Federal agencies, including DOD, can choose among numerous contract types to acquire products and services. One of the characteristics that vary 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. Federal acquisition regulations state that award- and incentive-fee 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. 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. These areas are susceptible to judgmental and qualitative measurement and evaluation, and as a result, award-fee criteria and evaluations tend to be subjective. Table 1 provides a description of the general process for evaluating the contractor and determining the amount of award fee earned. 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. These obligations include award- and incentive-fee payments as well as other contract costs. 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. Further, we estimate that most of the contracts and most of the dollars in our study population are related to the acquisition of weapon systems. 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. There is no limit on the maximum percentage of the value of the contract that can be made available in award fee, although the 20 percent included in the Space-Based Infrared Radar System High development contract we examined was outside the norm. The available award fees on all the award-fee contracts in our study population typically ranged from 7 to 15 percent of the estimated value of the contract. DOD’s use of award and incentive fees is symptomatic of an acquisition system in need of fundamental reform. DOD’s historical practice of routinely paying its contractors nearly all of the available award fee creates an environment in which programs pay and contractors expect to receive most of the available fee, regardless of acquisition outcomes. This is occurring at a time when DOD is giving contractors increased program management responsibilities to develop requirements, design products, and select major system and subsystem contractors. 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 and 2003. Estimates of total award fees earned 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. Figure 2 shows the percentage of available fee earned for the 63 award-fee contracts in our sample. 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 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. March 29, 2006, emphasizing the need to link award fees to desired program outcomes. Award fees have generally not been effective at helping DOD achieve its desired acquisition outcomes, in large part, because award-fee criteria are not linked to desired acquisition outcomes, such as meeting cost and schedule goals and delivering desired capabilities. Instead, DOD programs structure award fees to focus on the broad aspects of contractor performance, such as technical and management performance and cost control, that they view as keys to a successful program. In addition, elements of the award-fee process, such as the frequency of evaluations and the composition of award-fee boards, may also limit DOD’s ability to effectively and impartially evaluate the contractor’s progress toward acquisition outcomes. Most award-fee evaluations are time-based, generally every six months, rather than event-based; and award-fee boards are made up primarily of individuals directly connected to the program. As a result of all these factors, DOD programs frequently paid most of the available award fee for what they described as improved contractor performance, regardless of whether acquisition outcomes fell short of, met, or exceeded DOD’s expectations. 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 positive performance and adequate 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. These programs—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 received 85, 91, 100, and 74 percent of the award fee, respectively to date (adjusted for rollover), totaling $1.7 billion (see table 2). DOD can ensure that fee payments are more representative of program results by developing fee criteria that focus on its desired acquisition outcomes. For instance, DOD’s Missile Defense Agency attempted to hold contractors accountable for program outcomes on the Airborne Laser program. On this 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. Importantly, 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. While DOD stated that award fee motivating excellent contractor performance by only paying award fees for above satisfactory performance arrangements should be structured to encourage the contractor to earn the preponderance of fee by providing excellent performance, it maintains that paying a portion of the fee for satisfactory performance is appropriate to ensure that contractors receive an adequate fee on contracts. In its March 29, 2006 policy memo, DOD reiterated this position and emphasized that less than satisfactory performance is not entitled to any award fee. In its March 29, 2006 policy memo, DOD provided guidance and placed several limitations on the use of rollover. DOD programs routinely engage in award-fee practices that are inconsistent with the intent of award fees, reduce the effectiveness of these fees as motivators of performance, compromise the integrity of the fee process, and waste billions in taxpayer money. Two practices, in particular, paying significant amounts of fee for “acceptable, average, expected, good, or satisfactory” performance and providing contractors multiple opportunities to earn fees that were not earned when first made available, undermine the effectiveness of fees as a motivational tool and marginalize their use in holding contractors accountable for acquisition outcomes. Although DOD guidance and federal acquisition regulations state that award fees should be used to motivate excellent contractor performance, most DOD award-fee contracts pay a significant portion of the available fee for what award-fee plans describe as “acceptable, average, expected, good, or satisfactory” performance. Although the definition of this level of performance varies by contract, these definitions are generally not related to outcomes. Some plans for contracts in our sample did not even require the contractor to meet all of the minimum standards or requirements of the contract to receive one of these ratings. Some plans also allowed for fee to be paid for marginal performance. Even fixed-price-award-fee contracts, which already include a normal level of profit in the price, paid out award fees for satisfactory performance. Figure 3 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. The use of rollover is another indication that DOD’s management of award-fees lacks the appropriate incentives, transparency, and accountability necessary for an effective pay-for-performance system. 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 previously unearned award-fee. We estimate that 52 percent of DOD award-fee contracts rolled over unearned fees into subsequent evaluation periods, and in 52 percent of these periods, at least 99 percent of the unearned fee was rolled over. 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. DOD plans to conduct an analysis to to review new contracts to make sure award-fee criteria reflect desired acquisition outcomes and award-fee structures motivate excellent contractor performance by only providing fees for above satisfactory performance determine what the appropriate approving official level should be for new contracts utilizing award fees and issue additional guidance if needed by June 1, 2006. The inconsistent application of DOD’s existing policies on award fees and weapon system development reinforce the need for increased transparency and accountability in DOD’s management of award fees. Although DOD award-fee guidance and federal acquisition regulations state that award fees should be used to motivate excellent contractor performance, most DOD award-fee contracts still pay a significant portion of the available fee for what award-fee plans describe as “acceptable, average, expected, good, or satisfactory” performance. Air Force, Army, and Navy guidance that states rollover should rarely be used in order to avoid compromising the integrity of the award-fee evaluation process; however, about half of the contracts in our study population used rollover. DOD will conduct an analysis of existing award- and incentive-fee data within existing data systems, such as the Defense Acquisition Management Information Retrieval system systems and determine which, if any, is best suited, to capture this type of data and at what cost. DOD expects to complete the study by June 1, 2006. DOD will review and identify possible evaluate the effectiveness of award and incentive fees as a tool for improving contractor performance and achieving desired program outcomes performance measures and determine the appropriate actions by June 1, 2006. In its March 29, 2006 policy memo, DOD tasked Defense Acquisition University to develop an online repository for award- and incentive-fee policy information, related training courses, and examples of good award fee arrangements. 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 of Defense 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. However, DOD has not compiled information, conducted evaluations, shared lessons learned, 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 both necessary and appropriate. DOD’s use of award-fee contracts, especially for weapon system development, reflects the fundamental lack of knowledge and program instability that we have consistently cited as the main reasons for DOD’s poor acquisition outcomes. DOD uses these fees in an attempt to mitigate the risks that it creates through a flawed approach to major weapon system development. The DOD requirements, acquisition, budgeting, and investment processes are broken and need to be fixed. DOD’s requirements process generates much more demand for new programs than fiscal resources can reasonably support. The acquisition environment encourages launching product developments that promise the best capability, but embody too many technical unknowns and too little knowledge about the performance and production risks they entail. However, a new program will not be approved unless its costs fall within forecasts of available funds and, therefore, looks affordable. Further, because programs are funded annually and departmentwide, cross-portfolio priorities have not been established, competition for funding continues over time, forcing programs to view success as the ability to secure the next funding increment rather than delivering capabilities when expected and as promised. The business cases to support weapon system programs that result from these processes are in many cases not executable because the incentives inherent in the current defense acquisition system are not conducive to establishing realistic cost, schedule, and technical goals. As a result, DOD has to date not been willing to hold its programs or its contractors accountable for achieving its specified acquisition outcomes. Instead, faced with a lack of knowledge and the lack of a sound business case, DOD programs use award-fee contracts, which by their very nature allow DOD to evaluate its contractors on a subjective basis. This results in billions of dollars in wasteful payments because these evaluations are based on contractors’ ability to guide programs through a broken acquisition system, not on achieving desired acquisition outcomes. Implementing our recommendations on award and incentive fees will not fix the broader problems DOD faces with its management of major weapons or service acquisitions. However, by implementing our recommendations, DOD can improve incentives, increase transparency, and enhance accountability for the fees it pays. In particular, moving toward more outcome-based award-fee criteria would give contractors an increased stake in helping DOD to develop more realistic targets upfront or risk receiving less fee when unrealistic cost, schedule, and performance targets are not met. To make this new approach to incentives function as intended, DOD would also need to address the more fundamental issues related to its management approach, such as the lack of a sound business case, lack of well-defined requirements, lack of product knowledge at key junctions in development, and program instability caused by changing requirements and across-the-board budget cuts. Working in concert, these steps can help DOD set the right conditions for more successful acquisition outcomes and make more efficient use of its resources in what is sure to be a more fiscally constrained environment as the nation approaches the retirement of the “baby boom” generation. Last week, DOD issued a policy memorandum on award-fee contracts that takes steps towards addressing several of the recommendations made in our report, and the department has indicated that further actions are planned to address the remaining recommendations. This guidance is a positive first step, but, like so many prior DOD concurrences, its effectiveness will ultimately be determined by how well it is implemented. Identifying who will be responsible for ensuring it is carried out and how progress will be monitored and measured are key ingredients that are missing in the new guidance. We continue to believe that DOD must designate appropriate approving officials to review new contracts to ensure that award-fee criteria are tied to desired acquisition outcomes; fees are used to promote excellent performance; and the use of rollover provisions in contracts is the exception not the rule. Changing DOD award-fee practices will also require a change in culture and attitude. The policy memorandum’s position that it is appropriate to pay a portion of the available award fee for satisfactory performance to ensure that contractors receive an “adequate fee on contracts” is indicative of DOD’s resistance to cultural change. Finally, we encourage the department to fully implement our remaining recommendations including developing a mechanism to capture award- and incentive-fee data and developing performance measures to evaluate the effectiveness of these fees. Mr. Chairman and Members of the Committee, this concludes my prepared statement. I would be happy to answer any questions you may have at this time. In this statement, we examine fixed-price and cost-reimbursable award- and incentive-fee contracts, as well as contracts that featured combinations of these contract types. These contracts were selected as part of a probability sample of 93 contracts from a study population of 597 DOD award-fee and incentive-fee contracts that were active between fiscal years 1999 and 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. Unless otherwise noted, the estimates in this statement pertain to (1) this population of award- and incentive-fee contracts, (2) the subpopulation of award-fee contracts, or (3) the evaluation periods associated with contracts described in (1) or (2) that had been completed at the time of our review. In the sample, 52 contracts contained only award-fee provisions; 27 contracts contained only incentive-fee provisions; and 14 contracts included both. Estimates of total award fees earned and total award fees that contractors received at least two chances to earn 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. Because the estimates in this report are derived from a probability sample, they are subject to sampling error. All percentage estimates from our review have margins of error 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. This is a work of the U.S. government and is not subject to copyright protection in the United States. It may be reproduced and distributed in its entirety without further permission from GAO. 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Summary: With DOD spending over $200 billion annually to acquire products and services that include everything from spare parts to the development of major weapon systems, our numerous, large, and mounting fiscal challenges demand that DOD maximize its return on investment and provide the warfighter with needed capabilities at the best value for the taxpayer. In an effort to encourage defense contractors to perform in an innovative, efficient, and effective way, DOD gives its contractors the opportunity to collectively earn billions of dollars through monetary incentives known as award and incentive fees. Using these incentives properly--in concert with good acquisition practices--is a key to minimizing waste, maximizing value, and getting our military personnel what they need, when and where they need it. Congress asked GAO to testify on DOD's use of award and incentive fees and the role they play in the acquisition system. This statement highlights the risks of conducting business as usual and identifies the actions DOD needs to take to use these fees more effectively. DOD concurred or partially concurred with the seven recommendations GAO made in a previously issued report on award and incentive fees. GAO looks forward to seeing DOD turn these promised steps into actual policy and practice. DOD's use of award and incentive fees is an issue at the nexus of two areas that GAO has designated "high risk" for DOD--contract management and weapon system acquisition. Contract management has been a long-standing business management challenge for DOD because it often cannot assure that it is using sound business practices to acquire the goods and services the warfighter needs. For weapon system acquisitions, the persistent and long-standing nature of acquisition problems has perhaps made a range of key decision makers complacent about cost growth, schedule delays, quantity reductions, and performance shortfalls. DOD's strategies for incentivizing its contractors, especially for weapon system development programs, reflect the challenges in these areas. DOD programs routinely engage in award-fee practices that do not hold contractors accountable for achieving desired outcomes and undermine efforts to motivate contractor performance, such as evaluating contractors on award-fee criteria that are not directly related to key acquisition outcomes (e.g., meeting cost and schedule goals and delivering desired capabilities to the warfighter); paying contractors a significant portion of the available fee for what award-fee plans describe as "acceptable, average, expected, good, or satisfactory" performance; and giving contractors at least a second opportunity to earn initially unearned or deferred fees. As a result, DOD has paid out an estimated $8 billion in award fees on contracts in GAO's study population, regardless of whether acquisition outcomes fell short of, met, or exceeded DOD's expectations. Despite paying billions of dollars, DOD has not compiled data or developed performance measures to evaluate the validity of its belief that award and incentive fees improve contractor performance and acquisition outcomes. These issues, along with those GAO has identified in DOD's acquisition and business management processes, present a compelling case for change. By implementing the recommendations GAO has made on award and incentive fees, DOD can improve incentives, increase transparency, and enhance accountability for the fees it pays. At the same time, by working more broadly to improve its acquisition practices, DOD can set the right conditions for getting better acquisition outcomes and making more efficient use of its resources in what is sure to be a more fiscally constrained environment.