screening" and the "establishment of appropriate controls with respect to subcontracts when

"(a) The subcontract is for an item upon which there is no cost information or the pricing appears unrealistic, and the amounts involved are substantial;

"(b) Close working arrangements, or other business or ownership affiliations exist between the prime and the subcontractor which may preclude the free use of competition or close pricing;

"(c) The terms of the proposed subcontract, purchase order, or informal commitment provide for downward price revision at a given point or after completion and the prime contractor quotations are based on the subcontractor's maximum price;

"(d) The subcontractor is pricing less favorably to the prime contractor than it prices prime contracts with the Government to be performed in approximately the same periods;

"(e) The subcontract or purchase order is to be placed on a cost basis." It was further provided that (i) where "substantial contingencies, lack of cost experience, lack of available or effective competition" are apparent in proposed subcontract prices, the contracting officer will recommend "repricing provisions" in the subcontract or "consideration of another source" by the prime contractor; and (ii) "care should be taken to insure that the effects of repricing of subcontracts or purchase orders are reflected in the final contract price." Essentially these controls were incorporated in ASPR 3-808.5 (Feb. 1, 1957), but with the addition of a further contractual requirement for the Government to have the right to audit the records of subcontractors whose contracts are subject to Government approval.

2. Additional controls provided in 1959.—The foregoing controls were supplemented by a revision to ASPR of October 1, 1959, as follows:

(a) First-tier subcontractor's certificate of disclosure to prime contractor of all current cost and pricing data generally required for subcontracts in excess of $100,000: ASPR 3-807.5(a) (Oct. 1, 1959). The form of certificate is substantially that set forth in II A 4e supra, modified to reflect that it is a certification to the prime contractor rather than to the Government. Also "the prime contractor shall be required to furnish such certificate to the contracting officer." (b) Provision made for repricing prime contracts in light of subcontract repricing: ASPR 3–807.5(b) (Oct. 1, 1959). It is there provided that "where certain subcontracts are subject to redetermination and available cost data on these subcontracts are highly indefinite but other circumstances require prompt negotiation of revised prime contract prices, the contract modification which evidences the revised contract prices should provide for adjustment of the total amount paid or to be paid under the contract on account of subsequent redetermination of specified subcontracts. This may be done by including in the contract modification a provision substantially as follows:

"Promptly upon the establishment of firm prices for each of the subcontracts listed below, the contractor shall submit, in such form and detail as the contracting officer may reasonably require, a statement of costs incurred in the performance of such subcontract and the firm price established therefor. Thereupon, notwithstanding any other provisions of this contract as amended by this modification, the contractor and the contracting officer shall negotiate an equitable adjustment in the total amount paid or to be paid under this contract to reflect such subcontract price revision. The equitable adjustment shall be evidenced by a modification to this contract, signed by the contractor and the contracting officer.'

"[List subcontracts]"

(c) Standard clause for approval of certain subcontracts prescribed for fixedprice incentive and redeterminable prime contracts (ASPR 3-903.1 (Oct. 1, 1959)) This clause is generally required when one or more subcontracts will exceed $100,000 or when the prime contract will exceed $1,000,000. Among other things, it incorporates the requirements of the certificate described in II D 2a supra.

E. Special factors for pricing sole source items

ASPR 3-807.6 (Oct. 1, 1959): "When purchases of standard commercial or modified standard commercial items are to be made from sole source suppliers, use of the techniques of price and cost analysis may not always be possible. In such instances and consistent with the volume of procurement normally consummated with the contractor, the contractor's price lists and discount

or rebate arrangements should be examined and negotiations conducted on the basis of the 'best user,' 'most favored customer' or similar practice customarily followed by the contractor. Such price negotiations should consider the volume of business anticipated for a fixed period, such as a fiscal year, rather than the size of the individual procurement being negotiated. When a contractor whose product is required because of its proprietary character or whose technical assistance is essential declines to negotiate a profit or fee in accordance with the considerations and factors set forth in ASPR 3-808.1 or 3-808.2 or demands a profit or fee which the contracting officer considers to be unreasonable in relation to the supplies to be furnished or services or work to be performed, the procuring activity concerned should attempt to develop an alternate source of supply."

F. Neither statutory renegotiation nor contractor's certificate of reliability of cost data acceptable substitutes for pricing negotiations

ASPR 3-807.8 (Oct. 1, 1959): “Contracting officers shall not rely primarily (i) on the contractor's certificate as to the reliability of current data used in negotiations where effective competition is not obtained, nor (ii) on profit limiting statutes as remedies for ineffective pricing."

III. REQUIREMENTS FOR AUDIT OF CONTRACT PRICES

A. Auditing of contractors' proposals for price redetermination and for final pricing of incentive contracts generally required since 1951

Thus a letter from the Chief of the Bureau of Aeronautics of October 3, 1951, to the Chief, Bureau of Supplies and Accounts "requested that Bureau of Supplies and Accounts, Cost Inspection Service, submit an advisory report in connection with the final redetermination of each incentive fixed-price type contract issued by this Bureau." Similar requests for audit reports on the final pricing of incentive and redeterminable type contracts were made in 1951 by the Bureau of Ordnance and the Bureau of Ships."

8

B. Importance of auditing as a pricing aid emphasized in 1957 and 1958

1. General guidelines set forth in ASPR 3-809 (Feb. 1, 1957).—“The audit services within the Military Departments should be utilized as a pricing aid by the contracting officer to the fullest extent appropriate when the dollar amount involved is sufficiently large to, or special circumstances exist which warrant the time and expense required for the particular type of advisory audit, special survey, or audit analysis of price or cost desired. Judicious use of audit services will expedite proper pricing. The determination as to the necessity of an audit report for pricing purposes is the responsibility of the contracting officer. When requesting audit services, the contracting officer shall state the purpose for which the report is to be used and define any specific areas of audit examination which should be given special attention ***. Close coordination between the audit agency and procurement personnel will assist in determining the necessity of audit of price or cost proposals or the necessity of special surveys relating to contractor's accounting or purchasing systems. Some of the conditions under which the contracting officer should consider the use of audit services include

"(i) inadequate knowledge concerning the contractor's accounting policies, cost systems, or substantially changed methods or levels of operation; "(ii) previous unfavorable experience indicating doubtful reliability of the contractor's estimating, accounting, or purchasing methods;

"(iii) procurement of a new product for which cost experience is lacking; and

"(iv) contract performance requiring a substantial period of time."

8 Chief, BuOrd, letter of Jan. 10, 1951, to Chief, BuSandA: "It is requested that Cost Inspection Service schedule all Bureau of Ordnance contracts containing price redeter. mination clauses for submission of an advisory report *** as soon after the target date for price redetermination as is practicable."

® Chief, BuShips, letter of Aug. 9, 1951, to Chief, BuSandA :

"1. Effective immediately it will be the policy of the Bureau of Ships to require Cost Inspection advisory reports on all redeterminations except in the following:

(a) Contracts less than $100,000.

"(b) Contracts in excess of $100,000 if the Contract Division informs Cost Inspection Service that an advisory report is not desired.

"2. In those cases when the redetermination point has been reached and the contractor has submitted redetermination data to the Contract Division, Cost Inspection will not make any audit unless requested to do so by the Contract Division Also, should an advisory report be desired on any contract of less than $100,000, a specific request will be made by this Bureau."

2. May 1958: Secretary of the Navy policy statement that auditing is imperative in complex negotiations of large dollar amounts.-"Close adherence to the policies outlined in [ASPR 3-809] is essential to good contracting. In the more complex negotiations involving large dollar amounts, it is imperative that the contracting officer and negotiator avail themselves fully of the talents of specialists in the fields of law, accounting, finance, engineering, and particularly audit and cost analysis. Advisory reports submitted by cost analysts and auditors which are accompanied by appropriate comments of technical and engineering personnel, are valuable pricing aids and are especially important to the negotiator when normal price analysis techniques will not bring about the desired result. The policy requirement does not, however, relieve the contracting officer of his primary responsibility for accomplishing the objective of a fair and reasonably priced contract." 1o

C. October 1959: Auditing requirements explicitly extended to target prices under incentive contracts, conversion of letter contracts, equitable adjustments in contract prices, and other pricing actions primarily based on contractor's cost data

1. Advisory audit reports required.—“(1) Contracting officers shall request the Contract Audit Division for an advisory audit report for the purpose of obtaining an independent evaluation of contractors' proposals in the following

cases:

"(i) conversion of letter contracts;

"(ii) redetermination of contract prices;

“(iii) setting of firm targets under incentive contracts;

"(iv) final pricing of incentive contracts; and

"(v) equitable adjustments including change orders; unless the contract. ing officer determines that there are good and sufficient reasons for waiving the use of such audit assistance. Such reasons might be the availability of adequate current information from other sources or the small dollar amount of the proposal compared to the time and expense of securing an advisory report. Where audit assistance has been waived and business clearance is required, the details supporting the waivers shall be furnished as part of the business clearance.

"(2) Contracting officers should also generally obtain advisory audit reports for use in negotiating any pricing action where the negotiations involve submission of cost data by the contractor and reliance thereon is a major pricing factor. In all such cases where business clearance is required and an advisory report was not requested, the clearance submissions should cover this point." "

2. The auditor as part of the negotiating team.-"It is the policy of the Department of the Navy that the 'team concept' in negotiated procurement shall be utilized to the maximum extent practicable ***. This includes in appropriate cases, participation of the liaison accountant or field auditor in both prenegotiation and negotiation meetings internally and with the contractor whenever (i) substantial amounts of costs are questioned, (ii) cost considerations are influenced by method of accounting, or (iii) any other cost or accounting matter of substance requires professional accounting assistance in its disposition. Operation under the team concept, however, does not relieve the contracting officer of the sole responsibility of controlling and conducting negotiations and making final determinations with respect to prices, nor does such participation change the auditor's position to other than advisory." 12

D. Audit of adequacy of contractor's accounting system required prior to awarding contracts in excess of $300,000 on other than a firm fixed-price basis NPD 8-303 (Oct. 15, 1959): "When it is proposed to use other than a firm fixed-price type of contract, and the contract is subject to business clearance by the Office of Naval Material, the Contract Audit Division of the Office of the Comptroller of the Navy shall be requested by the contracting officer to furnish advice as to whether the proposed contractor has an accounting system which lends itself to the satisfactory administration of the particular type of contract

10 SecNav memo of May 19, 1958, to Navy Bureau Chiefs.

11 NCPD 6-60 (Oct. 8, 1959), to be published as NPD 3-809. This directive would appear to accord with the GAO recommendation in its report, note 2, supra, at 29, that "for significant items, the Navy should verify independently [contractor's representation as to actual costs and estimates of future costs] through review of the records from which it was derived."

12 Ibid.

or pricing provisions proposed. If placement of the contract is imperative due to a valid urgency, the request to the Contract Audit Division and the Contract Audit Division's reply may be made orally. The Business Clearance Memorandum submitted to the Office of Naval Material (Code M38) shall make reference to the advice received from the Contract Audit Division concerning the proposed contractor's accounting system. Omission from the Business Clearance of reference to such advice and action thereon will result in automatic return of the Business Clearance without action."

E. Use of auditors in analysis of significant subcontract prices required whenever audit is made of prime contract pricing (NavCompt notice 7572 of July 9, 1959)

IV. INSTRUCTIONS ON USE OF FIRM FIXED-PRICE AND INCENTIVE CONTRACTS

A. Navy contract law (1949) fully explained the advantages and limitations of these types of contracts; restated in 1959 edition

With regard to firm fixed-price contracts, "Navy Contract Law" stated at p. 140:

"The straight fixed-price contract, as the name implies, represents an agree ment by the contractor to furnish designated supplies or services at a specified firm price. In its basic form, it carries the greatest risk and offers the greatest possibility of profit of any type of contract, since the contractor cannot collect more than the agreed fixed price but is entitled to receive the full amount of the fixed price, regardless of the actual cost of performing the contract. type of contract is preferred whenever a sound estimate of the cost of performing a contract can be made at the time of negotiation. Since it is fundamentally a simple exchange of a specified sum of money for a specified item, it is also the easiest and least costly of all types of contracts to administer." "

This

With regard to fixed-price incentive contracts, "Navy Contract Law" stated at p. 143:

"From the standpoint of the Government, the worst type of contract is the type of contract (like the cost-plus-a-percentage-of-cost contract) under which the allowance for profit is increased as the cost of performance increases. Obviously, this type of contract serves as an incentive to contractors to increase the cost of performing the contract in order to secure a larger allowance for profit. Conversely, the best form of contract would seem to be one which gives the contractor the greatest incentive to save costs. Of course, the straight fixed-price contract gives the contractor such an incentive, but the Government does not share in the resulting saving of cost. The maximum price contract theoretically provides some incentive to reduce costs, since the negotiator may recognize economy of performance by allowing a greater sum for profit in the redetermined price; however, many contractors feel that by reducing the base against which profit is customarily measured, the overall profit allowed may be reduced, and so the incentive (if any) to reduce costs in this type of contract is slight. To meet the need of a type of contract which would provide a realistic incentive to save cost, the 'fixed-price incentive-type contract' was devised.

"The fixed-price incentive-type contract requires, first, that a realistic estimate be made of the cost of performing the contract. To this amount, a reasonable allowance for profit is added. The sum of these amounts constitutes the 'base' or 'target' price, in other words the price which the Navy estimates would be fair and reasonable. A maximum amount which the final contract price cannot exceed is next determined. If the final cost of performing the contract is exactly equal to the estimated cost, the contractor receives the predetermined profit. If the final cost is less than the estimated cost, the contractor shares the cost saving on the basis of previously negotiated percentages; the contractor thereby benefits by receiving a larger profit, while the Government benefits by being required to pay a lower total contract price. If the final cost of performing the contract is greater than the estimated cost, the contractor's profit is reduced. If the final cost is equal to the maximum price, the contractor makes no profit; and if it exceeds the maximum price, the contractor is required to absorb the excess at its own expense. Obviously, care must be exercised to keep the maximum price as low as possible if the Government is to enjoy the advantages inherent in the incentive contract. For this reason, the incentive contract should

13 See also "Navy Contract Law," sec. 7.3 (2d edition, 1959) to be published in December 1959 by the Government Printing Office.

be used only where there is sufficient previous cost experience to make it possible to determine a realistic base price.'

B. Navy procurement directives of 1953 repeated basic instructions on use of fixed-price and incentive contracts (NPD 15–201 (1953))

With regard to fixed-price contracts, NPD 15-201.4 stated:

"This type of contract is suitable for use when adequate and reasonably stable specifications are available and a sound estimate of the probable cost of performance can be made, or other assurances as to the reasonableness of price, through price comparisons or otherwise, are available. The firm fixed-price contract shall be the type of contract generally used since it places maximum risk and responsibility upon the contractor and gives him the greatest incentive for cost reduction. This type of contract is particularly suitable for commercial type items generally available from competing sources and for military type equipment which has been produced previously and on which relevant production and cost experience are available. The inclusion in the proposed contract price of reasonable amounts to cover contingencies which have some likelihood of occurrence does not necessarily require or warrant the use of price redetermination provisions."

Concerning the use of fixed-price incentive contracts, this directive further provided:

"This type of contract is suitable for use when the contract (i) requires production over a relatively long period; (ii) considerable difficulty is encountered in arriving at firm prices under the anticipated production circumstances; (iii) costs can be estimated either initially or at an early interim point wth substantal accuracy; (iv) reasonable opportunities exist for cost reductions due to the fact that a significant portion of the costs of manufacture are of a nature susceptible to contractor efficiency; e.g., reductions in labor hours due to im proved production techniques; or (v) where competitive or other information available to contracting personnel indicates that the price proposed by the contractor is susceptible to further reduction through greater efficiency."

C. "Navy Negotiators Handbook" (1953) contained thorough discussion of factors appropriate to the selection of fixed-price and incentive contracts; restated in 1958 edition

See chapter V B 2 for the discussion of firm fixed-price contracts and chapter V B 5 for the discussion of fixed-price incentive contracts. Particular emphasis is placed on the inappropriateness of these types of contracts when the cost of performance cannot be estimated with substantial accuracy. These points are restated in the 1958 edition of the handbook under the same subdivisions of chapter 5.

D. Current instructions in the Armed Services Procurement Regulation

1. The firm fixed-price contract shall not be used when contingencies proposed in the contract price are considered unreasonable (ASPR 3-403.1 (c)).

2. Limitations on the use of fixed-price incentive contracts.-"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 formula. In no case should such contracts be used where (i) reliable cost estimates are not available at the time of initial contract negotiation or at a very early point in performance, or (ii) the sole or principal purpose is to shift substantially all of the risk of performance to the Government" (ASPR 3-403.4 (c) (May 14, 1958)).

3. Criteria for selection of appropriate type of contract extended to review and approval of proposed subcontracts (ASPR 3-807.5, 3-903.4 (Oct. 1, 1959)).