Defense Contractor Negotiation & Pricing

Accounting 6310Fall 2002Richard E. McDermott, Ph.D.

Source

Data summarized from Pricing Manual of the Federal Acquisition Regulations (FAR).

Determining Contract Type• By contract type we mean

compensation arrangement• There is no best contract type for

every occasion• Select contract type that will result

in reasonable contractor risk with the greatest incentive for efficient economic performance

Three Contract Types

• Firm fixed price• Cost reimbursement• Labor hour and time and materials

A

FEDERAL RESERVE NOTE

THE UNITED STATES OF AMERICATHE UNITED STATES OF AMERICA

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ONE DOLLARONE DOLLAR

WASHINGTON, D.C.

THIS NOTE IS LEGAL TENDER

FOR ALL DEBTS, PUBLIC AND PRIVATE

SERIES

1985

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Firm fixed price

• Firm fixed price• Fixed price with economic price

adjustment• Fixed price incentive fee• Fixed price with successive targets• etc.

Cost reimbursement

• Cost reimbursement• Cost sharing• Cost plus fixed fee• Cost plus award fee• Cost plus incentive fee

Labor hour and time and materials

• Both of these include fixed labor rates but only estimates of hours to complete the contract

• Neither require the contractor to complete the required work within an agreed upon price

Consider Contractor Risk

• Having contractors accept unknown or uncontrollable risk can result in– Poor contract performance– Reduced competition– Substantial increase in contract price

Two Areas of Risk

• Performance Risk• Market risk

Performance Risk

• Most contract risk is related to contract requirements and the uncertainty surrounding contract performance

Performance Risk

• Consider– Stability and clarity of contract

specification or statement of work– Type and complexity of the item

being purchased– Availability of historical pricing data– Prior experience in providing required

supplies or services

Cost Risk and Contract Type• Exploration and development--cost plus

fixed fee• Test/demonstration--cost plus incentive

fee or fixed price incentive fee• Full scale development--cost plus

incentive fee, fixed price incentive fee, or firm fixed price

• Full production--firm fixed price

Market risk

• Changes in the marketplace will affect contract costs– Changes in prices of labor– Changes in prices of materials– Changes in availability of labor or

materials

Market Risk

• Address through contracts with economic price adjustment clause

Pricing

• Definition of price• Seller pricing objectives and

approaches• Government pricing objective• Government approaches to

contract pricing

Definition of price

• Price is the amount the buyer pays for a product or service

• When contract price is less than cost, performance risk increases

• If contractor effort to control costs result in unsatisfactory performance, contractor default is a real possibility

Seller pricing objectives

• Pricing objectives– Cover costs and earn profit

• Operational objectives– Short-term/long-term profitability– Market share– Survival– Product quality– Productivity

Seller Pricing Approaches

• Cost based pricing• Market based pricing

Cost based pricing

• Mark-up Pricing--price is based on cost plus markup

• Margin on Direct Cost--base price on amount necessary to achieve profit margin as a percent of price

• Rate of Return Pricing--profit is calculated based on return on investment

Market Based Pricing

• Profit maximization pricing• Marker share pricing• Market skimming• Current revenue pricing• Promotional pricing• Demand differential pricing

• Market competition pricing

Market Skimming Pricing

• Charge early buyers a premium

Promotional Pricing

• Products are priced to enhance the sales of the overall product line rather than the profitability of each product

Demand Differential Pricing• Products sold in different markets

are sold at different prices– Get what the customer will pay

Market Competition Pricing• Price is based on what action the

competitors have taken or are expected to take

• Firms follow this pricing strategy in relatively homogeneous markets

Government pricing objective• Pay a fair and reasonable price

– What is fair?

• Price each contract separately– Don’t try and balance the financial

results of one contract against another

• Exclude contingencies– Items that cannot reasonably be

estimated at the time of award

Examples of Contingencies

• Results of pending litigation• Cost of volatile market price

changes

Evaluating the Bid

• Evaluate price• Analyze cost

Evaluate price

• Compare prices in competitive bidding situations

• Look at competitive published price lists, rebate agreements etc.

• Get independent price estimates

Analyze cost

• When do you look at bidder’s costs?– When you require offeror to submit

cost or pricing data– Why have offeror submit cost data?

• To provide support that proposed price is reasonable

Contract Costs Include

• Direct costs• Indirect costs• Fee

Government approaches to contract pricing

• Quantitative Techniques for Contract Pricing

• Cost Analysis• Negotiation Techniques

Quantitative Techniques for Contract Pricing

• Round table estimating• Comparison• Detailed analysis

Round table estimating

• Get various experts around a table, have them come up with their best estimate of what the price will be

• Use only where historical costs, detailed drawings, bills of materials, and specifications are not available

Comparison• Index numbers can be used to

adjust historical costs for inflation• CVP is used

– Regression analysis used to determine relationship between independent and dependent cost variables

• Improvement curve analysis• Moving averages

Detailed analysis

• Break costs into tasks, estimate resources required for each task

Detailed Analysis Questions• Can the material requirements

stated in the bill of materials be tracked directly to the drawings and specifications?

• Are scrap rates reasonable?• Are price estimates based on the

quantities required by the contract?

Detailed Analysis Questions• Are labor requirements based on

detailed analysis of the processes and materials required to complete the contract?

• Do labor rate estimates consider the time period of the labor requirement?

• Do labor rate estimates consider the skill level of the labor required to complete the contract?

Detailed Analysis Questions• Do labor rate estimates consider

changes in the work force?• Do labor rate estimates consider

geographical differences?

Cost Analysis

• Contract costs are monetary measures of capital and labor required to complete a contract– Cash expenditures– Expense accrual– Inventory draw-down

Defective cost or pricing data• Cost or pricing data that is

inaccurate, incomplete, or non-current

• If the government suspects after the award that there was defective pricing, they can request an audit

Defective cost or pricing data

• If the audit shows there was defective pricing, the government is entitled to a price adjustment, including fee or profit.– Government can also get interest on

over-payment

Forward pricing rates

• Prepared by contractor• Audited by government• When accepted, used in bidding

contracts for that fiscal year

Fee or Profit

• The fee objective does not necessarily represent net income to the contractors– Some costs are disallowed

• Entertainment

Profit Analysis Factors

• Contractor effort– Material acquisition– Conversion direct labor– General management

Profit Analysis Factors

• Contractor risk– Cost responsibility and risk the

contractor will assume– Fixed price contracts have more risk,

will probably have more profit potential

Profit Analysis Factors

• Federal socioeconomic programs• Capital investment• Cost control and other past

accomplishments• Independent development--did

contractor do R&D on own?

Negotiation

• A process of communication in which two parties, each with its own viewpoint and objectives, attempts to reach a mutually satisfactory result on a matter of common concern.

Negotiation vs. Sealed Bidding• FAR states that any contract

awarded using other than sealed bidding is considered a negotiated contract

The best negotiators . . .• Plan carefully• Gain management support• Effectively apply bargaining techniques• Tolerate conflict while searching for

agreement• Project honestly• Foster team cooperation• Apply good business judgement

Win/win negotiators

• Attack the problem, not each other• Focus on long-term satisfaction and

common interests• Consider available alternatives• Base results on objective standards

whenever possible• Focus on positive tactics to resolve

differences

Win/lose negotiators . . .

• Are deceptive• Focus on negotiating positions

rather than long term satisfaction• Are argumentative• Show reluctance to make any

meaningful concessions• Are highly competitive and

mistrustful of others

Negotiating Strategies

• Plan the order for addressing issues– One approach: Start with least

important issues first, concessions on several less important issues may limit or eliminate the need for concession on more important issues

– Another approach: Address issues according to ease of reaching agreement.

Negotiating Strategies

• Building block approach– Basic requirements are addressed

before price is addressed– Tradeoffs between contract

requirements and contract price are addressed after resolution of other issues

– Contract price is not finally resolved until all other issues are settled

Draft a negotiating plan

• Background (contract, contractor, negotiation situation)

• Major and minor negotiation issues and objectives

• Negotiation priorities and positions on key issues

• Negotiation approach

Noncompetitive Negotiations• Occur in sole-source situations

– Example: Only one contractor has the technical expertise to perform a contract

Ten Rules for Bargaining Success• Be prepared• Aim high• Give yourself

room to compromise

• Put pressure on the contractor

• Do not volunteer weaknesses

• Use concessions wisely

• Say it right• Satisfy non-price

issues• Use the power of

patience• Be willing to walk

away from negotiations

Put pressure on the contractor• Refer to potential alternatives such

as:– Canceling and resoliciting– Changing product requirements to

encourage competition– Investing in new source development– Performing the contract with in-house

Government resources

Use concessions wisely

• Don’t rush to make concessions, concede slowly and in small amounts. Concessions too large or given too quickly:– Raise the expectations of the other negotiator– Give the impression the concessions were not

important to you– Leave little room for further maneuvering – Be more than necessary to get a mutually

satisfactory result

Use the power of patience

• Use patience to:– Increase the stress on the contractor’s

negotiator– Display resolve or firmness by showing

you are not overly anxious for a settlement

– Dissipate emotional feelings surrounding certain issues by showing a willingness to proceed through negotiations

Be willing to walk away from negotiations

• There is some risk to this tactic--it is difficult to get the negotiations started again if this is your eventual intent

The End