing rates.

Types of cost-reimbursement contracts available include cost-sharing, cost-reimbursement-only, cost-plus-fixed-fee, cost-plus-incentive-fee, and cost-plus-award-fee.

Cost-Sharing Contract

A cost-sharing contract is one in which the contractor receives no fee and is reimbursed only for an agreed-upon percentage (e.g., 80 percent) of allowable costs. A cost-sharing contract is used when a contractor agrees to absorb a portion of the costs, in the expectation of substantial compensating benefits. For example, a contractor might agree to share in the development costs of a weapon systems in anticipation of being awarded any resulting production contract. This contract type is more widely used for educational institutions and nonprofit entities than commercial organizations.

Cost-Reimbursement-Only Contract

A cost-reimbursement-only contract is one in which the contractor receives no fee. This contract type is more appropriate for research and development work, particularly with nonprofit educational institutions or other nonprofits.

Cost-Plus-Fixed-Fee Contract

A cost-plus-fixed-fee (CPFF) contract provides for payment to the contractor of a negotiated fee that is fixed at the inception of the contract. This contract type permits contracting for efforts that might otherwise present too great a risk to contractors, but it provides the contractor only a minimum incentive to control costs.

A cost-plus-fixed-fee contract may take one of two basic forms—completion or term. The completion form describes the scope of work by stating a definite goal or target and specifying an end product. This form of contract normally requires the contractor to complete and deliver the specified end product (e.g., a final report of research accomplishing the goal or target) within the estimated cost, if possible, as a condition for payment of the entire fixed fee. However, in the event that the work cannot be completed within the estimated cost, the government may require completion of the work without increase in fee, provided that the government increases the estimated cost. Additional fee under these circumstances depends on whether the “cost overrun” is due simply to more cost than anticipated or to increased scope of work. Simple cost overruns for the scope of work contemplated in the contract do not warrant additional fee. Cost increases due to change in the scope of work and contract risk do warrant additional fee (or less fee if the government believes a reduced scope of work has occurred).

The term form describes the scope of work in general terms and obligates the contractor to devote a specified level of effort for a stated time period. Under this form, if the government considers performance to be satisfactory, the fixed fee is payable at the expiration of the agreed-upon period—upon contractor statement that the level of effort specified in the contract has been expended in performing the contract work. Renewal for further periods of performance is a new acquisition that involves new cost and fee arrangements.

Because of the differences in obligation assumed by the contractor, the completion form is preferred over the term form whenever the work, or specific milestones for the work, can be defined well enough to permit development of estimates within which the contractor can be expected to complete the work. The term form should not be used unless the contractor is obligated by the contract to provide a specific level of effort within a definite time period.

Cost-Plus-Incentive-Fee Contract

The cost-plus-incentive-fee (CPIF) contract is a cost-reimbursement contract that provides for the initially negotiated fee to be adjusted later by a formula based on the relationship of total allowable costs to total target costs. This contract type specifies: (1) a target cost; (2) a target fee; (3) a minimum fee; (4) a maximum fee; and (5) a fee adjustment formula. The formula provides, within limits, for increases in fee above the target fee when total allowable costs are less than target costs, and decreases in fee below the target fee when total allowable costs exceed target costs. When total allowable costs are greater or less than the range of costs within which the fee-adjustment formula operates, the contractor is paid total allowable costs, plus the minimum or maximum fee.

Figures 13 through 16 describe how this contract type is applied. For each of these figures, the following basic assumptions are the same: (1) the estimated cost is $1,000,000; (2) the stated fee is $85,000; (3) the minimum fee is $60,000; (4) the maximum fee is $110,000; and (5) the contractor share of any cost over/underrun is 30 percent.

Figure 13 is a cost-plus-incentive-fee contract where the actual cost of $900,000 is well under the estimated cost. This results in a $100,000 underrun. The contract price is computed by starting with the actual cost on line (i). The fee calculation begins with the stated fee, $85,000, on line (j). The fee is then increased on line (k) by the contractor’s share of the cost underrun or $30,000, which is 30 percent of $100,000. This results in a calculated fee of $115,000 on line (l). However, this fee exceeds the maximum fee, so the allowable fee amount is the maximum or $110,000. The price on the contract is then $1,010,000, which is the sum of the actual cost and the allowable fee. The profit on this contract is $110,000, which is $1,010,000 minus $900,000.

Figure 14 is a cost-plus-incentive-fee contract where the actual cost of $950,000 is slightly under the estimated cost. This results in a $50,000 underrun. The contract price is computed by starting with the actual cost on line (i). The fee calculation begins with the stated fee, $85,000, on line (j). The fee is then increased on line (k) by the contractor’s share of the cost underrun or $15,000, which is 30 percent of $50,000. This results in a calculated fee of $100,000 on line (l). The price on the contract is then $1,050,000, which is the sum of the actual cost and the allowable fee. The profit on this contract is $100,000, which is $1,050,000 minus $950,000.

Figure 15 is a cost-plus-incentive-fee contract where the actual cost of $1,050,000 is slightly over the estimated cost. This results in a $50,000 overrun. The contract price is computed by starting with the actual cost on line (i). The fee calculation begins with the stated fee, $85,000, on line (j). The fee is then decreased on line (k) by the contractor’s share of the cost overrun or $15,000, which is 30 percent of $50,000. This results in a calculated fee of $70,000 on line (l). The price on the contract is then $1,120,000, which is the sum of the actual cost and the allowable fee. The profit on this contract is 70,000, which is $1,120,000 minus $1,050,000.

Figure 16 is a cost-plus-incentive-fee contract where the actual cost of $1,150,000 is well over the estimated cost. This results in a $100,000 overrun. The contract price is computed by starting with the actual cost on line (i). The fee calculation begins with the stated fee, $85,000, on line (j). The fee is then decreased on line (k) by the contractor’s share of the cost overrun or $45,000, which is 30 percent of $150,000. This results in a calculated fee of $40,000 on line (l). However, this fee is less than the minimum fee so the allowable fee amount is the minimum, or $60,000. The price on the contract is then $1,210,000, which is the sum of the actual cost and the allowable fee. The profit on this contract is 60,000, which is $1,210,000 minus $1,150,000.

Figure 17 contains the spreadsheet formulas for the calculations in Figures 13 through 16.

Cost-Plus-Award-Fee Contract

A cost-plus-award-fee (CPAF) contract is a cost-reimbursement contract that provides for a fee consisting of: (1) a base amount fixed at inception of the contract (which may be zero); and (2) an award amount that the contractor may earn in whole or in part during performance. The amount of the award fee to be paid is determined by the government’s judgmental evaluation of the contractor’s performance in terms of the criteria stated in the contract.