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be considered. For example, a profit incentive to control costs can be achieved E through use of the fixed-price incentive contract, and to a lesser degree, the costplus-incentive-fee contract, where appropriate target costs and incentive arrangements can be negotiated.

(2) In many procurement situations objectives other than cost control, for example, performance and time goals in the case of development projects, may also be significant. Such objectives may be (i) performance with a view toward a better or more reliable product; (ii) delivery when it is necessary to obtain supplies or services with the utmost speed to meet military needs; or (iii) a combination of any of the objectives of cost, = performance, and delivery (see § 3.407). A contractual arrangement can be used to provide incentive to obtain these objectives in addition to effective cost control. Thus, by providing for increased =profit for exceeding predetermined target levels and decreased profit for failing to meet target levels, an additional incentive is credited for maximum effort on the part of the contractor to accomplish the desired objectives. When additional objectives are made a part of the various types of incentive contracts described in this subpart (§§ 3.404-4 and 3.405-4), particular care must be taken by the contracting officer to maintain an appropriate balance between the various incentives, by weighting incentive objectives to apportion the total incentive profits or fee in accordance with the emphasis desired by, and maximum benefit to, the Government. Without proper balancing of the incentive objectives, the Government may receive at unwarranted expense, a product of greater quality than desired or delivery before needed. [27 FR. 4015, Apr. 27, 1962, as amended at 28 F.R. 4883, May 16, 1963; 30 F.R. 12001, Sept. 21, 1965]

§ 3.403 Negotiation of contract type.

(a) General. The selection of contract type is generally a matter for negotiation and requires the exercise of judgment. Type of contract and pricing are interrelated and should be considered together in negotiation in accordance with § 3.803. Because the type of contract affects the resulting price to the Government, use of an appropriate type is of primary importance in obtaining fair and reasonable prices. Each contract file shall include documentation to

show why the particular contract type was used, except for the following: First, small purchases (Subpart F of this part); second, repetitive types of procurement usually accomplished on a firm fixedprice basis, such as subsistence procurement; or third, awards made on the setaside portion of formally advertised procurements partially set aside for either small business, labor surplus or disaster areas. Although no absolute rules can be laid down, there are many factors which should be considered in the use of an appropriate type of contract, including those which follow:

(1) Price analysis. See $ 3.807-2(b). Price analysis may provide a basis for selection of contract type. The degree to which price analysis can provide a realistic pricing standard should be carefully considered, even where there may not be full and free competition.

(2) The cost estimate. In the absence of effective price competition and where price analysis if not sufficient, the cost estimates of the offeror and of the Government are the bases for negotiation of many pricing arrangements. As a minimum, the uncertainties involved in performing at the cost estimated, and their possible impact on costs, must be identified and evaluated so that a pricing arrangement can be negotiated which imposes a reasonable degree of cost responsibility upon the contractor. following are some of the considerations which may influence the estimate and hence, the selection of contract type:

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(i) Type and complexity of the item; (ii) Stability of design, which in turn may influence such subordinate considerations as the adequacy and firmness of specifications, and the availability of relevant historical pricing data and prior production experience;

(iii) Prospective period of contract performance and length of production run at the time of negotiation;

(iv) Extent and nature of subcontracting contemplated;

(v) Adequacy of the contractor's estimating system; and

(3) Urgency of the requirement. In certain procurements the best interests of the Government may dictate that the urgency of the requirement be a primary consideration in selection of contract

type.

(4) Technical capability and financial responsibility of the contractor.

(5) Adequacy of the contractor's accounting system. Before reaching agreement on price and contract type, determination should be made that the contractor's accounting system will permit timely development of all necessary cost data in the form required by the specific contract type contemplated. This may be particularly critical where the contract type requires revision of price while performance is in progress, or where a cost-reimbursement type of contract is being considered and all current or past experience with the contractor has been on a fixed-price basis (see § 3.809).

(6) Other concurrent contracts. If performance under a proposed procurement involves operations which concurrently are required in performance of other work, the nature of the pricing arrangements on the other work may be important in selecting the contract type for the proposed procurement. This factor may not be so important where close controls exist that will assure proper allocation of costs.

(b) Research. In the majority of research programs, including preliminary explorations and studies, the work to be performed cannot be described precisely. Hence, the negotiation of cost-plus-afixed-fee or cost-sharing contracts frequently is necessary. However, where the level of contractor effort desired can be identified and agreed upon in advance of performance, negotiation of a firm fixed-price contract should be considered.

(c) Development and test. Where possible, a final commitment to undertake specific product development and test should be avoided until preliminary exploration and studies have indicated a high degree of probability that the development is feasible and the Government generally has determined both its minimum requirements for product performance and schedule completion and its desired performance and schedule completion objectives. The precision with which the performance objectives can be defined will largely determine the type of contract employed, with firmfixed-price contracts receiving first consideration. In all major system developments, and in other development programs where use of cost and performance incentives are considered desirable and administratively practicable, fixed-priceincentive and cost-plus-incentive-fee contracts are to be considered in that

order of preference. The solicitation should describe the Government's minimum requirements for product performance and schedule completion, its desired performance and schedule completion objectives, and the type of contract contemplated. The Government's minimum requirements for product performance and schedule completion generally should not be considered subject to negotiation. The solicitation should also indicate the factors on which the Government will evaluate proposals and which of those factors the Government considers most important (e.g., greater weight may be assigned to the range of an aircraft than to its speed). When incentive contracts are to be used, contractors shall be required to submit targets and incentive sharing arrangements for meeting or surpassing the Government's requirements for performance and for schedule completion, together with an estimate of the cost thereof. The targets proposed by each offeror, the estimated cost thereof, and the sharing arrangements proposed should, to the extent practical, be considered by the Government in the contractor selection process. When this approach to contractor selection has been used, the resulting development program should be performed under an incentive contract which includes performance, schedule completion, and cost targets, the requisite test procedures by which attainment of performance targets will be measured, and provisions for varying profits to the extent targets are or are not met. order to provide maximum incentive, the swing of profit variation should in each case be as wide as practical (see § 3.4054(b)). The introduction of incentives into development is of such compelling importance that, to the extent practical, firms not willing to negotiate appropriate incentive provisions may be excluded from consideration for the award of development contracts.

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ices which are being procured. In providing for an adjustable price, the contract may fix a ceiling price, target price (including target cost), or minimum price. Unless otherwise provided in the contract, any such ceiling, target, or minimum price is subject to adjustment only if required by the operation of any contract clause which provides for equitable adjustment, escalation, or other revision of the contract price upon the occurrence of an event or a contingency.

§ 3.404-2 Firm fixed-price contract.

(a) Description. The firm fixed-price contract provides for a price which is not subject to any adjustment by reason of the cost experience of the contractor, in the performance of the contract. This type of contract, when appropriately applied as set forth below, places maximum risk upon the contractor. Because the contractor assumes full responsibility, in the form of profits or losses, for all costs under or over the firm fixed-price, he has a maximum profit incentive for effective cost control and contract performance. Use of the firm fixed-price contract imposes a minimum administrative burden on the contracting parties.

(b) Application. The firm fixed-price contract is suitable for use in procurements when reasonably definite design or performance specifications are availgable and whenever fair and reasonable prices can be established at the outset, such as where:

(1) Adequate competition has made = initial proposals effective;

(2) Prior purchases of the same or similar supplies or services under competitive conditions or supported by valid cost or pricing data provide reasonable price comparisons;

(3) Cost or pricing information is available permitting the development of realistic estimates of the probable costs of performance;

(4) The uncertainties involved in contract performance can be identified and reasonable estimates of their possible impact on costs made, and the contractor is willing to accept a firm fixed price at a level which represents assumption of a reasonable proportion of the risks involved; or

(5) Any other reasonable basis for pricing can be used consistent with the purpose of this type of contract.

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(a) Description. The fixed-price contract with escalation provides for the upward and downward revision of the stated contract price upon the occurrence of certain contingencies which are specifically defined in the contract. The risks in a fixed-price contract are reduced by the inclusion of escalation provisions in which the parties agree to revise the stated price upon the happening of a prescribed contingency. Where escalation is agreed upon, upward adjustments shall be limited by the establishment of a reasonable ceiling, and provisions will be included for downward adjustments in those instances where the prices or rates fall below the base levels provided in the contract. In the establishment of the base levels from which escalation will operate, contingency allowances shall be eliminated from the base to be set forth in the contract to the extent that escalation is provided for any particular contingency. Generally, escalation provisions are of two broad types:

(1) Price escalation provides for adjustment of the contract price on the basis of increases or decreases from an agreed upon level in published or established prices of specific items or in price levels of the contract end items.

(2) Labor and material escalation provides for adjustment of the contract price on the basis of increases or decreases from agreed standards or indices in wage rates, specific material costs, or both.

(b) Application. Use of this type of contract is appropriate where serious doubt exists as to the stability of market and labor conditions which will exist during an extended period of production and where contingencies which would otherwise be included in a firm fixed-price contract are identifiable and can be covered separately by escalation. Its usefulness is limited by the difficulties inherent in its administration. To the extent possible, escalation should be restricted to industrywide contingencies and labor and material escalation should be limited to contingencies beyond the normal control of the contractor.

§ 3.404-4 Fixed-price incentive con

tracts.

(a) Description (1) General. The fixed-price incentive contract is a fixedprice type contract with provision for adjustment of profit and establishment of the final contract price by a formula based on the relationship which final negotiated total cost bears to total target costs.

(2) Firm target. Under this type of incentive contract there is negotiated at the outset a target cost, a target profit, a price ceiling (but not a profit ceiling or floor), and a formula for establishing final profit and price. After performance of the contract, the final cost is negotiated and the final contract price is then established in accordance with the formula. Where the final cost is less than target cost, application of the formula results in a final profit greater than the target profit; conversely, where final cost is more than target cost, application of the formula results in a final profit less than the target profit, or even a net loss. Thus, within the price ceiling, the formula provides for the Government and the contractor to share the responsibility for costs greater or less than those originally estimated, as determined by a comparison of negotiated final cost with target cost. Because the profit resulting from application of the formula is in inverse relationship to costs, the formula provides the contractor in advance with a calculable profit incentive to control costs. To provide an incentive consistent with the circumstances, the formula should reflect the relative risks involved in contract performance. Thus, it is appropriate in certain procurements to establish formula which provides for contractor assumption of a considerable or major share of total cost responsibility. In such circumstances, when a major share of total cost responsibility is assumed by the contractor, every consideration will be given to establishing target profits which reflect assumption of such responsibility.

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(3) Successive targets. Under this type of incentive contract there is negotiated at the outset an initial target cost, an initial target profit, a price ceiling, a formula for fixing the firm target profit, and a production point at which the formula will be applied. Generally, the production point will be prior to delivery or shop completion of the first item. This

formula does not apply for the life of the contract but simply is used to fix the firm target profit for the contract. The initial formula shall also provide for a ceiling and floor on the firm target profit. To provide an incentive consistent with the circumstances, the formula for fixing the firm target profit should reflect the relative risk involved in establishing an incentive arrangement where cost and pricing information were not sufficient to permit the negotiation of firm targets at the outset (see paragraph (b) (3) of this section). Thus, it normally will not provide for as great a degree of contractor cost responsibility as would a formula for establishing final profit and price. When the production point for applying the formula is reached, the firm target cost is then negotiated, consideration being given to experienced cost and all other pertinent factors, and the firm target profit is automatically determined in accordance with the formula. At this point, two alternatives are possible. First, a firm fixed price may be negotiated using as a guide the firm target cost plus the firm target profit. Second, if use of the firm fixed price is determined to be inappropriate, a formula for establishing final profit and price may be negotiated, using the firm target profit and the firm target cost. As in the firm target type of contract described in subparagraph (2) of this paragraph, the final cost is negotiated at the completion of the contract and the final contract price is then established in accordance with the formula for establishing final profit and price.

(4) Billing price. In either of the above types of contract, a billing price will be established as an interim basis for payment. This billing price may be adjusted within the ceiling limits, upon request of either party to the contract, when it becomes apparent that final negotiated costs will be substantially different from the target cost.

(b) Application. (1) Fixed-price incentive contracts are appropriate when use of the firm fixed-price contract is inappropriate, and the supplies or services being procured are of such a nature that assumption of a degree of cost responsibility by the contractor is likely to provide him with a positive profit incentive for effective cost control and contract performance. It may also be appropriate to negotiate additional incentive provisions covering performance

levels and more timely delivery (see §3.407-2). Contract performance requirements must be such that there is reasonable opportunity for the incentive provisions to have a meaningful impact on the manner in which the contractor manages the work.

(2) The firm target type of incentive contract, described in paragraph (a) (2) of this section, is appropriate for use whenever a firm target and a formula for establishing final profit and price can be negotiated at the outset which will provide a fair and reasonable incentive.

(3) The successive targets type of incentive contract, described in paragraph (a)(3) of this section, is appropriate for use whenever available cost and pricing information is not sufficient to permit the negotiation of realistic firm targets at the outset. However, enough information should be available to permit negotiation of initial targets, and there should be reasonable assurance that additional reliable information will be available at an early point in the performance of the contract so as to permit negotiation of either a firm fixed price, or firm targets and a formula for establishing final profit and price, which will provide a fair and reasonable incentive. The additional information need not in all cases come from experience under the contract itself, but may be drawn from experience on any other contracts for the same or similar items.

(c) Limitations. Fixed-price incentive contracts shall not be used unless the contractor's accounting system is adequate for price revision purposes and permits satisfactory application of the profit and price adjustment formulas. In no case should such contracts be used where cost or pricing information adequate for firm targets is not available at the time of initial contract negotiation or at a very early point in performance, or the sole or principal purpose is to shift substantially all cost responsibility to the Government. In no case shall the firm target profit or the formula for final profit and price be established prior to the negotiation of the firm target cost. Neither type of fixed-price incentive contract shall be used unless a determination has been made, in accordance with the requirements of Subpart C of this part, that:

(1) Such method of contracting is likely to be less costly than other methods, or

(2) It is impractical to secure supplies or services of the kind or quality required without the use of such type of contract.

§ 3.404-5 Prospective price redetermination at a stated time or times during performance.

(a) Description. This type of contract provides for a firm fixed price for an initial period of contract deliveries or performance and for prospective price redetermination either upward or downward at a stated time or times during the performance of the contract. It also may provide for a price ceiling, where appropriate. Once established, ceiling prices are subject to adjustment only by reason of the operation of other contract clauses (see § 3.404-1).

(b) Application. This type of contract is appropriate in procurements calling for quantity production or services where it is possible to negotiate fair and reasonable firm fixed prices for an initial period, but not for subsequent periods of contract performance. This initial period should be the longest period for which it is possible to establish fair and reasonable firm fixed prices at the time of original negotiation. The length of the prospective pricing periods should depend on the circumstances of each case and should generally be at least twelve months each. Ceiling prices,

where appropriate, should be based on an evaluation of the uncertainties involved in contract performance, and their possible impact on cost, and should be negotiated at a level which represents contractor assumption of a reasonable degree of risk.

(c) Limitations. This type of contract shall not be used unless:

(1) It has been established through negotiation that a firm fixed-price contract does not fulfill the requirements established by the conditions surrounding the procurement;

(2) The contractor's accounting system is adequate for price redetermination purposes;

(3) The prospective pricing period can be made to conform with the operation of the contractor's accounting system; and

(4) Reasonable assurance exists that price redetermination action will be taken promptly at the time or times specified.

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