Incentive Contracts

To alleviate some of the previously mentioned problem areas, clients, especially the government, have been placing incentive objectives into their contracts. The fixed-price-incentive-fee (FPIF) contract is an example of this. The essence of the incentive contract is that it offers a contractor more profit if costs are reduced or performance is improved and less profit if costs are raised or if performance goals are not met. Cost incentives take the form of a sharing formula generally expressed as a ratio. For example, if a 90/10 formula were negotiated, the government would pay for 90 cents and the contractor 10 cents for every dollar above the target cost. Thus it benefits both the contractor and the government to reduce costs, because the contractor must consider that 10 percent of every dollar must be spent by the company. Expected profits can thus be increased by making maximum use of the contractor's managerial skills.

In the FPIF contract, the contractor agrees to perform a service at a given fixed cost. If the total cost is less than the target cost, than the contractor has made a profit according to the incentive-fee formula. If the total cost exceeds the target cost, then the contractor loses money.

Consider the following example, which appears in Figure 21-1. The contractor has a target cost and target profit. However, there is a price ceiling of $11,500, which is the maximum price that the contractor will be paid. If the contractor performs the work below the target cost of $10,000, then additional profit will be made. For example, by performing the work for $9,000, the contractor will receive a profit of $1,150, which is the target profit of $850 plus $300 for 30% of the underrun. The contractor will receive a total price of $10,150.

SHARING 70/30

TARGET COST 10,000 TARGET PROFIT 850

TARGET PRICE 10,850

PRICE CEILING 11,500 CONTRACTOR SHARE 30% BUYER SHARE 70%

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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