Defense Contractor Negotiation
& Pricing
Accounting 6310
Fall 2002
Richard 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
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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 overpayment
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