The Hidden Costs of Firm-Fixed Price Contracts

hidden costs As fiscal pressures rise, senior leaders across the federal government place additional emphasis on Firm-Fixed Price (FFP) contracts.  A prime example is the Department of Defense “Better Buying Power” memoranda.  FFP contracting is an important method to add simplicity and cost efficiency, but with respect to services, FFP contracting is not always appropriate.  When bound by inflexible FFP contracts, the government can miss out on savings associated with changes in requirements and may actually spend more and incur additional administrative burden.

When are FFP contracts appropriate?  What planning tool can reveal potential hidden costs?  And how can a touch of flexibility result in better ROI? 

As explained by Federal Acquisition Regulation (FAR) Part 16, FFP contracts establish a price that is not subject to adjustment based on the contractor’s costs.  FFP contracts place all risk and responsibility for cost on the contractor, maximizing the contractor’s incentive to control costs.  FFP contracts also reduce the administrative burden on the government by eliminating the government’s responsibility to monitor contractor costs.

The FAR outlines four considerations to determine if a FFP contract is appropriate:

  • The supplies or services have reasonably definite functional or detailed specifications;
  • The contracting officer can establish fair and reasonable prices;
  • Uncertainties can be identified and their costs reasonably estimated; and
  • The contractor is willing to assume the risks involved.

Challenge: Uncertainties Create Hidden Costs.

FFP Considerations ChartFFP works well for routine or recurring services, such as administrative support, training, and non-complex services.  However, many times the services performed are integrated with the government client’s operations.  The key cost discriminator is process control.  The contractor cannot control costs effectively without controlling the processes, inputs, and outputs.  When contractors support government activities, the business rules, reviews, approvals, priorities, and processes are at best controlled by the supported activity but more likely are controlled by other external government entities.  Government delays, false starts, and re-work related to changes in priority, funding, or approvals inject uncertainties into professional services that lend themselves to Labor Hour or Cost contract types.

The inability to predict changing requirements is the Achilles heels of FFP contracts.  When work requirements grow or decline unexpectedly, funding is reduced, or government offices are reorganized, the impact on contracted services can be significant.  FFP contracts lack the flexibility to respond to these changes without modifications.  Remember, one of the reasons to use a FFP contract is to reduce the administrative burden; bi-lateral agreements, contract modifications, and partial terminations may negate those efficiencies.  It’s tempting to seek no-cost performance adjustments, but this can become a slippery slope of scope creep and result in constructive changes.  Constructive changes are one of the most common sources of contractor claims for additional compensation on FFP contracts.  Surges in requirements are especially problematic: the contract modification’s lead-time delays the ability of the contractor to provide needed support.  Further, the government is in a position of weakness in negotiations because the contractor knows the urgency of the client’s surge requirements and the threat of a new contract is unrealistic.

Additionally, FFP contracts can result in government payments for non-value-added effort or expertise.  A typical scenario is the change in the contracted service requirement over the life cycle of a program.  It’s human nature to emphasize the current need over future requirements.  The government may seek contracted support in anticipation of a surge in workload, or in the early stages of a project or program when uncertainty upticks.  We tend to overestimate or safe-side our requirements, the number of personnel, or the skills mix required performing the contracted effort, covering our bases.  As a program enters sustainment, or learning curves result in process efficiencies however, FFP contracts obligate the government to pay for excess capability, capacity, or expertise.

Solution: A WBS Adds Focus and Clarity

Work Breakdown StructureTo reduce the uncertainty, services requirements must be defined and developed using a deliberate process.  The Work Breakdown Structure (WBS) is an effective method.  A WBS deconstructs the work into functions, tasks, and subtasks better defining the span of effort.  A WBS lists what to do, not how … it is not a list of prescriptive steps for the contractor to follow.

  • To properly identify requirements and reduce uncertainties, ensure the WBS process is a collaborative effort.  Form an integrated project team (IPT) and obtain input from all departments, teams, and key personnel that the contract will support.
  • Review saved emails from the previous year, scanning for issues and unexpected tasks that are likely to be repeated.
  • Review calendars, searching for internal and external events that require support but may get overlooked.
  • Review policies and standing operating procedures for reporting requirements and standard processes.

Combining these reviews with the expertise of the IPT will better define the service requirement, improve the accuracy of the cost estimate, and, if the WBS is provided to potential offerors, will result in a better understanding of the requirement, more accurate pricing, and ultimately a positive ROI.

Solution: Hybrid Contracts Accommodate Unexpected Needs

One solution to FFP’s hazards is incorporating flexibility into your contract structure by using Hybrid Contracts.  During requirements generation, add a column to your WBS identifying each task as Core or Surge.  Core tasks can be Fixed Price – the contractor will be performing them.  An example would be daily operations and sustainment of a system, as well as regularly scheduled maintenance requirements that can be identified and their costs reasonably estimated.  A surge task, like unscheduled maintenance or repair, should be Time & Materials, Labor Hours, or Cost.  Another alternative is the use of contract options.  Price surge tasks, additional expertise, and short term requirements as contract options that can be exercised as needed.  When requirements return to steady state and the options expire, contract costs and performance return to pre-surge levels without costly claims or terminations.

Result:  Hidden Costs Are Avoided

By developing a solid WBS and employing hybrid contracts, the hidden costs of a FFP contract may be avoided.  For complex services, where the contractor lacks process control, Time and Materials, Labor Hours, or other Cost-type contracts may better address the uncertainties.

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