Federal agencies, including DOD, can choose among numerous contract types to acquire products and services. One of the characteristics that varies across contract types is the amount and nature of the fee that agencies offer to the contractor for achieving or exceeding specified objectives or goals. Of all the contract types available, only award- and incentive-fee contracts allow an agency to adjust the amount of fee paid to contractors based on the contractor’s performance. Typically, award-fee contracts emphasize multiple aspects of contractor performance in a wide variety of areas, such as quality, timeliness, technical ingenuity, and cost- effective management. Incentive-fee contracts usually focus on cost control, although they can also be used to motivate contractors to achieve specific delivery targets or performance goals in areas such as missile range, aircraft speed, engine thrust, or vehicle maneuverability. Regardless of differences between award- and incentive-fee contracts, federal acquisition regulations state that these contracts should be used to achieve specific acquisition objectives, such as delivering products and services on time or within cost goals and with the promised capabilities. For award-fee contracts, the assumption underlying the regulation is that the likelihood of meeting these acquisition objectives will be enhanced by using a contract that effectively motivates the contractor toward exceptional performance. The reason or basis for selecting an award- or incentive-fee contract can vary, depending on the type of work a contractor is expected to perform. The acquisition environment, including the knowledge DOD has prior to starting an acquisition program, the adequacy of resources, and the soundness of acquisition practices, can also be a critical factor that affects how well contractor performance translates into acquisition outcomes. The development and administration of award-fee contracts involve substantially more effort over the life of a contract than incentive-fee contracts. For award-fee contracts, DOD personnel (usually members of an award-fee evaluation board) conduct periodic—typically semiannual— evaluations of the contractor’s performance against specified criteria in an award-fee plan and recommend the amount of fee to be paid. Because award fees are intended to motivate contractor performance in areas that are susceptible to judgmental and qualitative measurement and evaluation (e.g., technical, logistics support, cost, and schedule), these criteria and evaluations tend to be subjective. After receiving the recommendation of the award-fee evaluation board, a fee-determining official makes the final decision about the amount of fee the contractor will receive. The fee- determining official can also decide to move unearned award fee from one evaluation period to a subsequent evaluation period or periods, thus providing the contractor an additional opportunity to earn previously unearned fee—a practice called rollover. Table 1 provides a general look at the process for evaluating and determining award fee amounts. Incentive-fee contracts use what is considered to be an objective evaluation of the contractor’s performance to adjust the fee paid. DOD’s evaluation usually involves the application of a fee-determination formula that is specified in the contract. Evaluations occur at the end of the contract or, in the case of a performance or delivery incentive, at program milestones. The evaluations do not require an extensive evaluation process or the participation of a large number of contracting or program personnel. Table 2 provides a general look at the process for evaluating and determining the amount of incentive fee paid for a contract with a cost incentive. For this report, we examined fixed-price and cost-reimbursable award- and incentive-fee contracts, as well as contracts that combined aspects of both of these contract types. (See app. III for an explanation of various contract types.) Our probability sample of 93 contracts was drawn from a total of 597 DOD award- and incentive-fee contracts that were active from fiscal years 1999 through 2003 and had at least one contract action coded as cost-plus-award-fee, cost-plus-incentive-fee, fixed-price award-fee, or fixed-price-incentive valued at $10 million or more during that time. Among the sample, 52 contracts contained only award-fee provisions, 27 contracts contained only incentive-fee provisions, and 14 contracts included both. (App. I contains additional information on our scope and methodology.) From fiscal year 1999 through fiscal year 2003, award- and incentive-fee contract actions accounted for 4.6 percent of all DOD contract actions over $25,000. However, when taking into account the dollars obligated— award- and incentive-fee contract actions accounted for 20.6 percent of the dollars obligated on actions over $25,000, or over $157 billion, as shown in figure 1. Our sample of 93 contracts includes $51.6 billion, or almost one-third, of those obligated award- and incentive-fee contract dollars. DOD utilized the contracts in our sample for a number of purposes. For example, research and development contracts accounted for 51 percent (or $26.4 billion) of the dollars obligated against contracts in our sample from fiscal years 1999 through 2003, while non-research-and-development services accounted for the highest number of contracts in our sample. Contract actions include any action related to the purchasing, renting, or leasing of supplies, services, or construction. Contract actions include definitive contracts; letter contracts; purchase orders; orders made under existing contracts or agreements; and contract modifications, which would include the payment of award and incentive fees. Table 3 shows the dollars obligated and the types of contracts by product and service. Appendix IV contains a breakdown of the contracts in our sample by contract type and military service. DOD has the flexibility to mix and match characteristics from different contract types. The risks for both DOD and the contractor vary depending on the exact combination chosen, which, according to the Federal Acquisition Regulation, should reflect the uncertainties involved in contract performance. Based on the results from our sample, about half of the contracts in our study population were cost-plus-award-fee contracts. The theory behind these contracts is that although the government assumes most of the cost risk, it retains control over most or all of the contractor’s potential fee as leverage. On cost-plus-award-fee contracts, the award fee is often the only source of potential fee for the contractor. According to defense acquisition regulations, these contracts can include a base fee—a fixed fee for performance paid to the contractor—of anywhere from 0 to 3 percent of the value of the contract; however, based on our sample results, we estimate that about 60 percent of the cost-plus-award- fee contracts in our study population included zero base fee. Tables 4 and 5 show the estimated percentage of DOD award-fee contracts that had a particular percentage of the value of the contract available in award fees and base fees. Based on the results from our sample, an estimated 16 percent of the contracts in our study population were fixed-price incentive contracts, and an estimated 13 percent were cost-plus-incentive-fee contracts. In both of these cases, the government and the contractor share the cost risks. However, on fixed-price incentive contracts, the contractor usually assumes more risk because if the contract reaches its ceiling price, the contractor absorbs the loss. Under a cost-plus-incentive-fee contract, when costs increase to the point where the contractor will only earn the minimum fee, no further fee adjustments occur and the government continues to pay the contractor’s reimbursable costs. When discussing award- and incentive-fee contracts, it is important to acknowledge the acquisition environment in which they are used. For instance, based on our sample results, we estimate that most of the contracts and most of the dollars in our study population are related to the acquisition of weapon systems. Since 1990, GAO has designated DOD weapon system acquisition as a high-risk area. Although U.S. weapons are the best in the world, DOD’s acquisition process for weapon programs consistently yields undesirable consequences—cost increases, late deliveries to the warfighter, and performance shortfalls. These problems occur because DOD’s weapon programs do not capture early on the requisite knowledge that is needed to efficiently and effectively manage program risks. For example, programs move forward with unrealistic program cost and schedule estimates, lack clearly defined and stable requirements, use immature technologies in launching product development, and fail to solidify design and manufacturing processes at appropriate junctures in development. As a result, wants are not always distinguished from needs, problems often surface late in the development process, and fixes tend to be more costly than if made earlier. When programs require more resources than planned, the buying power of the defense dollar is reduced, and funds are not available for other competing needs. The persistence of these problems reflects the fact that the design, development, and production of major weapon systems are extremely complex technical processes that must operate within equally complex budget and political processes. A program that is not well conceived, planned, managed, funded, and supported may easily be subject to such problems as cost growth, schedule delays, and performance shortfalls. Even properly run programs can experience problems that arise from unknowns, such as technical obstacles and changes in circumstances. In short, it takes a myriad of things to go right for a program to be successful but only a few things to go wrong to cause major problems. DOD has not structured and implemented award-fee contracts in a way that effectively motivates contractors to improve performance and achieve acquisition outcomes. DOD practices—such as routinely paying its contractors nearly all of the available award fee, amounting to billions of dollars, regardless of whether the acquisition outcomes fell short of, met, or exceeded expectations; rolling an estimated $669 million in unearned or withheld award fees to future evaluation periods; and paying a significant portion of the available fee for what award-fee plans describe as “acceptable, average, expected, good, or satisfactory” performance—all lessen the motivation for the contractor to strive for excellent performance. In addition, DOD award-fee plans have not been structured to focus the contractor’s attention on achieving desired acquisition outcomes. DOD generally does not evaluate contractors on criteria that are directly related to acquisition outcomes, and the link between the elements of contractor performance that are included in award-fee criteria and acquisition outcomes is not always clear. While incentive-fee contracts are more directly linked to select acquisition outcomes, DOD has not fared well at using these types of contracts to improve cost control behavior or meet program goals. However, when contractor performance does not result in the desired acquisition outcome under an incentive-fee contract, the reduction of fees is usually automatic and based on the application of a predetermined formula. Figure 2 summarizes our findings within the general framework of issues surrounding DOD’s use of award and incentive fees. DOD’s practice of routinely paying its contractors nearly all of the available award fee puts DOD at risk of creating an environment in which programs pay and contractors expect to receive most of the available fee, regardless of acquisition outcomes. Based on our sample, we estimate that for DOD award-fee contracts, the median percentage of available award fee paid to date (adjusted for rollover) was 90 percent, representing an estimated $8 billion in award fees for contracts active between fiscal years 1999 through 2003. The lowest percentage of available fee paid to date for contracts in our sample was 36 percent, and the highest was 100 percent. Figure 3 shows the percentage of available fee earned for the 63 award-fee contracts in our sample and the lack of variation, especially across the contracts in the middle of the distribution. The pattern of consistently high award-fee payouts is also present in DOD’s fee decisions from evaluation period to evaluation period. This pattern is evidence of reluctance among DOD programs to deny contractors significant amounts of fee, even in the short term. We estimate that the median percentage of award fee earned for each evaluation period was 93 percent and the level of variation across the evaluation periods in our sample was similar to the trend shown in figure 3. On DOD award-fee contracts, we estimate that the contractor received 70 percent or less of the available fee in only 9 percent of the evaluation periods and none of the available fee in only 1 percent of the evaluation periods. Figure 4 shows the percentage of available fee earned by evaluation period for the award-fee contracts in our sample. There were 572 evaluation periods overall for these contracts. In addition to consistently awarding most of the available award fee on an evaluation period-by-evaluation period basis, the use of “rollover” is another indication of DOD’s reluctance to withhold fees. Rollover is the process of moving unearned available award fee from one evaluation period to a subsequent evaluation period, thereby providing the contractor an additional opportunity to earn that unearned award-fee amount. DOD and program officials view rollover as an important mechanism for maintaining leverage with contractors; however, award-fee guidance issued by the Air Force, Army, and Navy in the last 3 years states that this practice should rarely be used in order to avoid compromising the integrity of the award-fee evaluation process. We estimate that 52 percent of DOD award-fee contracts rolled over unearned fees into subsequent evaluation periods. We estimate that unearned fees were rolled over in 42 percent of evaluation periods of contracts that used this practice. Further, we estimate that the mean percentage of unearned fees that were rolled over in these periods was 86 percent, and in 52 percent of these periods at least 99 percent of the unearned fee was rolled over. Consequently, in many evaluation periods when rollover was used, the contractor still had the chance to earn almost all of the unearned fee, even in instances when the program was experiencing problems. Across all the evaluation periods for the 32 contracts in our sample that used this practice, the amount rolled over was almost $500 million, or an average of 51 percent of the total unearned fees. (See fig. 5 for a depiction of DOD’s use of rollover on the contracts in our sample.) Overall, for DOD award-fee contracts active between fiscal years 1999 through 2003, we estimate that the total dollars rolled over across all evaluation periods that had been conducted by the time of our review was $669 million. Several of the contracts in our sample routinely rolled over 100 percent of a contractor’s unearned award fee into fee pools for use later in the programs. For example, the Joint Strike Fighter program has rolled over 100 percent of the unearned award fee for its development contracts into a reserve award-fee pool that the program uses to target areas not covered in the award-fee plan, such as encouraging the contractor to track awards to small businesses and improving communications with countries that are partners in the development program. However, the program has also used the reserve award-fee pool to provide additional money to motivate cost control, even though this area is already a focus of the award-fee plan. If the contractor does not earn the fee in the targeted area, the program keeps rolling the unearned fee back into the reserve pool. The practical effect of this is that the Joint Strike Fighter program’s prime contractors still have the ability to earn the maximum award fee despite the cost and technical issues the program has experienced. DOD may also be diluting the motivational effectiveness of award fees by paying significant amounts of fee for satisfactory performance. Although DOD guidance and federal acquisition regulations state that award fees should be used to motivate excellent contractor performance in key areas, most DOD award-fee contracts pay a significant portion of the available fee from one evaluation period to the next for what award-fee plans describe as “acceptable, average, expected, good, or satisfactory” performance. Figure 6 shows the maximum percentage of award fee paid for “acceptable, average, expected, good, or satisfactory” performance and the estimated percentage of DOD award-fee contracts active between fiscal years 1999 through 2003 that paid these percentages. Some plans for contracts in our sample did not require the contractor to meet all of the minimum standards or requirements of the contract to receive one of these ratings. Some DOD award-fee contracts in our sample also allowed for a portion of the available award fee to be paid for marginal performance—a rating lower than satisfactory. Even fixed-price-award-fee contracts, which already include a normal level of profit in the price, paid out award fees for satisfactory performance. Six of the eight fixed-price contracts with award fee provisions in our sample paid out 50 percent or more of the available award fee for satisfactory performance. The amount of award fee being paid for performance at or below the minimum standards or requirements of the contract appears to not only be inconsistent with the intent of award fees (as explained in DOD guidance and federal acquisition regulations) but also is inconsistent with the reasons contracting and program officials cited on our questionnaire for their use. According to responses to our questionnaire, rewarding satisfactory performance was one reason that award or incentive fees were used on an estimated 29 percent of DOD award- and incentive-fee contracts. However, rewarding better than satisfactory performance was one reason that these fees were used on an estimated 77 percent of these contracts. The responses provided to our questionnaire also seem to rule out the administration of award fees as one of the reasons for their general lack of effectiveness. Several key elements related to development and administration of award-fee contracts were present on almost all contracts. Specifically, contracting and program officials’ questionnaire responses showed that the appropriate people were involved in the development and administration of award-fee contracts, and there was adequate guidance and training in place. We estimate that for 91 percent of DOD award-fee contracts, there were designated performance monitors responsible for evaluating specific areas described in the award-fee plan. On an estimated 88 percent of DOD award-fee contracts, award-fee evaluation board members received training on their roles and responsibilities. We further estimate that on 85 percent of DOD award-fee contracts, performance monitors also received training. Evaluation boards were held as planned for an estimated 86 percent of DOD award-fee contracts, and some programs conducted interim assessments of contractor performance to support the end-of-period evaluations. Based on questionnaire responses from contracting and program officials, an estimated 95 percent of DOD award-fee contracts had rating category descriptions that provided enough detail to distinguish between categories. An estimated 79 percent of the contracting officers responsible for developing and administering award-fee contracts and an estimated 80 percent of the contracting officers responsible for incentive-fee contracts believed the training was adequate. Finally, the contracting and program officials on an estimated 94 percent of DOD award- and incentive- fee contracts felt that the guidance they used to develop and administer the contract was adequate. DOD programs do not structure award fees in a way that motivates contractors to achieve or holds contractors accountable for achieving desired acquisition outcomes. In several contracts we evaluated, DOD established award-fee criteria that were focused on broad areas, such as how well the contractor was managing the program. This can result in award-fee plans and criteria that seemingly have little to do with acquisition outcomes, such as meeting cost and schedule goals and delivering desired capabilities. For example, on a Navy ship construction contract, 50 percent of the award-fee money, or $28 million, was based on management criterion including how responsive the contractor was to the government customers, the quality and accuracy of contract proposals, and the timeliness of contract data requirements. Elements of the award- fee process, such as the frequency of evaluations, may also limit DOD’s ability to effectively evaluate the contractor’s progress toward acquisition outcomes. For instance, while holding award-fee evaluations every quarter was successful for three Pentagon Renovation Management construction contracts because the contractor’s short-term progress could easily be assessed, a similar strategy might not be effective for a long-term development effort because quarterly or even semiannual evaluations may not generate meaningful information about progress. High award-fee payouts on programs that have fallen or are falling well short of meeting their stated goals are also indicative of DOD’s failure to implement award fees in a way that promotes accountability. Several major development programs—accounting for 52 percent of the available award-fee dollars in our sample and 46 percent of the award-fee dollars paid to date—are not achieving or have not achieved their desired acquisition outcomes, yet contractors received most of the available award fee. The Comanche helicopter, F/A-22 and Joint Strike Fighter aircraft, and the Space-Based Infrared System High satellite system, have experienced significant cost increases, technical problems, and development delays, but the prime systems contractors have respectively received 85, 91, 100, and 74 percent of the award fee made available to date (adjusted for rollover), totaling $1.7 billion (see table 6). DOD can ensure that fee payments are more representative of program results by developing fee criteria that focus on its desired acquisition outcomes. We found two notable examples in which DOD’s Missile Defense Agency attempted to hold contractors accountable for program outcomes. In the case of the Airborne Laser program, DOD revised the award-fee plan in June 2002 as part of a program and contract restructuring. The award-fee plan was changed to focus on achieving a successful system demonstration by December 2004. Prior to the restructuring, the contractor had received 95 percent of the available award fee, even though the program had experienced a series of cost increases and schedule delays. The contractor did not receive any of the $73.6 million award fee available under the revised plan because it did not achieve the key program outcome—successful system demonstration. Similarly, the development contract for the Terminal High Altitude Area Defense program, a ground-based missile defense system, contains a portion of the award fee tied specifically to desired program outcomes— conducting successful flight tests, including intercepts of incoming missiles. This $50 million special award-fee pool is separate from and in addition to the subjective award-fee portion of the contract, which is worth more than $524 million (of which $275 million has already been paid). If one of the first two test flights is successful, the contractor will receive $25 million. If the missile misses the target, the contractor provides DOD with a cost credit of $15 million. The first of these flight tests is scheduled to occur before the end of calendar year 2005. Other programs have utilized different fee strategies to focus the contractor’s attention on specific acquisition outcomes. However, contracting officials have stated that there are few mechanisms to share lessons learned and innovative practices outside the local level. These approaches include conditional fees and linked incentives. Conditional fees stipulate that certain requirements must be met for a contractor to earn and keep fees. For example, we reviewed an Intercontinental Ballistic Missile program award-fee plan that included an “After Discover Performance Deficiencies” provision to ensure that award-fee payouts were consistent with program outcomes. This provision allowed the program to retrieve funds paid during prior award-fee periods if the program experienced overruns or if performance deficiencies were discovered after the award fee has been paid. Linked incentives evaluate cooperation across multiple contracts and contractors. For example, after initial interoperability problems, the Cooperative Engagement Capability program added award-fee criteria to evaluate how well the system integrated with the Aegis destroyer. Contracts with incentive fees have also not fared well at motivating cost- control behavior or meeting program targets; however, fee payments are more consistent with acquisition outcomes. According to DOD contracting and program officials, contractors overran or were expected to overrun the target price on 52 percent of the 27 incentive-fee contracts in our sample. In these cases, the contractor does not earn the target fee but may earn a minimum fee, if one is specified in the contract. For example, the Navy’s cost-plus-incentive-fee contract for the LPD 17, an amphibious transport dock ship, is projected to overrun the target price of $644 million by at least 139 percent; on the Army’s Brilliant Anti-Armor Submunition program, a fixed-price incentive contract for test hardware, overran the $75 million target cost by 27 percent ($20 million); and the fixed-price incentive contract for the Navy’s P-3C Sustained Readiness Program initially called for 50 kits to be produced, but only 13 were delivered before contract funding was exhausted. Incentive-fee contracts that also included performance and delivery incentives similarly have not met those key objectives, as shown in the examples below. Even though the system received approval from the Navy in June 2005 for low-rate initial production, the contracting officer and program manager stated that the cost, delivery, and technical incentives in the Airborne Laser Mine Detection System program did not improve contractor performance. During the course of the effort, the contractor experienced several cost overruns, as well as technical performance shortfalls. In addition, because of government delays, program officials decided to eliminate the delivery incentive included in the initial contract. According to the contracting and program officials responsible for administering and managing one of the Army’s chemical demilitarization contracts, performance milestones with incentive fees were an important part of the Army’s effort to accelerate the destruction of chemical weapons stockpiles after the events of September 11, 2001. However, these incentives did not keep the contract on schedule. The contractor missed the target completion date for the third of its four performance incentive milestones and the program was delayed by over a year. According to DOD, the failure to meet this milestone was due to unforeseen technical difficulties, and could not have been ultimately influenced by any type of contractual language. In contrast, the successful use of fee is supported by the level of product knowledge attained by officials and their ability to leverage this knowledge. For example, DOD contracting officials for the Patriot Advanced Capability-3 missile had a well-developed knowledge of the acquisition’s cost risks and were able to reduce costs by $42 million for the low-rate initial production contract. Contracting officials stated that the favorable outcome was due to the use of a cost model that was developed and matured on the previous production contract. Unlike award-fee contracts, incentive-fee contracts are based on formula- like mechanisms that determine the amount of fee earned. When a contractor misses a target in an incentive-fee contract, the reduction of fees is usually automatic and based on the application of a predetermined formula. The nature of the fee criteria in these contracts also eliminates most of the subjectivity in the evaluation process. Cost, schedule or delivery, and performance incentives are all based on targets that can be evaluated against actual costs, actual dates, and actual performance. In addition, negative incentives allow for fee reductions if the contractor does not meet certain criteria. For example, on one of the Navy’s carrier refueling and overhaul contracts, the contractor’s fee could be reduced if its overhead rate exceeded a certain target. Since incentive fees, especially those related to cost, are primarily evaluated at the conclusion of the contract, the officials applying the evaluation criteria or fee formula have a clear sense of the contractor’s performance. DOD’s use of monetary incentives is based on the assumption that such incentives can improve contractor performance and acquisition outcomes; however, past studies have challenged the validity of this assumption. Research on incentive fees going back to the 1960s has concluded these incentive fees are not effective in controlling cost. Studies conducted by GAO, Harvard University, and the RAND Corporation, among others, have concluded that these incentives do not motivate cost efficiency, in part because profit is not the contractor’s only motivation. Other considerations, such as securing future contracts with the government, can be stronger motivators than earning additional profit. More recently, research on award fees revealed that while these fees are an intuitively appealing way to improve contractor performance, they do not always operate that way in practice. Contractor respondents in one study stated that award fees motivate performance to some extent; however, the consensus was that they do not in and of themselves increase performance significantly. Research has also pointed to recurring disconnects between the intent and the administration of award-fee contracts. Award-fee criteria were not applied as intended; and many award-fee board members and fee-determining officials approached the process with the assumption the contractors should earn the full amount unless there were specific instances of poor performance that warranted deductions, instead of starting at zero and considering the actions the contractor had taken to earn the available fee. Finally, the lack of explicit rationale and documentation in support of performance ratings has led some researchers to conclude that fees were being paid without adequate justification. Despite these findings and the concerns raised by senior DOD officials about the amounts of award fee paid to contractors on acquisitions that were not performing to their established baselines, very little effort has gone into determining whether DOD’s current use of monetary incentives is effective. Over the past few years, officials including the Undersecretary for Acquisition Technology and Logistics and the Assistant Secretary of the Air Force for Acquisition expressed concerns that contractors routinely earn high percentages of fee while programs have experienced performance problems, schedule slips, and cost growth. In 1999, following a report by a DOD-led integrated process team addressing contractor incentives, the Undersecretary of Defense also issued a memorandum for all service secretaries specifically noting that contractors do not always have an incentive to focus their attention on the government’s desired outcomes and offered several principles for structuring future contract incentives. However, according to the lead of the integrated process team from the Office of the Secretary of Defense, the effort did not result in any new policy directives, changes in guidance, or new training. In addition, DOD did not assess the results of the study. In contrast to the concerns expressed by DOD’s senior acquisition leadership, we gathered testimonial evidence that indicates DOD contracting and program officials believe that these monetary incentives are effective for improving contractor performance. Based on responses to our questionnaire, an estimated 77 percent of DOD award- and incentive- fee contracts had improved performance because of the incentive provisions, in the opinion of contracting and program officials. On award- fee contracts, officials pointed to increased responsiveness or attention from the contractor at the management level as evidence of this improvement, even if this increased responsiveness did not result in overall desired program outcomes being achieved. One of the potential reasons for this disconnect between statements at the policy level and the opinions of practitioners is the lack of a DOD-wide system for compiling and aggregating award- and incentive-fee information and for identifying resulting trends and outcomes. DOD has not compiled information, conducted evaluations, or used performance measures to judge how well award and incentive fees are improving or can improve contractor performance and acquisition outcomes. The lack of data is exemplified by the fact that DOD does not track such basic information as how much it pays in award and incentive fees. Such information collection across DOD is possible. For instance, DOD is implementing the Defense Acquisition Management Information Retrieval system to collect data on acquisition costs and variances, schedules, and program baseline breaches on major acquisition systems. This system provides DOD policymakers with readily available information they can use to oversee program performance across the department. If DOD does not begin to collect similar information on award and incentive fee payments, it may not be able to measure progress toward meeting one of the goals listed in its fiscal 2004 performance and accountability report, that is, invigorating the fiscal well-being of the defense industry by rewarding good performance. The existence or application of a well-developed and well-implemented monetary incentive alone does not determine the overall success or failure of an acquisition. DOD acquisition programs operate in an environment with underlying pressures and incentives that drive both program and contractor behavior. Competition for funding and contracts leads to situations, especially in major system acquisitions, in which costs are underestimated and capabilities are overpromised. Resulting problems require additional time and money to address. At the same time, DOD customers are tolerant of cost overruns and delays in order to get a high- performance weapon system. DOD’s current approach toward monetary incentives reflects these realities and has resulted in a failure to hold contractors accountable for delivering and supporting fielded capabilities within cost and schedule baselines. While DOD and contractors share the responsibility for program success, award and incentive fees, to be effective, need to be realigned with acquisition outcomes. Awarding large amounts of fee for satisfactory or lesser performance and offering contractors multiple chances to earn previously withheld fees has fostered an environment in which DOD expects to pay and contractors expect to receive most of the available award fee regardless of outcomes. In addition, DOD’s lack of information on how well award and incentive fees are achieving their intended purpose leaves the department vulnerable to millions of dollars of potential waste. Successes do exist at the individual contract level, but DOD will need to leverage this knowledge if it hopes to identify proven incentive strategies across a wide variety of DOD acquisitions. To strengthen the link between monetary incentives and acquisition outcomes and by extension increase the accountability of DOD programs for fees paid and of contractors for results achieved, we recommend that the Secretary of Defense direct the Undersecretary of Defense for Acquisition, Technology, and Logistics to take the following seven actions. DOD can immediately improve its use of award fees on all new contracts by (1) instructing the military services to move toward more outcome- based award-fee criteria that are both achievable and promote accountability for acquisition outcomes; (2) ensuring that award-fee structures are motivating excellent contractor performance by only paying award fees for above satisfactory performance; and (3) requiring the appropriate approving officials to review new contracts to make sure these actions are being taken. DOD can improve its use of award fees on all existing contracts by (4) issuing DOD guidance on when rollover is appropriate. In the longer term, DOD can improve its use of award and incentive fees by (5) developing a mechanism for capturing award- and incentive-fee data within existing data systems, such as the Defense Acquisition Management Information Retrieval system; (6) developing performance measures to evaluate the effectiveness of award and incentive fees as a tool for improving contractor performance and achieving desired program outcomes; and (7) developing a mechanism to share proven incentive strategies for the acquisition of different types of products and services with contracting and program officials across DOD. DOD’s Office of Defense Procurement and Acquisition Policy provided written comments on a draft of this report. These comments are reprinted in appendix II. DOD also provided separate technical comments, which we have incorporated as appropriate. DOD concurred with three of our seven recommendations—moving toward more outcome-based award-fee criteria, issuing guidance on rollover, and developing a mechanism to share proven incentive strategies. The department indicated that it would implement these recommendations by issuing a policy memorandum on award fees and completing a communications plan for sharing incentive strategies on March 31, 2006. DOD partially concurred with four of our seven recommendations. Concerning three of the four recommendations—requiring the appropriate officials to make sure these recommendations are implemented in new contracts, collecting award and incentive fee data, and developing performance measures to evaluate the effectiveness of award and incentive fees in improving acquisition outcomes—DOD indicated that the Director of the Office of Defense Procurement and Acquisition Policy, in collaboration with the military departments and defense agencies, would conduct a study to determine the appropriate actions to address them. The office plans to complete the study by June 1, 2006. While this study may provide additional insights, we encourage DOD to use it as a mechanism for identifying the specific steps the department will take to fully address our recommendations, not to determine whether the department will take action. For instance, in its response to our recommendation on developing a mechanism for capturing award and incentive fee data, DOD raises the issue of cost. We agree that the potential cost of implementing this recommendation should be considered, while deciding on an appropriate course of action. However, given that the department paid out an estimated $8 billion in award fees on the contracts in our study population regardless of outcomes, we believe that a reasonable investment in ensuring that these funds are well-spent in the future is warranted. Collecting this data is also necessary to support the development of meaningful performance measures, which can be used to evaluate the costs and benefits of continuing to use these contract types and determine if they are achieving their goal of improving contractor performance and acquisition outcomes. Further, without data and performance measures, DOD will not be in a position to measure the effectiveness of any actions it takes to address the issues identified in this report. DOD also partially concurred with our recommendation related to only paying award fees for above satisfactory performance. Specifically, the department stated that it is fair and reasonable to allow the contractor to earn a portion of the award fee for satisfactory performance. However, we believe that this use of award fee should be the exception, not the rule. Fixed-price-award-fee contracts already include a normal level of profit in the price which is paid for satisfactory performance. In addition, the inclusion of base fee in a cost-plus-award-fee contract may be a more appropriate mechanism for providing fee for satisfactory performance. According to the Army Contracting Agency’s Handbook for Award Fee Contracts, base fee (not exceeding three percent of the estimated contract cost) can be paid to the contractor for acceptable performance and is designed to compensate the contractor for factors such as risk assumption, investment, and the nature of the work. DOD also stated that award fee arrangements should be structured to encourage the contractor to earn the preponderance of fee by providing excellent performance. According to its comments, DOD plans to address this issue in the March 2006 policy memorandum on award fees. While DOD may conclude that it needs the flexibility to pay a portion of the award fee for satisfactory performance, especially for high risk efforts, current practice on most award fee contracts is to pay a significant portion of the available fee for “acceptable, average, expected, good, or satisfactory” performance. We would encourage DOD to consider limiting the maximum percentage of fee available for this level of performance to, consistent with its comments, keep the preponderance of fee available for excellent performance. We are sending copies of this report to interested congressional committees; the Secretary of Defense; the Secretaries of the Air Force, Army, and Navy; the Commandant of the Marine Corps; and the Director, Office of Management and Budget. We will provide copies to others on request. This report will also be available at no charge on GAO’s Web site at http://www.gao.gov. If you have any questions about this report or need additional information, please call me at (202) 512-4841 (calvaresibarra@gao.gov). Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Other staff making key contributions to this report were Thomas J. Denomme, Assistant Director; Robert Ackley; Heather Barker; Lily J. Chin; Aftab Hossain; Julia Kennon; John Krump; Jerry Sandau; Sidney Schwartz; Ron Schwenn; Najeema Davis Washington; and E. Chris Woodard. Our objective was to determine whether award and incentive fees are an effective management tool for achieving the Department of Defense’s (DOD) desired outcomes. To conduct our work, we selected a sample of 93 award- and incentive-fee contracts, interviewed contracting and program officials, analyzed contract documentation related to incentive provisions, collected and analyzed data on award-fee payments, reviewed DOD and military service guidance on award and incentive fees, and examined the results of initiatives related to improving the use of these fees. Our sample for this review was based on contract data from the Federal Procurement Data System. We extracted information from this database on all DOD contracts active between fiscal years 1999 through 2003 that had at least one contract action coded as cost-plus-award-fee, cost-plus- incentive-fee, fixed-price-award-fee, or fixed-price incentive valued at $10 million or more during that time. These criteria gave us a study population of 597 unique contracts, which were associated with 2,474 award- and incentive-fee contract actions. To ensure the validity of the database from which we drew our sample, we tested the reliability of the contract type field in the Federal Procurement Data System. We selected a sample of 30 contracts from the population of DOD contracts active between fiscal years 1999 through 2003 and asked DOD and the military services to provide data on the contract type(s) for each one using data sources other than the Federal Procurement Data System or Individual Contracting Action Reports (DD Form 350). We also requested that DOD and the military services verify that at least one contract action between fiscal years 1999 through 2003 was valued at over $10 million. Of the 30 contracts, DOD and the military services reported that 10 were either incorrectly coded or omitted information on a relevant contract type in the Federal Procurement Data System. Of these 10 errors, only 3 would have caused a contract to be mistakenly included or excluded in the population from which our sample was selected. Based upon these responses and the exclusion of only one contract from our sample because of miscoding in the Federal Procurement Data System, we determined that the data were sufficiently reliable for the purposes of this report. To select the sample for this review, we stratified the population of 597 contracts based on the total dollar value of award- and incentive-fee contract actions associated with the contract during this period. We included all 12 contracts in the sample for which the total value of the award- and incentive-fee contract actions during this period exceeded $2 billion. We used probability sampling techniques to select 85 contracts from the remaining 585 contracts in the population, ensuring that the number of contracts from the Navy, Army, Air Force, and all other defense agencies and organizations combined were proportional to their representation among the 585. During our work, we discovered that 2 of the 85 contracts we sampled from the stratum of 585 contracts were outside of the scope of this review. These contracts were removed from the sample. We also discovered that for 2 other in-scope contracts in this stratum, the officials involved in developing and administering the contract and the contract documentation were not available. We excluded these contracts from our analysis. We randomly selected a total of 4 additional contracts from the same stratum to include in our analysis. Because we followed a probability procedure based on random selections, our sample is only one of a large number of samples that we might have drawn. Since each sample could have provided different estimates, we express our confidence in the precision of our particular sample’s results as 95 percent confidence intervals (for example, plus or minus 7 percentage points). These are the intervals that would contain the actual population values for 95 percent of the samples we could have drawn. As a result, we are 95 percent confident that each of the confidence intervals in this report will include the true values in the study population. All percentage estimates from our review have margins of error (that is, confidence interval widths) not exceeding plus or minus 10 percentage points, unless otherwise noted. All numerical estimates other than percentages (such as totals and ratios) have margins of error not exceeding plus or minus 25 percent of the value of those estimates. Our analysis also tested the extent to which statistically significant relationships existed between such factors as contract type, reasons an incentive contract was chosen, types of officials involved in developing the incentive structure, use of rollover, training, and guidance; and contracts that contracting and program officials have cited improved contractor performance because of the use of incentive. To determine whether award and incentive fees are an effective management tool, we conducted structured interviews with contracting and program officials about the development, implementation, and effectiveness of the incentive structure for 92 of the 93 award- and incentive-fee contracts in our sample; analyzed contract documentation related to incentive provisions; and collected and analyzed data on award- fee payments for 63 of the 66 contracts with award-fee provisions in our sample. For one contract, the office responsible for administering the contract could not identify any contracting or program personnel who could address our interview topics and all questions were coded as “no response.” For three contracts, the office responsible for administering the contract could not provide complete documentation on award-fee payments. To conduct our structured interviews on the development, implementation, and effectiveness of the incentive structure, we used a questionnaire that was a combination of open- and close-ended questions. When possible, these interviews were held in person. We visited the Defense Threat Reduction Agency Headquarters; Joint Strike Fighter Program Office; Los Angeles Air Force Base; Missile Defense Agency (Navy Annex); Patuxent Naval Air Station; Pentagon Renovation and Construction Program Office; Redstone Arsenal; U.S. Army Contracting Agency’s Information Technology, E-Commerce and Commercial Contracting Center; U.S. Navy’s Strategic System Program Office; Warner Robins Air Force Base; Washington Navy Yard; and Wright Patterson Air Force Base for this purpose. The remaining interviews were held by video teleconference or by telephone. All interviews were conducted between October 2004 and April 2005. We also reviewed contract documentation related to the development and implementation of the contracts’ incentives, including the basic contract, statement of work, acquisition planning documents, modifications related the incentive structure, award-fee plan, documentation describing fee criteria for specific evaluation periods, contractor self-assessments, award-fee board evaluation reports, and fee-determination documents. We used this information to corroborate and supplement the information provided in the structured interviews, determine the extent to which linkages exist between fee criteria and the desired program outcomes identified by contracting and program officials, and examine fee payments in the context of program performance. When possible, we evaluated program and contract performance using GAO’s body of work on DOD systems acquisitions, including the annual assessment of selected major weapon programs and annual status report on the ballistic missile defense program. For each of the 66 award-fee contracts in our sample, we collected and analyzed data on the base fee and maximum award fee, expressed as a percentage of the estimated cost, exclusive of the cost of money; the award fee available and paid for each evaluation period; the amount of unearned fee rolled over into subsequent evaluation periods; the total award-fee pool; and the remaining award-fee pool, which included any rolled-over fee still remaining to be potentially earned. In most cases, contracting and program officials submitted the data on a standard template we provided. In cases where the program did not submit data in the requested format, we gathered this information from fee-determination letters and contract modifications. We also used these documents to verify the reliability of the data that were submitted by contracting and program officials. From this data, we calculated the percentage of the available fee that was awarded for individual evaluation periods, entire contracts to date, and the overall sample. We included rollover amounts available and earned in our calculations of fee awarded for individual evaluation periods. When calculating the percentage of fee earned for entire contracts, we excluded rolled-over fees from the available fee pool when those fees were still available to be earned in future evaluation periods. We also calculated the percentage of unearned fee that was made available to the contractor as rollover for individual evaluation periods, entire contracts, and the overall sample. Estimates of total award fees earned and total award fees that were rolled over are based on all evaluation periods held from the inception of our sample contracts through our data collection phase, not just those from fiscal years 1999 through 2003. We did not analyze incentive fee payments because most fee determinations are related to cost and are not complete until the contract is closed out. We interviewed officials from Defense Acquisition University, Office of Director of Defense Procurement and Acquisition Policy, Office of the Deputy Assistant Secretary of the Air Force for Contracting (Policy and Implementation), Office of Deputy Assistant Secretary of the Army (Policy and Procurement), Office of the Deputy Assistant Secretary of the Navy for Acquisition Management, Office of the Air Force Inspector General, and the U.S. Army Audit Agency, as well as government contracting experts on recent initiatives and current trends in incentive contracting. We reviewed previous audit and inspection reports from the Air Force, Army, and Navy. We analyzed current award- and incentive-fee guidance provided in the Federal Acquisition Regulation, Defense Federal Acquisition Regulation Supplement, U.S. Army Audit Agency’s report on Best Practices for Using Award Fees, Air Force Award Fee Guide, Air Force Material Command Award Fee Guide, and other service-specific policies, as well as the National Aeronautics and Space Administration’s Award Fee Guide. We identified and reviewed DOD and military service policy memos and initiatives including DOD’s Contractor Incentives Integrated Process Team; the Assistant Secretary of the Navy for Research, Development, and Acquisition’s policy memo on Contract Incentives, Profits and Fees; the Deputy Assistant Secretary of the Army for Procurement’s report on Innovation in Contractual Incentives; and the Office of the Undersecretary of Defense for Acquisition, Technology, and Logistics’ “quick look” at DOD Profit Policy and Defense Industry Profitability. We identified innovative monetary incentives used on contracts within our sample and the mechanisms available to share those across DOD. We performed our review from February 2004 to November 2005 in accordance with generally accepted government auditing standards. Award fee: An amount of money that is added to a contract and that a contractor may earn in whole or in part during performance and that is sufficient to provide motivation for excellence in the areas such as quality, schedule, technical performance, and cost management. Base fee: An award-fee contract mechanism that is an amount of money over the estimated costs (typically in the range of 0 to 3 percent of the contract value), which is fixed at the inception of the contract and paid to the contractor for performance in a cost-plus-award-fee contract. A base fee is similar to the fixed fee paid to a contractor under a cost-plus-fixed- fee contract that does not vary for performance. Ceiling price: A prenegotiated maximum price that may be paid to the contractor. Cost contract: A cost-reimbursement contract in which the contractor receives no fee. A cost contract may be appropriate for research and development work, particularly with nonprofit educational institutions or other nonprofit organizations, and for facilities contracts. Cost-plus-award-fee contract: A cost-reimbursement contract that provides for a fee consisting of a base amount (which may be zero) fixed at inception of the contract and an award amount, based upon a judgmental evaluation by the government, sufficient to provide motivation for excellence in contract performance. Cost-plus-incentive-fee contract: A cost-reimbursement contract that provides for an initially negotiated fee to be adjusted by a formula based on the relationship of total allowable costs to total target costs. Cost-reimbursable contract: A contract that provides for payment of the contractor’s allowable cost to the extent prescribed in the contract not to exceed a ceiling. Delivery incentives: A monetary incentive used to motivate the contractor to meet a particular product or service delivery objective. Fixed-price contract: A contract that provides for a price that is either fixed or subject to adjustment obligating the contractor to complete work according to terms and for the government to pay the specified price regardless of the contractor’s cost of performance. Fixed-price-award-fee contract: A variation of the fixed-price contract in which the contractor is paid the fixed price and may be paid a subjectively determined award fee based on periodic evaluation of the contractor’s performance. Fixed-price incentive contract: 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. Incentive contract: A contract used to motivate a contractor to provide supplies or services at lower costs and, in certain instances, with improved delivery or technical performance, by relating the amount of fee to contractor performance. Linked incentives: Incentives tied to performance in areas across multiple contracts and contractors and used to motivate contractors to cooperate. Negative incentives: A method used by the government to allow for fee reductions if the contractor does not meet certain criteria. Rollover: The process of moving unearned award fee from one evaluation period to a subsequent period or periods, thus allowing the contractor an additional opportunity to earn that unearned award fee. Share ratio: A fee-adjustment formula written as a ratio of the cost risk between the government and the contractor. Target cost: The preestablished cost of the contracted goods/services that is a reasonable prediction of final incurred costs. GAO’s sample of 93 award and incentive contracts comprises the following contract types: 48 cost-plus-award-fee contracts, 4 fixed-price-award-fee contracts, 12 cost-plus-incentive-fee contracts, 14 fixed-price incentive contracts, 1 cost-plus-incentive-fee / fixed-price incentive contract, and 14 contracts that are combinations of award- and incentive-fee contract types. The sample contracts included the following breakdown by military service and DOD agency or organization: 37 Navy contracts, 30 Air Force contracts, 18 Army contracts, 3 Missile Defense Agency contracts, 3 Pentagon Renovation Management Office contracts, 1 Marine Corps contract, and 1 Defense Threat Reduction Agency contract. Defense Acquisitions: Stronger Management Practices Are Needed to Improve DOD’s Software-Intensive Weapon Acquisitions. GAO-04-393. Washington, D.C.: March 1, 2004. Defense Acquisitions: DOD’s Revised Policy Emphasizes Best Practices, but More Controls Are Needed. GAO-04-53. Washington, D.C.: November 10, 2003. Best Practices: Setting Requirements Differently Could Reduce Weapon Systems’ Total Ownership Costs. GAO-03-57. Washington, D.C.: February 11, 2003. Best Practices: Capturing Design and Manufacturing Knowledge Early Improves Acquisition Outcomes. GAO-02-701. Washington, D.C.: July 15, 2002. Defense Acquisitions: DOD Faces Challenges in Implementing Best Practices. GAO-02-469T. Washington, D.C.: February 27, 2002. Best Practices: Better Matching of Needs and Resources Will Lead to Better Weapon System Outcomes. GAO-01-288. Washington, D.C.: March 8, 2001. Best Practices: A More Constructive Test Approach Is Key to Better Weapon System Outcomes. GAO/NSIAD-00-199. Washington, D.C.: July 31, 2000. Defense Acquisition: Employing Best Practices Can Shape Better Weapon System Decisions. GAO/T-NSIAD-00-137. Washington, D.C.: April 26, 2000. Best Practices: DOD Training Can Do More to Help Weapon System Program Implement Best Practices. GAO/NSIAD-99-206. Washington, D.C.: August 16, 1999. Best Practices: Better Management of Technology Development Can Improve Weapon System Outcomes. GAO/NSIAD-99-162. Washington, D.C.: July 30, 1999. Defense Acquisitions: Best Commercial Practices Can Improve Program Outcomes. GAO/T-NSIAD-99-116. Washington, D.C.: March 17, 1999. Defense Acquisition: Improved Program Outcomes Are Possible. GAO/T-NSIAD-98-123. Washington, D.C.: March 18, 1998. Best Practices: Successful Application to Weapon Acquisition Requires Changes in DOD’s Environment. GAO/NSIAD-98-56. Washington, D.C.: February 24, 1998. Major Acquisitions: Significant Changes Underway in DOD’s Earned Value Management Process. GAO/NSIAD-97-108. Washington, D.C.: May 5, 1997. Best Practices: Commercial Quality Assurance Practices Offer Improvements for DOD. GAO/NSIAD-96-162. Washington, D.C.: August 26, 1996.

Summary: Collectively, the Department of Defense (DOD) gives its contractors the opportunity to earn billions of dollars through monetary incentives--known as award fees and incentive fees. These fees are intended to motivate excellent contractor performance in areas deemed critical to an acquisition program's success, with award fees being appropriate when contracting and program officials cannot devise objective incentive fee targets related to cost, technical performance, or schedule. GAO was asked to determine whether award and incentive fees have been used effectively as a tool for achieving DOD's desired acquisition outcomes. To do this, GAO selected a probability sample of 93 contracts from the study population of 597 DOD award- and incentive-fee contracts that were active and had at least one contract action valued at $10 million or more from fiscal year 1999 through 2003. The power of monetary incentives to motivate excellent contractor performance and improve acquisition outcomes is diluted by the way DOD structures and implements incentives. While there were two examples in our sample in which the Missile Defense Agency attempted to link award fees directly to desired acquisition outcomes, such as demonstrating a capability within an established schedule, award fees are generally not linked to acquisition outcomes. As a result, DOD has paid out an estimated $8 billion in award fees to date on the contracts in our study population, regardless of outcomes. The following selected programs show this disconnect. When DOD programs did not pay all of the available award fee, DOD gave contractors on an estimated 52 percent of award-fee contracts at least a second opportunity to earn an estimated $669 million in initially unearned or deferred fees. GAO believes these practices, along with paying significant amounts of fee for "acceptable, average, expected, good, or satisfactory" performance, undermine the effectiveness of fees as a motivational tool and marginalize their use in holding contractors accountable for acquisition outcomes. They also serve to waste taxpayer funds. Incentive fees provide a clearer link to acquisition outcomes; however, a majority of the 27 contracts with cost incentives that GAO reviewed failed or are projected to fail to complete the acquisition at or below the target price. Despite paying billions in fees, DOD has little evidence to support its belief that these fees improve contractor performance and acquisition outcomes. The department has not compiled data, conducted analyses, or developed performance measures to evaluate the effectiveness of award and incentive fees. In addition, when contracts have utilized different fee strategies to focus the contractor's attention on specific acquisition outcomes, contracting officials have stated that DOD has few mechanisms to share lessons learned and innovative practices outside the local level.