An interesting conversation with an astute, anonymous interviewer on Quora, replicated here for those who may be confused at times with regard
to some of the nuances between fixed price and cost plus federal government contracting.
Anonymous:
Why
are cost-plus-fee government contracts less profitable for defense companies
than fixed cost contracts?
KEN
They are extremely low risk because the contractor is
guaranteed reimbursement of any and all costs up to the funded ceiling on the
contract.
Therefore under the guidelines for negotiation of profit based on risk, the
profit range is always settled at a lower range than other types of contracts
with higher risk factors.
Anonymous:
Thank
you Ken. Is the government moving more towards cost-plus contracts and away
from fixed cost contracts?
KEN
It depends on the type of
effort involved. Cost plus is generally in very advanced development
arena, where the state of the art is being pressed, the requirements are
nebulous and the design baseline is tough.
Higher profit production programs where the
product or service is mature, predictable and repetitive are usually the
recipients of firm fixed price contracts at higher profits.
It is common for the huge billions for services in the war
zone for instance to be cost plus due to the unknown nature of warfare. A similar program stateside at an
air force base would lock them into fixed rates for several years but at a
higher profit.
Cost type contracts are generally pursued for
cash flow, "Keep the lights on and bill every month" reasons, while higher
profit programs are being pursued at the same time in the company
Anonymous:
What
about small UAVs / drones? Are those now mostly cost plus contracts?
KEN
During development the more
complex ones are indeed. Size in the services and the intelligence
community does not necessarily equate to simplicity with micro technology, Satcom and sensors involved.
When they hit production on a repetitive basis
they move to more fixed price oriented and incentive oriented higher profit
contract types, which of course is the real goal of the companies involved.
Anonymous:
I'm
confused, I thought cost plus was for more established technology product and
fixed price was for more complex technology product (because it allowed for
higher returns)?
KEN
It is just the opposite.
Companies will not
undertake advanced technology like the F-35 without a cost plus contract
because of the risk in pressing the state of the art and meeting an enormously
difficult specification. A prototype is a one of a kind item.
A production program has high volume potential and yields less risk at a higher profit rate overall at fixed prices.
Pentagon history is replete with incidents where
companies went broke on new product development on a fixed price basis. At one
point the FAR disallowed fixed price product development because of that issue.
The Lockheed Skunk works went broke years ago and
had to be bailed out. The Pentagon simply plussed up their cost plus
contracts and the Black Bird was the result.
The F-35 cost plus contract was finally capped by
the Air Force recently and a portion of the risk shifted to Lockheed due abuse
of the cost plus contracting by Lockheed Martin.
F-35 Program Overruns
Companies seek a production program follow-on at
a high volume and fixed prices with higher profit with lower risk to ultimately
make the real bucks, Under such an arrangement they also own the
tooling. Uncle Sam owns the tooling on a cost plus contract.
Anonymous:
I'm still confused. A company I know had high gross margins because they
had more fixed price business in the last two years. For this year, they will
have more cost plus and are guiding to lower margins. I thought they and more
cost plus this year because they are doing more retrofitting as opposed to the
original technology? I am ultimately trying to understand if this is a
permanent shift in their Department of Defense business... but any
clarification would help!
KEN
It is not surprising that
gross margins go down when the cost plus base increases. I have never
seen it any other way in my 40 years in the aerospace industry. Cost plus
is low risk and low profit.
In fact, on certain cost plus contracts there has been a regulated maximum ceiling on profit.
At the bottom line there is no shift in what you
are observing. It is simply the mix of business in the company driving a
lower profit rate due to the low risk, hence lower profit, nature of the cost
plus environment.
If the mix were to change to a higher base of
fixed price contracts (and higher risk) the opposite trend would occur.
Anonymous:
Is
there a reason why for the last three years they had more fixed contracts but
now over a sudden the mix shifts to cost plus? Does that make
sense? So to understand - this can change every year? Is there any way
to predict it based on the types of products they have going forward? Is it
because they are retrofitting that its cost plus and not fixed?
KEN
Cost plus = high tech, high
risk, difficult to meet the spec, full of unknowns and a specification that is
moving around all the time until the product is base lined.
Fixed Price = mature product, prototyped and
tested, probably through low rate initial production and now going high
quantity for fielding. Lower risk, company willing to commit to FFP;
government comfortable the company will not go broke in doing so at a fixed
price.
Rule of thumb - look at your product or service
complexity and technical challenge mix, not a government trend.
Check the above mix in the company, the mix in
the market, the mix in the competition, the mix in the environment the product
or service will encounter. Then assume cost plus for high
risk, pressing the state of the art procurements and fixed price for lower risk
mature products or experienced services.
Anonymous:
Can
a program start off as fixed price and then become cost plus? Or is it the
opposite?
KEN
The opposite. A program
generally moves from cost plus to fixed price as it matures.
The federal government generally recognizes 6
principal categories of acquisitions. Below is an extract from the FAR
for each.
It is possible for a product to go through,
or be supported by, all 6 acquisition categories during its life cycle
and many different contact types, depending on the nature of the work, the risk
and the product.
