TOPIC: Fixed Price Incentive Fee

Hi,

I'm going through some fixed price incentive fee calculation examples and can't get my head around one thing. Take the following example:

Target cost: $150,000
Target fee: $30,000
Target price: $180,00
Sharing ratio: 60% buyer / 40% seller
Ceiling price:$200,000
Actual cost: $210,000

We are $60,000 over planned cost. The seller takes a 40% share of the overage, so his share of the overage is $24,000. This is taken away from the $30,000 target fee, so the actual fee is just $6000. The price for the buyer to pay would be $210,000 (cost) + $6000 (fee)=$216,000, but as it is higher than the ceiling price of $200,000, the seller is payed only $200,000, making $10,000 loss.

What I can't get my head around is the following: fixed price contracts are not supposed to contain the typical kind of cost audits that cost reimbursable contracts must have. Instead, I understand that fixed prices are not transparent for the buyer, i.e. he doesn't know exactly what the seller's actual cost are as there is always some risk reserve for the seller in there. Let's assume that the seller lies and tells the buyer that the actual cost is $210,000 where in reality the target cost has been reached. If the buyer is honest and tells that he finished at target cost of $150,000, he would earn $30,000. If he lies and tells that his cost was $210,000, he would make $50,000, the ceiling price value. It is the nature of this share ratio distribution that it is in most cases easier to get more money by lying instead of actually finishing at a lower cost. So when the buyer doesn't audit costs in fixed price contracts, why would the buyer tell the truth? He probably has to work much harder to earn the same amount ethically correctly.

Ethics aside in this, doesn't the fixed price incentive fee with an share ratio in favor of the buyer imply that the buyer must have tight control of the seller costs in order to ensure that he is not betrayed and thus it make it somewhat of a cost reimbursable contract (buyer control, required transparency of the seller)? The way I see it, the share ratio must always be in favor of the seller or 50/50 to work.

Did I understand something wrong here? Thanks for any help!

Ben, why do you think the buyer doesn't audit costs if they HAVE incentive fee closure in the contract? Isn't this type of contract closer to a T&M nature? I would add the mandatory audit closure also.

Well, it's somewhat of an overall impression on what is written about the contracts.

For example, in Rita's book, there is a list of advantages of fixed price contracts that contains "This type of contract is less work for the buyer to manage". If the buyer has to audit all costs of a fixed price contract _and_ provide a more detailed statement of work, he actually loses most of the advantages of this contract type and actually has a lot of work to do. Second example from Rita: "You need work done, but you don't have time to audit invoices on this work". Answer: FP (without specifying if that means FFP or all FP types). If have seen nowhere pointers that fixed price contracts should by nature include audits whereas this is written for cost-reimbursable contracts all the time. Third example (from Rita): "How might the profit be stated in the contract": (Fixed Price) "Included in the price and unknown to the buyer". How should you actually audit things that are not made transparent to you?

I could probably go on and list further such small indicative examples. Overall, it is the sum of all these little pointers that created this impression that something feels off. I somehow miss a firm statement how cost overruns are dealt with by the buyer in FPIF contracts (audits, trust, etc.) given that there are scenarios where the seller might be able to make more money by lying.