Key Details: The government contracting marketplace offers a wide variety of contract types, each with individual benefits and drawbacks. These contract vehicles specify the agreement between your business and the federal government and can cause shifts in the placement of risk. Many contractors kick off with firm-fixed-price (FFP) contracts. However, cost-plus contracts are gaining popularity. There are significant differences between these two contract types. Government contractors are encouraged to understand the various benefits and challenges associated with each type of contract and to analyze how each contract impacts profitability. In part 1 of this two part series, we explore the differences between FFP and cost-plus contracts, the advantages of each, and the questions to ask before accepting a contract. Stay tuned for part 2 where we dive into the key requirements of cost-plus contracts. For further information and expertise, contact Ryan & Wetmore today.
What are Firm-Fixed-Price Contracts & How Do They Work?
Under FAR (Federal Acquisition Regulation) 16.202-1 FFP contracts prescribe a price that is not subject to any adjustment based on a contractor’s cost while performing the contract. As such, FFP contracts place maximum and full risk and responsibility on the contractor regarding costs and the resulting profit or loss. Therefore, contractors are incentivized to control costs to maintain efficiency and profit margins. Furthermore, performing on an FFP contract places additional inflation risk on the contractor as prices remain constant throughout the lifetime of a contract.
When Does the Government Utilize Firm Fixed Price Contracts?
FFP contracts are typically used when the government is purchasing commercial items, supplies, or services that have very detailed and definite specifications and quantities. These items are also offered at a reasonable price and usually include the following situations:
- There is price competition.
- There are reasonable price comparisons.
- There is available and adequate information to estimate costs.
- The fixed price takes into account uncertainties.
Recently, the federal government has started utilizing fixed-price contracts under many different scenarios for a wide variety of products and services. As such, contractors are encouraged to fully understand the benefits and drawbacks of this type of contract as well as the placement of risk on the contractor.
Questions to Ask Before Accepting a Firm-Fixed-Price Contract
Contractors are encouraged to consider the following key items prior to accepting FFP contracts due to the large amount of risk placed on the business:
- Can costs be accurately estimated and controlled throughout the performance of the contract?
- Have costs fluctuated historically and are they expected to change in the future?
- Is your company able to provide the level of effort required to remain profitable on the contract while also meeting all expectations?
- Is this contract going through a competitive bidding process? Should your prices be driven down to improve competitiveness?
- Are you able to reduce the actual cost of contract performance to increase profitability?
What are Cost-Plus Contracts & How Do They Work?
Under FAR 16.3, cost-reimbursement contracts allow contractors to request payment of allowable costs incurred. Through this, an estimate of the total cost is established for obligating funds and establishing a ceiling that contractors may not exceed.
Most cost-plus contracts are broken down into 3 components that we describe in the following sections.
Different Types of Cost-Plus Contracts
There are varying forms of cost-plus contracts, each with different components. Contractors are encouraged to understand the following cost-plus contract types:
- Cost-plus fixed fee: payment provided to the contractor of a negotiated fee that is fixed at inception of the contract.
- Cost-plus award fee: contractor is awarded a fee for good performance.
- Cost-plus incentive fee: contractors are given a fee if their performance meets or exceeds expectations.
- Cost-plus-percent-of-cost: reimbursement based on contractor’s cost increase is allowed.
Under FAR 16.306 CPFF contracts are a type of cost-reimbursement contract that provides payment of a negotiated fee (profit) amount that is fixed upon inception of the contract. This negotiated fixed amount does not vary based on the actual cost incurred but can be adjusted due to changes in work performance under the contract. Therefore, accepting a CPFF contract type lowers the risk contractors may face and places more risk on the government as there is a lower incentive to control costs. This may be especially appealing during periods of high inflation.
Components of a Cost-Plus-Fixed-Fee Contract
CPFF contracts also provide both the government and the contractor with the flexibility of entering into either a large or small-scale project. These contracts allow for more complex jobs where instructions or job specifications are not well defined. CPFF contracts typically include three key components:
- Direct costs relating to materials, supplies, labor, or equipment.
- Overhead costs such as business-related expenses like rent and insurance are incurred to perform on the contract. These costs are then allocated based on a percentage of labor costs.
- The fee or profit that is typically a fixed percentage calculated through direct labor cost.
Contractors are also encouraged to fully understand unallowable costs while performing on cost-plus contracts as these costs must not be billed to the government. Under FAR Part 31, unallowable costs include expenses incurred by the contractor that do not meet the authorization under contract terms and cannot be billed or claimed as part of the contract. Common examples include certain donations, advertisements, entertainment expenses, or fines and penalties. As such, government contractors must have an adequate accounting system and chart of accounts whereby unallowable costs are easily distinguishable and segregated from calculation of indirect rates.
Questions to Ask Before Accepting Cost-Plus-Contracts
Cost-plus contract types bring about another layer of government surveillance due to the reimbursement of allowable costs. As such, contractors are encouraged to consider the following key items before accepting a cost-plus type contract:
- Does your company have an adequate accounting system in place that complies with all requirements on Standard Form 1408 Preaward Survey of Prospective Contractor Accounting System (SF 1408)?
- Can your accounting system segregate direct and indirect costs?
- Is there a logical allocation method in place to allocate indirect costs to intermediate and final cost objectives?
- Do you have a labor distribution or timekeeping system that can track both direct and indirect labor by account or contract?
- Is your accounting system ready for an annual audit by the government?
- Does the contract have ceiling caps on overhead and general and administrative rates
Advantages and Disadvantages of Firm-Fixed-Price Contracts & Cost-Plus-Fixed-Fee Contracts
FFP and cost-plus type contract contracts both bring about various benefits and drawbacks. Government contractors are encouraged to review the list below to understand how each contract may impact your business and operations strategy or to contact Ryan & Wetmore today to speak with an expert.
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Firm Fixed Price |
Cost Plus Contracts |
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Advantages |
Price guarantee |
Profits subject to cost incurred |
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Contractors reap the benefit of higher efficiencies and lower costs |
Lower risk borne by contractor |
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Low administrative management |
Possibility for additional reimbursement |
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The contractor bears full responsibility for the performance costs and net income from the contract Helpful in the solicitation and bidding process |
Lower stress relating to cost control |
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Higher performance incentives Allows the contact to be bid when scope of work is not defined
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Disadvantages |
Need to control costs |
Accounting system must be adequate |
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Inflexible process |
High administrative management requires more software, accounting staff, contracts management etc. |
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High risk and higher prices Risk of estimating errors and cost overruns not covered Supply chain disruptions and inflation could lead to unprofitable contracts |
Accounting system compliance Cost savings are passed on to the government Low profit margins, only costs plus some fixed cost of fee percentage are allowed Be aware of ceiling caps on Overhead & G&A rates |
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Difficult for complex projects |
DCAA unallowable costs are not reimbursed |
Conclusion
Government contractors performing under FFP or cost-plus type contract contracts should understand the regulations and impacts each contract type brings. Furthermore, risk assessment and profit margin analysis associated with performance on different types of contracts should be conducted. As the contracting marketplace consists of a wide variety of contracts, government contractors are encouraged to review and understand the challenges and benefits of each. For more information, contact Ryan & Wetmore today and stay tuned for part 2 of this series.
Today’s Thought Leaders
About Peter Ryan
Partner, Co-founder, & CPA
Peter T. Ryan co-founded Ryan & Wetmore in 1988 with business partner Michael J. Wetmore. Peter provides clients with the best strategies for success. His expertise extends across various industries. Peter obtained a Master of Business Administration in Finance from the University of Baltimore and a Bachelor of Arts in Accounting from the Catholic University of America.
About Rosie Cheng
Finance Consultant
Rosie Cheng is a Finance Consultant at Ryan & Wetmore. She focuses on government contracting services and produces many of the firm’s government contracting newsletters. Rosie graduated from Georgetown University with a Master of Science in Management and from William and Mary with a Bachelor of Business Administration.