Subpart 16.4 - Incentive Contracts

Parent topic: Part 16 - Types of Contracts

16.401 General.

(a) Incentive contracts as described in this subpart are appropriate when a firm-fixed-price contract

is not appropriate and the required supplies or services can be acquired at lower costs and, in

certain instances, with improved delivery or technical performance, by relating the amount of profit

or fee payable under the contract to the contractor’s performance. Incentive contracts are designed

to obtain specific acquisition objectives by-

(1) Establishing reasonable and attainable targets that are clearly communicated to the contractor;

and

(2) Including appropriate incentive arrangements designed to-

(i) motivate contractor efforts that might not otherwise be emphasized; and

(ii) discourage contractor inefficiency and waste.

(b) When predetermined, formula-type incentives on technical performance or delivery are included,

increases in profit or fee are provided only for achievement that surpasses the targets, and

decreases are provided for to the extent that such targets are not met. The incentive increases or

decreases are applied to performance targets rather than minimum performance requirements.

(c) The two basic categories of incentive contracts are fixed-price incentive contracts (see 16.403

and 16.404) and cost-reimbursement incentive contracts (see 16.405). Since it is usually to the

Government’s advantage for the contractor to assume substantial cost responsibility and an

appropriate share of the cost risk, fixed-price incentive contracts are preferred when contract costs

and performance requirements are reasonably certain. Cost-reimbursement incentive contracts are

subject to the overall limitations in 16.301 that apply to all cost-reimbursement contracts.

(d) A determination and finding, signed by the head of the contracting activity, shall be completed

for all incentive- and award-fee contracts justifying that the use of this type of contract is in the best

interest of the Government. This determination shall be documented in the contract file and, for

award-fee contracts, shall address all of the suitability items in 16.401(e)(1).

(e) Award-fee contracts are a type of incentive contract.

(1) Application. An award-fee contract is suitable for use when-

(i) The work to be performed is such that it is neither feasible nor effective to devise predetermined

objective incentive targets applicable to cost, schedule, and technical performance;

(ii) The likelihood of meeting acquisition objectives will be enhanced by using a contract that

effectively motivates the contractor toward exceptional performance and provides the Government

with the flexibility to evaluate both actual performance and the conditions under which it was

achieved; and

(iii) Any additional administrative effort and cost required to monitor and evaluate performance are
justified by the expected benefits as documented by a risk and cost benefit analysis to be included in

the Determination and Findings referenced in 16.401(e)(5)(iii).

(2) Award-fee amount. The amount of award fee earned shall be commensurate with the contractor’s

overall cost, schedule, and technical performance as measured against contract requirements in

accordance with the criteria stated in the award-fee plan. Award fee shall not be earned if the

contractor’s overall cost, schedule, and technical performance in the aggregate is below satisfactory.

The basis for all award-fee determinations shall be documented in the contract file to include, at a

minimum, a determination that overall cost, schedule and technical performance in the aggregate is

or is not at a satisfactory level. This determination and the methodology for determining the award

fee are unilateral decisions made solely at the discretion of the Government.

(3) Award-fee plan. All contracts providing for award fees shall be supported by an award-fee plan

that establishes the procedures for evaluating award fee and an Award-Fee Board for conducting the

award-fee evaluation. Award-fee plans shall-

(i) Be approved by the FDO unless otherwise authorized by agency procedures;

(ii) Identify the award-fee evaluation criteria and how they are linked to acquisition objectives which

shall be defined in terms of contract cost, schedule, and technical performance. Criteria should

motivate the contractor to enhance performance in the areas rated, but not at the expense of at least

minimum acceptable performance in all other areas;

(iii) Describe how the contractor’s performance will be measured against the award-fee evaluation

criteria;

(iv) Utilize the adjectival rating and associated description as well as the award-fee pool earned

percentages shown below in Table 16-1. Contracting officers may supplement the adjectival rating

description. The method used to determine the adjectival rating must be documented in the awardfee plan;

Table 16-1

Award-Fee

Adjectival

Rating

Award-Fee

Pool

Available To

Be Earned

Description

Excellent 91%-100%

Contractor has exceeded almost all of the significant

award-fee criteria and has met overall cost, schedule,

and technical performance requirements of the

contract in the aggregate as defined and measured

against the criteria in the award-fee plan for the

award-fee evaluation period.

Very Good 76%-90%

Contractor has exceeded many of the significant

award-fee criteria and has met overall cost, schedule,

and technical performance requirements of the

contract in the aggregate as defined and measured

against the criteria in the award-fee plan for the

award-fee evaluation period.
Award-Fee

Adjectival

Rating

Award-Fee

Pool

Available To

Be Earned

Description

Good 51%-75%

Contractor has exceeded some of the significant

award-fee criteria and has met overall cost, schedule,

and technical performance requirements of the

contract in the aggregate as defined and measured

against the criteria in the award-fee plan for the

award-fee evaluation period.

Satisfactory No Greater

Than 50%

Contractor has met overall cost, schedule, and

technical performance requirements of the contract

in the aggregate as defined and measured against

the criteria in the award-fee plan for the award-fee

evaluation period.

Unsatisfactory 0%

Contractor has failed to meet overall cost, schedule,

and technical performance requirements of the

contract in the aggregate as defined and measured

against the criteria in the award-fee plan for the

award-fee evaluation period.

(v) Prohibit earning any award fee when a contractor’s overall cost, schedule, and technical

performance in the aggregate is below satisfactory;

(vi) Provide for evaluation period(s) to be conducted at stated intervals during the contract period of

performance so that the contractor will periodically be informed of the quality of its performance

and the areas in which improvement is expected (e.g. six months, nine months, twelve months, or at

specific milestones); and

(vii) Define the total award-fee pool amount and how this amount is allocated across each evaluation

period.

(4) Rollover of unearned award fee. The use of rollover of unearned award fee is prohibited.

(5) Limitations. No award-fee contract shall be awarded unless-

(i) All of the limitations in 16.301-3, that are applicable to cost-reimbursement contracts only, are

complied with;

(ii) An award-fee plan is completed in accordance with the requirements in 16.401(e)(3); and

(iii) A determination and finding is completed in accordance with 16.401(d) addressing all of the

suitability items in 16.401(e)(1).

(f) Incentive- and Award-Fee Data Collection and Analysis. Each agency shall collect relevant data on

award fee and incentive fees paid to contractors and include performance measures to evaluate such

data on a regular basis to determine effectiveness of award and incentive fees as a tool for

improving contractor performance and achieving desired program outcomes. This information
should be considered as part of the acquisition planning process (see 7.105) in determining the

appropriate type of contract to be utilized for future acquisitions.

(g) Incentive- and Award-Fee Best Practices. Each agency head shall provide mechanisms for

sharing proven incentive strategies for the acquisition of different types of products and services

among contracting and program management officials.

16.402 Application of predetermined, formula-type

incentives.

16.402-1 Cost incentives.

(a) Most incentive contracts include only cost incentives, which take the form of a profit or fee

adjustment formula and are intended to motivate the contractor to effectively manage costs. No

incentive contract may provide for other incentives without also providing a cost incentive (or

constraint).

(b) Except for award-fee contracts (see 16.404 and 16.401(e)), incentive contracts include a target

cost, a target profit or fee, and a profit or fee adjustment formula that (within the constraints of a

price ceiling or minimum and maximum fee) provides that-

(1) Actual cost that meets the target will result in the target profit or fee;

(2) Actual cost that exceeds the target will result in downward adjustment of target profit or fee; and

(3) Actual cost that is below the target will result in upward adjustment of target profit or fee.

16.402-2 Performance incentives.

(a) Performance incentives may be considered in connection with specific product characteristics

(e.g.,a missile range, an aircraft speed, an engine thrust, or a vehicle maneuverability) or other

specific elements of the contractor’s performance. These incentives should be designed to relate

profit or fee to results achieved by the contractor, compared with specified targets.

(b) To the maximum extent practicable, positive and negative performance incentives shall be

considered in connection with service contracts for performance of objectively measurable tasks

when quality of performance is critical and incentives are likely to motivate the contractor.

(c) Technical performance incentives may be particularly appropriate in major systems contracts,

both in development (when performance objectives are known and the fabrication of prototypes for

test and evaluation is required) and in production (if improved performance is attainable and highly

desirable to the Government).

(d) Technical performance incentives may involve a variety of specific characteristics that contribute

to the overall performance of the end item. Accordingly, the incentives on individual technical

characteristics must be balanced so that no one of them is exaggerated to the detriment of the

overall performance of the end item.
(e) Performance tests and/or assessments of work performance are generally essential in order to

determine the degree of attainment of performance targets. Therefore, the contract must be as

specific as possible in establishing test criteria (such as testing conditions, instrumentation

precision, and data interpretation) and performance standards (such as the quality levels of services

to be provided).

(f) Because performance incentives present complex problems in contract administration, the

contracting officer should negotiate them in full coordination with Government engineering and

pricing specialists.

(g) It is essential that the Government and contractor agree explicitly on the effect that contract

changes (e.g., pursuant to the Changes clause) will have on performance incentives.

(h) The contracting officer must exercise care, in establishing performance criteria, to recognize that

the contractor should not be rewarded or penalized for attainments of Government-furnished

components.

16.402-3 Delivery incentives.

(a) Delivery incentives should be considered when improvement from a required delivery schedule is

a significant Government objective. It is important to determine the Government’s primary

objectives in a given contract (e.g., earliest possible delivery or earliest quantity production).

(b) Incentive arrangements on delivery should specify the application of the reward-penalty

structure in the event of Government-caused delays or other delays beyond the control, and without

the fault or negligence, of the contractor or subcontractor.

16.402-4 Structuring multiple-incentive contracts.

A properly structured multiple-incentive arrangement should-

(a) Motivate the contractor to strive for outstanding results in all incentive areas; and

(b) Compel trade-off decisions among the incentive areas, consistent with the Government’s overall

objectives for the acquisition. Because of the interdependency of the Government’s cost, the

technical performance, and the delivery goals, a contract that emphasizes only one of the goals may

jeopardize control over the others. Because outstanding results may not be attainable for each of the

incentive areas, all multiple-incentive contracts must include a cost incentive (or constraint) that

operates to preclude rewarding a contractor for superior technical performance or delivery results

when the cost of those results outweighs their value to the Government.

16.403 Fixed-price incentive contracts.

(a) Description. A fixed-price incentive contract is a fixed-price contract that provides for adjusting

profit and establishing the final contract price by application of a formula based on the relationship

of total final negotiated cost to total target cost. The final price is subject to a price ceiling,

negotiated at the outset. The two forms of fixed-price incentive contracts, firm target and successive
targets, are further described in 16.403-1 and 16.403-2 below.

(b) Application. A fixed-price incentive contract is appropriate when-

(1) A firm-fixed-price contract is not suitable;

(2) The nature of the supplies or services being acquired and other circumstances of the acquisition

are such that the contractor’s assumption of a degree of cost responsibility will provide a positive

profit incentive for effective cost control and performance; and

(3) If the contract also includes incentives on technical performance and/or delivery, the

performance requirements provide a reasonable opportunity for the incentives to have a meaningful

impact on the contractor’s management of the work.

(c) Billing prices. In fixed-price incentive contracts, billing prices are established as an interim basis

for payment. These billing prices may be adjusted, within the ceiling limits, upon request of either

party to the contract, when it becomes apparent that final negotiated cost will be substantially

different from the target cost.

16.403-1 Fixed-price incentive (firm target) contracts.

(a) Description. A fixed-price incentive (firm target) contract specifies a target cost, a target profit, a

price ceiling (but not a profit ceiling or floor), and a profit adjustment formula. These elements are

all negotiated at the outset. The price ceiling is the maximum that may be paid to the contractor,

except for any adjustment under other contract clauses. When the contractor completes

performance, the parties negotiate the final cost, and the final price is established by applying the

formula. When the final cost is less than the target cost, application of the formula results in a final

profit greater than the target profit; conversely, when final cost is more than target cost, application

of the formula results in a final profit less than the target profit, or even a net loss. If the final

negotiated cost exceeds the price ceiling, the contractor absorbs the difference as a loss. Because

the profit varies inversely with the cost, this contract type provides a positive, calculable profit

incentive for the contractor to control costs.

(b) Application. A fixed-price incentive (firm target) contract is appropriate when the parties can

negotiate at the outset a firm target cost, target profit, and profit adjustment formula that will

provide a fair and reasonable incentive and a ceiling that provides for the contractor to assume an

appropriate share of the risk. When the contractor assumes a considerable or major share of the cost

responsibility under the adjustment formula, the target profit should reflect this responsibility.

(c) Limitations. This contract type may be used only when-

(1) The contractor’s accounting system is adequate for providing data to support negotiation of final

cost and incentive price revision; and

(2) Adequate cost or pricing information for establishing reasonable firm targets is available at the

time of initial contract negotiation.

(d) Contract schedule. The contracting officer shall specify in the contract schedule the target cost,

target profit, and target price for each item subject to incentive price revision.
16.403-2 Fixed-price incentive (successive targets) contracts.

(a) Description.

(1) A fixed-price incentive (successive targets) contract specifies the following elements, all of which

are negotiated at the outset:

(i) An initial target cost.

(ii) An initial target profit.

(iii) An initial profit adjustment formula to be used for establishing the firm target profit, including a

ceiling and floor for the firm target profit. (This formula normally provides for a lesser degree of

contractor cost responsibility than would a formula for establishing final profit and price.)

(iv) The production point at which the firm target cost and firm target profit will be negotiated

(usually before delivery or shop completion of the first item).

(v) A ceiling price that is the maximum that may be paid to the contractor, except for any adjustment

under other contract clauses providing for equitable adjustment or other revision of the contract

price under stated circumstances.

(2) When the production point specified in the contract is reached, the parties negotiate the firm

target cost, giving consideration to cost experience under the contract and other pertinent factors.

The firm target profit is established by the formula. At this point, the parties have two alternatives,

as follows:

(i) They may negotiate a firm fixed price, using the firm target cost plus the firm target profit as a

guide.

(ii) If negotiation of a firm fixed price is inappropriate, they may negotiate a formula for establishing

the final price using the firm target cost and firm target profit. The final cost is then negotiated at

completion, and the final profit is established by formula, as under the fixed-price incentive (firm

target) contract (see 16.403-1 above).

(b) Application. A fixed-price incentive (successive targets) contract is appropriate when-

(1) Available cost or pricing information is not sufficient to permit the negotiation of a realistic firm

target cost and profit before award;

(2) Sufficient information is available to permit negotiation of initial targets; and

(3) There is reasonable assurance that additional reliable information will be available at an early

point in the contract performance so as to permit negotiation of either (i)a firm fixed price or (ii) firm

targets and a formula for establishing final profit and price that will provide a fair and reasonable

incentive. This additional information is not limited to experience under the contract, itself, but may

be drawn from other contracts for the same or similar items.

(c) Limitations. This contract type may be used only when-

(1) The contractor’s accounting system is adequate for providing data for negotiating firm targets

and a realistic profit adjustment formula, as well as later negotiation of final costs; and
(2) Cost or pricing information adequate for establishing a reasonable firm target cost is reasonably

expected to be available at an early point in contract performance.

(d) Contract schedule. The contracting officer shall specify in the contract schedule the initial target

cost, initial target profit, and initial target price for each item subject to incentive price revision.

16.404 Fixed-price contracts with award fees.

Award-fee provisions may be used in fixed-price contracts when the Government wishes to motivate

a contractor and other incentives cannot be used because contractor performance cannot be

measured objectively. Such contracts shall establish a fixed price (including normal profit) for the

effort. This price will be paid for satisfactory contract performance. Award fee earned (if any) will be

paid in addition to that fixed price. See 16.401(e) for the requirements relative to utilizing this

contract type.

16.405 Cost-reimbursement incentive contracts.

See 16.301 for requirements applicable to all cost-reimbursement contracts, for use in conjunction

with the following subsections.

16.405-1 Cost-plus-incentive-fee contracts.

(a) Description. The cost-plus-incentive-fee contract is a cost-reimbursement contract that provides

for the initially negotiated fee to be adjusted later by a formula based on the relationship of total

allowable costs to total target costs. This contract type specifies a target cost, a target fee, minimum

and maximum fees, and a fee adjustment formula. After contract performance, the fee payable to the

contractor is determined in accordance with the formula. The formula provides, within limits, for

increases in fee above target fee when total allowable costs are less than target costs, and decreases

in fee below target fee when total allowable costs exceed target costs. This increase or decrease is

intended to provide an incentive for the contractor to manage the contract effectively. When total

allowable cost is greater than or less than the range of costs within which the fee-adjustment

formula operates, the contractor is paid total allowable costs, plus the minimum or maximum fee.

(b) Application.

(1) A cost-plus-incentive-fee contract is appropriate for services or development and test programs

when-

(i) A cost-reimbursement contract is necessary (see 16.301-2); and

(ii) A target cost and a fee adjustment formula can be negotiated that are likely to motivate the

contractor to manage effectively.

(2) The contract may include technical performance incentives when it is highly probable that the

required development of a major system is feasible and the Government has established its

performance objectives, at least in general terms. This approach also may apply to other
acquisitions, if the use of both cost and technical performance incentives is desirable and

administratively practical.

(3) The fee adjustment formula should provide an incentive that will be effective over the full range

of reasonably foreseeable variations from target cost. If a high maximum fee is negotiated, the

contract shall also provide for a low minimum fee that may be a zero fee or, in rare cases, a negative

fee.

(c) Limitations. No cost-plus-incentive-fee contract shall be awarded unless all limitations in

16.301-3 are complied with.

16.405-2 Cost-plus-award-fee contracts.

A cost-plus-award-fee contract is a cost-reimbursement contract that provides for a fee consisting of

(1) a base amount fixed at inception of the contract, if applicable and at the discretion of the

contracting officer, and (2) an award amount that the contractor may earn in whole or in part during

performance and that is sufficient to provide motivation for excellence in the areas of cost, schedule,

and technical performance. See 16.401(e) for the requirements relative to utilizing this contract

type.

16.406 Contract clauses.

(a) Insert the clause at 52.216-16, Incentive Price Revision-Firm Target, in solicitations and

contracts when a fixed-price incentive (firm target) contract is contemplated. If the contract calls for

supplies or services to be ordered under a provisioning document or Government option and the

prices are to be subject to the incentive price revision under the clause, the contracting officer shall

use the clause with its Alternate I.

(b) Insert the clause at 52.216-17, Incentive Price Revision-Successive Targets, in solicitations and

contracts when a fixed-price incentive (successive targets) contract is contemplated. If the contract

calls for supplies or services to be ordered under a provisioning document or Government option and

the prices are to be subject to incentive price revision under the clause, the contracting officer shall

use the clause with its Alternate I.

(c) The clause at 52.216-7, Allowable Cost and Payment, is prescribed in 16.307(a) for insertion in

solicitations and contracts when a cost-plus-incentive-fee contract or a cost-plus-award-fee contract

is contemplated.

(d) The clause at 52.216-10, Incentive Fee, is prescribed in 16.307(d) for insertion in solicitations

and contracts when a cost-plus-incentive-fee contract is contemplated.

(e) Insert an appropriate award-fee clause in solicitations and contracts when an award-fee contract

is contemplated, provided that the clause-

(1) Is prescribed by or approved under agency acquisition regulations;

(2) Is compatible with the clause at 52.216-7, Allowable Cost and Payment; and

(3) Expressly provides that the award amount and the award-fee determination methodology are
unilateral decisions made solely at the discretion of the Government.