The Basics of Government Contracts
This page will explain the basics of Government Contracts. It will begin with the history and basics of each contract type, as well as obligations and the risks for each category. Also discussed are the different features of each contract and some of the newer hybrid contracts emerging in the industry.
Brief History of Government Contracts:
Contract types have been around since the very first financial transactions. In the beginning, all contracts were Fixed Price. When World War I came around, the concept of tear down and repair contract types were introduced. There was a Fixed Price order to tear down a piece of equipment that had failed. However, the problem was identified, and a proposal was prepared to repair it.
Next, a Time and Materials (T&M) order was issued to make the repair. This type of contract is still very common today, even at your local auto repair shop. A major difference is that the auto repair shop usually does the diagnosis part at no charge. They look at it and tell you what’s wrong with it and do the proposal on speculation.
When World War II rolled around, the concept of Cost Reimbursable contracts was born because there simply wasn’t time for definitive specifications. The contractors found themselves developing things while the specifications were being written. It’s just not possible to provide a fixed price for an effort like that; you don’t know where you’re going, much less where you are.
In the 1950s, the government forayed into R&D, like project Moho, where the government gave Howard Hughes a contract to drill a hole to the center of the Earth, and he figured out he couldn’t do it. It was a Fixed Price contract, and rather than roll over and let the government do to him what they do to you when you fail to complete a Fixed Price contract, he sued. The resulting court case established the principle that when performance and cost risk is very high, the federal government should assume the risk, and the Cost Type contract was born.
The DoD has experimented over the years with Fixed Price contracts in all kinds of areas, including R&D, mostly unsuccessfully. The last significant Fixed Price R&D contract was for the NAVY 8a12, the very first stealth aircraft. This was in the early 1990s, when stealth aircraft didn’t exist, and it wasn’t even certain that it was possible to have an aircraft that could evade radar. The researchers weren’t successful, and the government terminated them for default. This was eventually converted to a termination for convenience, and the last of the lawsuits were settled at over 20 years old. Fixed Price R&D’s have never been particularly successful, but, Fixed Price contracts make for good press. The reality is that when the risk is very high, both cost risk and performance risk, Fixed Price just isn’t appropriate.
The three basic contract types are fixed price, also called Firm Fixed Price and abbreviated FFP. If you are looking in the dictionary of acronyms, you will find FFP under contract types, Time and Materials, or labor hour T&M contracts, and Cost Reimbursement or Cost-Plus type contracts.
There is a lot of variation within these contract types. Your contract could have a mixture of Fixed Price labor and Cost Reimbursable for other direct costs. It could also be a fixed price contract with time as a unit of measure that is really Time and Materials. Another deviant is Fixed-Price services with level of effort, that has a special contract type that will be discussed later. There can be several combinations here and these mixed contracts are referred to as hybrids. Hybrid contracts are experiencing an increase in popularity.
So how much money does the government spends on these contracts, and how much is allocated to each type?
The chart below is not as easy to analyze because the annual totals are changing, but you can see the contract percentage mix. Note that there is a lot of money in fixed price, this is not because fixed price is inherently better or worse, it because very large production and construction contracts are always fixed price. While it is a lot of money, it represents a relatively small number of contracts.
Federal Obligations on Contracts – GFYs 2010 – 2014
You will notice that cost type contracts remain between 31% and 32%. This stability is a result of the principle that what the government buys determines the level of risk and the level of risk determines the type of contract.
All the pounding on the podium that the politicians do and all the preferences that the administration states for the types of contracts has had little impact for 20 years. The number of dollars spent on caucus type contracts is still roughly the same proportion—approximately a third of all procurement spending—simply because about a third of everything the government buys can’t reasonably be fixed price. This is because an important factor is unknown: either the delivery specifications, the delivery schedule, when we want it, where we want it, what we want to buy, or something similar, that makes the risk inordinately high.
What is the difference between contract types?
Firm Fixed Price contracts: This contract type should be used when requirements are known and can be precisely described. We also know exactly when we want it and where we want it. Cost of performance can be reasonably predicted. We know what it ought to cost and the risk is relatively low, making a fixed-price appropriate.
Time and Materials contracts: This contracting type is used when requirements are poorly described and we don’t know exactly what we want or exactly when or where we want it. It is typically services; the cost of performance can be predicted with a reasonable degree of certainty with respect to the cost per hour. However, when it’s going to be performed, where it’s going to be performed, and which categories of labor might be used are less understood. With the unknowns, the use of individual delivery orders is appropriate. Often T&Ms are Indefinite Delivery Indefinite Quantity contracts (IDIQs). The basic contract’s an empty template and the delivery orders carry the money specifications and other details.
Cost Reimbursable contracts: This type is a good option when the requirements or ability to fulfill the requirements are uncertain. In the case of Howard Hughes and project MoHo, it wasn’t certain that the task the government gave him could be even be completed, a perfect example of the use of cost reimbursable contracting. It is also appropriate when we are sure something can be completed but we are unsure of the cost. When costs cannot be predicted with any degree of certainty, a cost type contract is appropriate.
Fixed Price Contracts
Let’s look first at the fixed-price contract. This category can be broken into two different contract types: Fixed Price completion contracts and Firm Fixed price.
Fixed Price Completion Contract: The contractor’s obligation is to simply deliver the goods or the services. The government’s obligation is to pay on delivery, to pay promptly, provide inspection acceptance, and presentation of an invoice are all required. Once those things have been fulfilled, the government must pay the agreed upon price. This type of contract is most of the fixed price contracts.
Fixed-Price Level of Effort Contract: The contractor’s obligation is to deliver exactly the hours specified in the contract level of effort. If you don’t meet the goal, the contract requirements are not fulfilled, and you don’t get paid. If you go over, you don’t get paid any more. This is a fixed price contract, but it’s dependent on fulfilling exactly a certain level of effort by labor category.
Firm Fixed Price: The government’s only obligation is to pay, once all the hours are delivered as specified in the contract. However, certain fixed level of effort contracts will occasionally have a special provision in them or clause that treats them like a Time and Materials contract during performance, especially if they’re going to last more than three or four months. This means the contractor does not have to finance the entire performance of the contract, only getting paid at the end.
Time and Materials Contracts
Time and Materials contract: This type is used when there will be non-labor costs involved in the contract like travel, materials, and usage of equipment. Typically, travel, materials, and other direct costs (ODCs) are reimbursed at actual cost. The government’s obligation here is to pay for the hours that are delivered and accepted upon pursuant to a proper statement of work.
Cost Reimbursable Contracts
Cost Reimbursable contracts: This type comes in multiple variations, with the two basic types being completion type and level of effort. These are often referred to as a “best efforts statement of work”.
The contractor’s obligation is to provide his or her best efforts in pursuit of the objectives stated in a statement of work. There is no other obligation under a cost type contract whether it’s completion type or level of effort. When the money runs out, you are supposed to stop. If there is a cost growth after the contract is completed, like rates and direct rates, you can collect that over and above the original estimate. The government’s obligation is to reimburse the contractors total cost of performance, if the contractor has abided by all the allowability and eligibility rules.
Risk is inherent in all contracts; it just depends on what side of the contract you sit. It is a very important aspect of contracting and it comes in two forms: performance risk and cost risk.
- Performance risk revolves around these questions: Can this be done? Is the schedule realistic? Is the timeline attainable? The contract will establish responsibilities in the event the contract cannot be completed or completed on time.
- Cost risks are used in situations where we know something can be done and how long it will take, but we do not know the final cost. For example, this can be due to fluctuation in precious metal costs that are driven by market supply and demand.
So, let’s dive deeper. As explained in the below infographic, there’s a wide spectrum of risks for government contracts.
Fixed Price Risk
Fixed price completion contracts performance risk for the contractor is very high. There are obligations to perform: deliver the goods, deliver the services, no matter what it costs. So, both performance risk and cost risks are very high. The government’s risk on a Firm Fixed Price completion contract is very low. They have no obligation to the contractor to pay or do anything else until the goods or services are delivered, inspected, and accepted, then they pay. That’s about as low risk as it gets.
For the level of effort Fixed Price contract, it’s exactly the opposite. There the performance risk is very low, and the cost risk is also moderately low, because the contractor’s sole obligation on a fixed price level of effort contract is to furnish the hours purchased—exactly the hours purchased, no more, no less. For the government the risk is high, because they’re not assured that when the level of effort has been provided, that the job will be done. All they know is how many hours they’re going to get. They don’t know what work is going to be finished, so performance risk is high on that.
There is a variant of fixed price contract called a fixed price incentive contract. This is always a completion type. With this type, the government puts into the contract what are called cost shares, so if the contractor underruns the contact, the government shares part of the savings. On the flipside if the contractor overruns the contract, the government pays part of the overrun, not all of it. So, it’s still high risk for the contractor, but the risk is less than with Firm Fixed Price.
Time and Materials Risk
For Time and Materials contract, they are always level of effort contracts, because that’s what a Time and Materials contract buys: hours. The contractor’s performance risk is very low, because the only obligation is to furnish the hours. The cost risk is also moderately low because remember part of Time and Materials is Cost Reimbursable so there you’re going to get back whatever you spend. It’s only the labor that has any risk at all, and that’s only the pricing of the labor and the indirect costs. If your pricing model is good, then the cost risk is going to be low on the labor portion of a Time and Materials contract. The government’s risk is just like a fixed price level of effort; it’s going to be high because there’s no assurance they’re going to get what they want. The only assurance they have is that they’re going to get the hours they ordered. Now the cost risk is relatively low because they know exactly what every hour is going to cost upfront. What they don’t know is whether they’re going to get what they wanted out of those hours or not, and that’s why the performance risk is high.
Cost Reimbursable Risk
For all the cost type contracts—whether it’s fixed fee or an incentive fee—where the contractor has an incentive to achieve something technical, they will get more fee if they achieve that objective. For the contractor, performance risk is very low across the entire Cost Reimbursable contract spectrum. Why? Because the contractor has no obligation except to do their best. Cost risk is very low on cost plus fixed fee, incentive fee, and award fee contracts because the government’s going to reimburse all the costs. That’s the obligation of the government under a cost type contract; the government’s risk is very high. The reason it’s very high is because we don’t know whether the task can even be done or not, or—if it is possible—how much it’s going to cost. That’s why we’re in a cost type environment to begin with, so the government’s risk is as high as it gets in the cost type environment.
This contract type evolved from a strong Government/DOD preference for fixed price contracts. These contracts feature multiple characteristics of various contract types but are labeled as fixed price. For example:
- Fixed Price Labor but Cost Reimbursable sub contracts
- Labor billed as a unit of time rather than hours, such as a Fixed Price per month, but then they go on to define month as X number of labor hours, so it’s really a Labor Hour contract, or a Time & Materials Contract. However, because it is described in the statement of work as a Fixed Price per unit of time, it might be reported in the data as a Fixed Price Contract.
DCAA audit with hybrid contracts
Sometimes these hybrid contracts will contain the allowable cost and payment clause. If they do, that triggers the requirement for an Incurred Cost Submission. DCAA considers the Fixed Price hybrids, if they have cost type features, to be cost type contracts. They look for them in the Incurred Cost Submission schedules, and they will reject the submission when they find a hybrid contract that has been “improperly classified”.
These things are difficult to detect and they’re often missed, especially on a cursory review, and DCAA will sometimes miss them until it’s time to audit the incurred cost submission, three, four, or five years after the costs were booked. They then find that the contract was misclassified, reject the submission, and it must be done all over again.
The Incurred Cost Submission is used to establish a firm’s indirect rates for each year. Your fringe rates, your overhead rates, your General and Administrative or G&A rate, your Subcontract and Material Handling or SCMH rate, this is required if you have any contracts with the Allowable Cost and Payments clause in them. It is not determined by contract type. Contract type should be determined whether the clause is there or not, but if the clause is there, then the incurred cost submission is required, so it’s worth looking in your contracts and contracts groups to determine whether the clause is there or not, and not look at what the contract type says it is.
What does the government look for in selecting contract types? Here is where a Government contract really differs from a commercial negotiation. In the commercial world, the contract type is a matter of agreement between the parties. The buyer and the seller agree on what kind of arrangement they’re going to have, but in the government world, that’s all determined before the solicitation is ever issued for contractors to bid on. In the government contracting world there is not a choice of contract type. Competition, price, cost, complexity, frequency of need, and segregation/fragmentation are all factors that play into the upfront contracting type decision made by the government.
As a government contractor you may have no choice about the type of contract you are bidding on, but you sure have the choice to understand the impact that contract types have on your overall financials. Selecting the right tool, one battle tested by government contractors can help you navigate the financial nuances of each contract type. To learn more about how Unanet can help you effectively manage your government contracts, visit our video demonstrations page or watch our on-demand webinar, "How to Pick an ERP Solution."