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.