TOPIC: Cost Plus Incentive Fee Calculation

Given the following, calculate final fee and final price:
Target cost: 210,000
Target fee: 25,000
Target price: 235,000
Sharing ratio: 80/20
Actual cost: 200,000

210,000 - 200,000 = 10,000 savings
10,000 x 20% = 2,000 share
25,000 incentive (for under target price) + share price (2,000) is 27,000 final fee
200,000 + 27,000 is 227,000

First of all, why is that the 80/20 rule is 80 buyer and 20 seller? In the case of the a cost saving (or coming in under target cost), would it not be a greater incentive it to be 20/80, so that when the cost is an overrun, the buyer only pays 20?

So in the example, the target cost is 210,000, the target fee is 25,000. The target fee is only received if the target cost is met. Since the actual cost is 200,000, the difference between the target cost (210,000) and actual cost (200,000) is 10,000. The seller gets 20 percent of that, given that the sharing ratio is 80/20. So the seller gets 20% of 10,000, which is 2,000, to add on to the target fee of 25,000, making the seller’s target fee 27,000 for a grand total of 227,000.

Given the same information (target cost, target fee, sharing ratio) are the same, and the seller went over target cost by 10,000. If the buyer is to share in the overrun (or savings in the first example) at 80%, then the buyer is to pay 8,000 plus the target cost of 210,000, making the grand total 218,000, since they did not meet the requirements to earn the target fee. (IS THIS CORRECT)?

So… for a savings (coming in under cost) costs the buyer more (227000) than if the seller overran cost (218000)??? Is this right? I can see that the incentive provided is there to produce schedule commitments, quality requirements, etc., that would not otherwise be met without the incentive. But in the end, the buyer still pays more.

Because if it were 20/80, in the first example, it would be 8000 + 25000 + 200000 = 233000 (vs the 80/20 of 227000). If the cost were to overrun, it would only cost the buyer 2,000 extra, making the total 212,000.

What am I missing?

Joe, The scenario you present is a valid question. I thought about it myself in my study prep. What I've learned since then is contract types are represent types of risk buyers and sellers are willing to take.

A good discussion on this topic can be found at the reference:

Phillips, Joseph. "Chapter 12 - Introducing Project Procurement Management". PMP Project Management Professional Study Guide, Fourth Edition. McGraw-Hill/Osborne, © 2013. Books24x7. Web. Aug. 18, 2014. < common.books24x7.com/toc.aspx?bookid=57469 >

In this chapter, the author describes in detail the types of the contracts and the meaning of risk within each one. Specifically related to your question is why would the buyer select a cost share that appears to give him a disadvantage. This appears to be a disadvantage because the attribute of a cost plus incentive fee contract is that it places the risks of cost overruns on the buyer. So, if the costs were to exceed what was agreed upon, the buyer would pay the 80%. The decision to select a CPIF was, presumably, made by the project manager and the procurement team after reviewing the impact of time and ability to meet the specified contract statement of work. The commonly accepted breakdown of this risk is the 80/20 split. It appears in several study books.

In this example -
Target cost: 210,000
Target fee: 25,000
Target price: 235,000
Sharing ratio: 80/20
Actual cost: 200,000
Seller fee = (Target cost - Actual cost) * Seller's ratio +Target Fee
If Actual cost increases beyond Target cost, the Seller fee reduces accordingly.
For cost overruns, It is true that the risk is more for the buyer but it also has a diminishing profits for the Seller - unless the Seller attempts to Gold plate actuals - the contract administration must ensure that the contract is drafted such a way to protect buyer's interest.
In my opinion, these types of contracts may become the basis when Organization uses the products of a Seller that is patented/copyrighted to the Seller. Seller will be in-position to demand the fee required to implement the product (customization, integration. training etc.,) based on their assessment of Project cost/ viability.