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The Award Term Incentive—What
It Is And How It Works
The award term incentive is a
relatively new development in government contracting, one that
was first used in 1997 and that is not yet described in
government acquisition regulations. It is modeled after the
award fee incentive described in Federal Acquisition Regulation
(FAR) 16.405-2, but instead of rewarding a contractor for
excellent performance with additional fee it rewards the
contractor by extending the contract period of performance without a new competition. Under an
award term incentive the government monitors and evaluates the
contractor’s performance, and if a government term
determining official decides that the contractor’s
performance was excellent, then the contractor earns an
extension. The extension is (or should be) conditioned upon the
government’s continuing need for the service and the
availability of funds.
The award term incentive was the
inspiration of Mr. Thomas Jordan, a senior Air Force civilian
employee who was working at Kelly Air Force Base when he thought
it up. Its first use was on a task order contract that the Air
Force’s Aeronautical Systems Center awarded to the McDonnell
Douglas Corporation in October of 1997, for simulation services
for the F-15C aircraft. The contract has a seven year base
period, which the contractor can extend to 15 years by rendering
excellent service. Since that first use at least 25 acquisitions
have included or plan to include award term incentives.
A true award term incentive
rewards the contractor with legal entitlement to a contract
extension, not an additional option. An option is a unilateral
right of the Government; a contractor is not entitled to the
exercise of an option. But under a true award term incentive, if
the contractor’s performance meets the award term criteria
stipulated in the contract and if any stipulated conditions such
as continuing need and availability of funds are met, then the
government must either extend the contract or terminate it for
convenience or default. Many contracts have included incentives
that have been labeled “award term,” but that should be
called “award option” or “incentive option,” because the
contractor’s reward is not an actual extension, but an option
to extend, which entitles the contractor to nothing.
Agencies have used award term
incentives in acquisitions for a variety of services, including
technical and logistics support, laundry and dry-cleaning,
depot-level maintenance, aircraft maintenance, grounds
maintenance, janitorial services, real property maintenance and
repair, and training. The incentives have been used in
association with several different pricing and delivery
arrangements—fixed-price, cost-reimbursement,
indefinite-delivery-indefinite-quantity, and requirements. It
has been used in combination with other incentives, such as
cost-plus-incentive-fee and cost-plus-award-fee.
Most of the acquisitions that
have included award term incentives have been conducted by the
Air Force, but the National Aeronautics and Space
Administration, the Naval Facilities Engineering Command, the
Naval Sea Systems Command, the Army’s Ft. Drum in New York,
and the General Services Administration have all conducted or
announced plans to conduct acquisitions that include award term
incentives. Those acquisitions include or plan to include
provisions that will enable the contractor to extend its
performance for periods ranging from a maximum of seven years
(Naval Facilities Engineering Command) to a maximum of 20 years
(Air Force Electronic Systems Center).
A More All-Encompassing Incentive
Reward
The award term incentive may
provide a solution to one of the most vexing shortcomings of
contractual incentives—that they do not work as advertised.
The standard contractual incentives described in FAR Part 16 are
all profit incentives—they reward excellent performance by
paying more money. Since the early 1960s, researchers have
concluded that such profit incentives do not produce the results
predicted by incentive theory. Studies conducted by Harvard
University, the Rand Corporation, the Logistics Management
Institute, the U.S. General Accounting Office (GAO), and a
number of independent researchers have concluded that there is
little evidence that incentives designed to motivate cost
efficiency have been effective.
Perhaps the definitive assessment
of contractual incentives was made by Harvard professor Frederic
M. Scherer, in his classic study of their use in weapons
development contracts. Writing in 1964 about fixed-price
incentive and cost-plus-incentive-fee contracts, which he called
“automatic contractual incentives,” he said:
The automatic contractual
incentives applied to most advanced weapon system and major
subsystem development and production efforts have not been
powerful enough to compel the elimination of inefficiencies
which companies were reluctant to eliminate. They have not
been able to offset the inherent tendencies toward
inefficiency propagated by weapons makers’ competition for
survival in an environment of technological change. Nor is
it likely, given the strategic role which contractors play
in drawing up cost estimates and negotiating profit-cost
correlation provisions, that the automatic contractual
incentives approach can be greatly strengthened.
[Scherer, F. M., The Weapons
Acquisition Process: Economic Incentives (Boston: Harvard
University, 1964), pp. 324-325.]
Later researchers have reached
similar conclusions. In 1968, Rand Corporation researcher Irving
N. Fisher describing his findings based on a comprehensive
statistical analysis of cost outcomes under incentive contracts.
He wrote:
The statistical analysis
presented here suggests that some of the advantages usually
attributed to incentive contracts may be illusory. It is
commonly believed that incentive contracts provide
substantial entrepreneurial motivation for increased
efficiency and tighter cost control. This belief is one of
the stronger justifications for the current extensive use of
cost-incentive contracts. The evidence presented here,
however, implies that the incentive effect on contractors’
costs and efficiency may be weaker than is customarily
believed. Rather, the evidence suggests that the cost
underruns commonly observed for Air Force incentive
contracts are the result of a general upward shift in target
costs rather than improved cost control.
[Fisher, I. N., A Reappraisal
of Incentive Contracting Experience, Memorandum RM-5700-PR
(Santa Monica: The Rand Corporation, 1968), p.47.]
In 1974, Harvard professor and
former defense official J. Ronald Fox wrote: “In the past few
years there has been increasing evidence that incentive
contracts do not accomplish the Government’s management
objectives.” He cited, among others, a 1968 study by the
Logistics Management Institute that concluded: “Incentives
have not been significantly effective as protection against cost
growth on programs.” [Fox, J. R., Arming America: How the
U.S. Buys Weapons (Boston: Harvard University, 1974), pp.
240-241.]
Nearly 20 years after Irving
Fisher’s Rand Corporation study, and 13 years after Ronald
Fox’s analysis of the research on incentives, the U.S. General
Accounting Office studied 573 Department of Defense fixed-price
incentive contracts and found as follows:
If target prices are
reasonably set we would expect to see final target prices
both above and below, but clustering near, target prices.
For the contracts we examined, however, there was no
relationship between the cost-sharing ratio and achievement
of a contract’s target price. For any particular sharing
ratio, we found final contract prices both above and below
target price by similar amounts. We did not find any
apparent relationship between the cost-sharing ratio and
attainment of ceiling prices. These findings do not support
that part of incentive theory which holds that as the
contractor’s share ratio increases the contractor has a
greater incentive to meet or underrun target costs. Other
research has also found that final contract costs and price
seem unrelated to the sharing ratio.
[U.S. General Accounting Office,
Incentive Contracts: Examination of Fixed-Price Incentive
Contracts, GAO/NSIAD-88 (Washington, DC: 1987), pp. 3-4.]
If the standard cost incentives
to do not work, the question is: Why not? J. Ronald Fox
described the Logistics Management Institute’s 1968 findings
as follows:
Extra-contractual
considerations dominate over profit or fee. A contractor
rarely seeks to maximize profit during the short run of a
single contract. He is more interested in taking actions
that will expand company operations, lead to increased
future business, enhance company image and reputation,
benefit his nondefense business, or relieve such immediate
problems as loss of skilled personnel and a narrow base for
fixed costs.
[Logistics Management Institute,
An Examination of the Foundations of Incentive Contracts,
LMI Task 66-67, May 1968, cited by Fox, J. R. in Arming
America: How the U.S. Buys Weapons (Boston: Harvard
University, 1974), p. 241.] Frederic Scherer had reached similar
conclusions in 1964. [Scherer, F. M., The Weapons Acquisition
Process: Economic Incentives (Boston: Harvard University,
1964), pp. 159-162, 268-269, and 321-323.]
All of the above cited research
looked at cost incentives. What about performance incentives?
There appears to have been relatively little empirical research
about performance incentives, probably because performance is so
difficult to measure objectively. However, a 1978 article by
Richard F. DeMong reported that several researchers considered
performance incentives to be redundant, since most organizations
were already motivated to provide quality performance. (Frederic
Scherer came to the same conclusion in 1964.) DeMong also
reported that one set of researchers could find no statistical
relationship between contract type and performance in a study of
35 civil engineering service contracts. [DeMong, R. F., “The
Effectiveness of Incentive Contracts: What Research Tells Us,”
in National Contract Management Quarterly Journal, Vol.
12, No. 4 (1978), p.12.]
If the researchers are correct
that contractual incentives have had little demonstrable effect
on contract performance outcomes, and if that failure is due to
the fact that short term profit rewards are not an adequate
incentive, then the award term incentive is a promising
development. That is because the award term incentive rewards a
contractor with additional business, which satisfies four of the
long term goals identified by Logistics Management Institute in
its 1968 study: enhanced company image and reputation, increased
future business, retention of skilled personnel, and the
maintenance of an allocation base for fixed costs. The award
term incentive gives a contractor a chance to earn a more
all-encompassing reward than short term profit dollars.
The Advantages of Long-Term Business
Relationships
Aside from the potential for
motivating contractors to render excellent performance, there
are at least two other advantages to the use of award term
incentives to establish long term business relationships: (1)
increased operational efficiency and effectiveness, and (2)
reduced acquisition transaction costs.
Increased Operational
Efficiency and Effectiveness.
Government service contracts are
becoming more complex as government agencies outsource ever more
of their internal functions. As service requirements become more
complex (multifunctional and multitask) and require performance
over an extended period of time (one year or longer), it becomes
exceedingly difficult to write statements of work and contract
clauses that fully describe all of the government’s
requirements and that cover all of the contingencies that may
affect performance. Such complex, long term contracts are
referred to as relational contracts by legal scholars and
incomplete contracts by economists, and a large body of
legal and economic scholarship has developed concerning them.
Richard E. Speidel,
Beatrice Kuhn Professor of Law at the Northwestern
University School of Law, has described relational contracts as
follows:
Most commentators agree that
relational contracts have at least three distinguishing
characteristics. First, the exchange relationship extends
over time. It is not a “spot” market deal. Rather, it is
more like a long-term supply contract, a franchise or
distribution arrangement, or a marriage. Second, because of
the extended duration, parts of the exchange cannot be
easily measured or precisely defined at the time of
contracting. This dictates a planning strategy that favors
open terms, reserves discretion in performance to one or
both parties, and incorporates dispute resolution
procedures, such a mediation or arbitration, into the
contract. The inability of the parties to “presentiate”
the terms of the bargain at the time of contracting shifts
the focus to circumstances and conduct that occur ex post
contract. Third, in the words of Lewis Kornhauser, in a
relational contract the “interdependence of the parties to
the exchange extends at any given moment beyond the single
discrete transaction to a range of social
interrelationships.” For example, a complex, cooperative
relationship between the parties may expand over time to
others who support or rely on the exchange relationship.
[Speidel, R. E., “The
Characteristics and Challenges of Relational Contracts,” Northwestern
University Law Review, Spring 2000, p. 823.]
Economist Bruce R. Lyons
described the difficulties associated with planning complex,
long term contracts as follows:
Human nature is assumed to
be fundamentally opportunistic, so firms must make full
allowance for adverse selection and moral hazard problems in
their dealings. One way to insure against opportunistic
behavior is to write a detailed contingent contract that
specifies all possible eventualities and is watertight
against all forms of opportunism. Unfortunately, because of
bounded rationality, formal contracts have only limited
value as a means of governing relationships. If the input is
fairly standard and potential changes in circumstances are
well understood, then contracts may be effective. Very
often, however, it is beyond the practical capacity of man
or woman to fully specify detail, predict all possible
contingencies, and verify breaches in court.
[Lyons, B. R., “Contracts and
Specific Investment: An Empirical Test of Transaction Cost
Theory,” Journal of Economics and Management Strategy,
Vol. 3, No. 2 (Summer 1994), p.258.]
So complex, long term contracts
have gaps, and wise business-people know this. During the course
of an cooperative long term relationship the parties will fill
the gaps in their contract by adapting their expectations to
emerging contingencies and prevailing conditions and making cooperative, ad hoc
decisions. They will do so through formal contract
modifications, to be sure, but also through informal,
undocumented daily cooperation. As the parties fill the gaps in
their contract, they develop a shared body of knowledge about
the contract work and an informal protocol of cooperation that
will enable them to respond to new conditions and solve new
problems as they arise. The shared knowledge and the cooperative
protocol becomes a part of the culture of the relationship. By
consciously recognizing the fact that their contract is
incomplete, by adapting their expectations to contingencies, and by adopting a cooperative approach to
decision-making, the parties can satisfy their requirements and
actually increase the efficiency and effectiveness of their
joint endeavor. In short, a long-term, cooperative relationship
facilitates team development and effectiveness. If the
relationship works poorly, then a change in contractors may be
necessary, but if it works well, a change in contractors may
degrade performance, at least temporarily.
Reduced Acquisition
Transaction Costs.
A second benefit of a long term
relationship is a reduction in acquisition transaction costs.
Government contract formation is often a long, tedious, and
expensive process for both the government and competing offerors.
New awards are expensive to plan, and proposals are expensive to
solicit, prepare, and evaluate. And a source selection decision
may be followed by a protest. So by reducing the frequency with
which they must conduct new competitions for continuing
requirements, agencies can reduce the transaction costs
associated with the formation of new contracts. The Competition
in Contracting Act (CICA) does not prohibit the use of award
term incentives, no more than it prohibits the use of options.
However, reducing the frequency of re-competitions for
continuing service requirements can be justified on business
grounds only if there is an overall net savings to the
government.
The Disadvantages of Long-Term
Relationships
A potential disadvantage of a
long-term relationship is the possibility that the agents of the
contracting parties will begin to conduct business on a personal
basis instead of a proper professional basis. Contractual
relationships are, after all, human relationships. People who
have come to know and like one another in the course of time may
relax their standards and overlook performance deficiencies for
the sake of their personal relations; they may become reluctant
to criticize or to take an action that could hurt the other
person. On the other hand, a change in personnel may bring
conflict as the parties try to adapt to new personalities and
changes in long-standing ways of seeing, understanding, and
doing. These sorts of developments are probably a natural and
unavoidable byproduct of long-term business relationships.
Commercial
Idea—Government Rules
The award term incentive is an
attempt to use a commercial idea within a framework of
government rules. The commercial idea is to dangle before a
contractor the prospect of a long term business relationship and
the sales that come with it in order to motivate it to provide
excellent service. This is something that commercial
organizations generally do implicitly and informally—i.e.,
without writing it into a contract. In the commercial sector, it
usually goes without saying that a customer will generally stick
with a contractor that performs well and charges reasonable
prices. But unlike a commercial organization, a government
agency cannot continue to give its business to a contractor just
because the firm did well on the last job; it must conduct a new
competition for each acquisition.
CICA and FAR Part 6 require
agencies to promote and provide for “full and open
competition” every time they acquire a service or product
unless they can justify doing otherwise. Moreover, agencies must
use the competitive procedures in FAR parts 12, 13, 14, or 15
when conducting those competitions. In order to avoid the
necessity of conducting a new competition in order to extend a
contract, a government agency must ensure that prospective award
term extensions are included within the scope of the original
competition. The GAO, in ruling on the use of options to extend
the term of a contract, has long insisted that agencies meet
three conditions: first, that the solicitation state that the
contract will include options and the maximum length of the
contract as extended by the options; second, that the government
solicit prices for each option; and, third, that the government
evaluate the option prices during the source selection for the
original contract. The GAO will not go along with the use of
unpriced options. [For a lengthy discussion of the GAO’s
position on these matters, see the GAO’s 1986 letter: The
Honorable Caspar W. Weinberger, The Secretary of Defense,
GAO file number B-217655, April 23, 1986.]
Thus, in order to comply with
the dictates of CICA and the GAO, government agencies must do
something that commercial organizations do not have to do—they
must make the award term incentive express and formal by writing
it into their solicitations and resulting contracts. This is a
task wherein lie many difficulties.
Problems
Arising from the Need for Contractual Formality
The need for government agencies
to make the award term incentive express and formal in order to
include the award term extensions in the scope of the
competition gives rise to problems that commercial firms do not
have to face. No sensible business person would make an irrevocable
legal commitment—enforceable in court—to a long term
business relationship. Markets and organizations can change
rapidly in today’s highly dynamic global market; it is very
difficult to predict conditions even two years hence, and almost
impossible to predict the state of a market or organization 10
to 15 years in the future. A deal that is highly advantageous
today can be utterly worthless or bad business two years from
now. Thus, one challenge for government agencies using an award
term incentive is to find a way to write it into the contract so
that the demands of CICA and the GAO are met and there is a real
incentive, while providing enough ways out of the deal so that
the parties do not become locked in a legal death grip. Failing
to provide enough outs would be a serious mistake, but providing
too many outs might undermine the incentive.
Aside from the conditions of
continuing need and availability of funds, there may be many
reasons why the government would want to renege on an award
term. Inconsistent performance is one such reason. Many award
term contracts have provided for a base year and four option
years during which the contractor can earn a one-year award term
extension in each of the first five years of performance.
Suppose that a contractor renders excellent performance during
the first year and earns an award term extension, but renders
only marginally acceptable performance during the second year.
Suppose that such inconsistent performance continues throughout
the first five years, so that by the end of that time the
contractor has earned only two of the five available award
terms. Should the government remain in a relationship with such
an inconsistent performer? What provision if any should the
contract make for inconsistent performance?
Should an award term extension
be contingent upon the continuing reasonableness of the award
term prices? What if a price that was fair and reasonable at the
time of the original source selection is no longer fair and
reasonable 10 years later? What provision should the contract
make for this possibility?
What provision should the
contract make for the possibility that the contractor is no
longer responsible—as defined by FAR 9.101—at the point in
time that an award term is scheduled to begin? (What if it was
debarred by another agency for reasons that have nothing to do
with the contract?) Should the government be contractually
obligated to continue to do business with such a firm? If the
contract allows the government to get out of the award term in
the event that the contractor is no longer responsible for some
reason, and if the contractor is a small business, would the
Small Business Administration’s Certificate of Competency
Program apply?
Even if all of the conditions
for an award term are met, the government can still get out of a
bad deal by terminating the contract for its convenience. But it
would seem that fairness demands that the contractor should have
a way out as well. Remember that we are talking about relational
contracts for services, not spot market contracts for goods.
Contract law aside, is it good business to compel a contractor
to perform an award term even though the contract no longer
serves its interests, or is harmful to its interests? But what
about the government’s notoriously long acquisition lead
times? If the contract is to allow the contractor to opt out of
an award term, how much notice should it require the contractor
to give the government? Six months? A year? Two years?
These considerations pose two
challenges to award term contract writers: First, they must
include enough escape mechanisms to enable the government to
respond to deal-wrecking organizational and market changes
without including so many that they undermine the incentive.
Second, they must allow the contractor to opt out the contract
in a way that does not make the arrangement too risky for the
government in light of its long acquisition lead times. They
must insist on reasonable advance notice.
Yet another challenge has to do
with contract pricing. In the commercial sector, firms do not
have to negotiate prices far in advance. They can agree to
negotiate them later, or they can agree on baseline prices and
then renegotiate them as the need arises. But in light of the
GAO’s position that agencies must obtain and evaluate prices
for option periods, and evaluate those prices during source
selection, it is likely to insist upon the same conditions for
prospective award term extensions. Moreover, the GAO is also
likely to object to any contract provision that would allow the
parties to renegotiate the award term extension prices, since it
has objected to the renegotiation of option prices, insisting
that such renegotiations are sole source contract actions for
which justification and approval are required in accordance with
CICA. [See Magnavox
Electronic Systems Co., Comp. Gen. Dec. B-231795, 88-2 CPD
¶ 431: “An agency is not permitted to negotiate with the
awardee to reduce the option prices stated in the contract price
if price competition for the option quantity is available.”
See, also, Varian Associates, Inc., Comp. Gen. Dec.
B-208281, February 16, 1983, 83-1 CPD ¶ 160; request for
reconsideration denied, 83-2 CPD ¶ 78.] The GAO’s position on
the renegotiation of option prices is reflected in FAR
17.207(f), which requires that options must be exercisable at
prices that are “reasonably determinable” from the terms of
the basic contract.
In light of the fact that most
agencies that have used or that plan to use award term
incentives have provided for as many as 10 to 15 years of
performance, the GAO’s requirement to price those years at the
time of initial contract award, and its objection to
renegotiating those prices, confront agencies and contractors
with a daunting problem. It is hard to imagine any business
person making a firm commitment to prices 10 to 15 years in
advance without some provision for price adjustment or escape
from the deal. Economic price adjustment clauses, in the sense
in which they are described in FAR 16.203, can help, but they
usually do not cover all exigencies that could affect prices
significantly. Thus, agencies that are contemplating the use of
award term incentives must develop another solution, one that
will meet with the approval of the GAO. One such solution may be
for the parties to agree on ceiling prices that are subject to
downward adjustment based on clearly stipulated terms and
conditions. Upward adjustments of such ceilings could be based
on economic price adjustment provisions or some other reasonable
basis.
Conclusion
It is too soon to say whether
the award term incentive is a good idea and will receive
widespread acceptance within the acquisition community. One
thing is clear: The effective use of an award term incentive
demands a high level of contracting knowledge and skill during
contract formation. It requires that acquisition planners
effectively solve many complex incentive design problems. It
requires that the contracting parties communicate clearly and
work together effectively when negotiating contract terms and
drafting contract language in order to ensure a common
understanding of the nature of their undertaking. They must
remember that they are thinking and writing for people who were
not a part of the original negotiation. It requires a new
approach to contract management, one in which the parties openly
acknowledge that they cannot see or plan far into the future and
that their contract is incomplete, and in which they agree to
learn together, adjust their expectations when necessary, and
engage in cooperative, ad hoc decision making during the course
of performance in order to fill the gaps in their original
agreement.
In light of the need to make
award term incentives express and formal and subject to contract
law enforcement, and in light of the fact that technology and
the modern global economy sometimes seem to change with the
speed of light, we must ask whether it is a good idea to enter
into formal contracts of 10, 15, or 20 years duration. Does it
make good business sense to do so? The answer
ultimately depends on how effectively award term incentives
actually work to motivate contractors to provide and maintain a
high level of service performance, and to reduce acquisition
transaction costs. In short, the answer depends on the actual
investment return to the taxpayers. The effectiveness of award
term incentives will undoubtedly depend on the wisdom and skill
with which agencies and their contractors plan, design, and
manage them. All we can say for certain at this time is that the
award term incentive is an interesting experiment.
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