DOD contracting officers use a structured approach called the Weighted Guidelines Method to develop profit objectives for use in contract negotiations. Using these profit guidelines, contracting officers address a contractor’s (1) risk in fulfilling the contract requirements, known as performance risk; (2) degree of cost risk because of the type of contract (e.g., fixed-price versus cost contract); and (3) investment in facilities that benefit DOD. Prior to the profit policy change, the performance risk factor consisted of three elements: Technical—the technical uncertainties of performance. Management—the degree of management effort necessary to ensure that contract requirements are met. Cost control—the contractor’s efforts to reduce and control costs. In the National Defense Authorization Act for Fiscal Year 2000, Congress included provisions to stimulate technical innovation in military research and development. Section 813 required DOD to review its profit guidelines to consider whether modifications to the guidelines—such as placing increased emphasis on technical risk as a factor for determining appropriate profit margins—would provide an incentive for contractors to develop and produce complex and innovative new technologies. After completing its review, DOD reported to Congress that it planned to make two changes to the guidelines. As shown in table 1, the first change was to increase the weight contracting officers would likely assign to technical risk by reducing performance risk from three to two elements. The second was to add a special incentive for contractors that propose significant technological innovation. Using the technology incentive, contracting officers can assign a profit range of 6 to10 percent for the technical element instead of the standard range of 2 to 6 percent. On December 13, 2000, DOD published a final rule in the Federal Register to implement the two changes. (Appendix I presents an example of the application of the incentive to a contract.) During the same time period, DOD sought to realize the benefits of best commercial practices by revising its policies that guide the system acquisition process. The result was a new system acquisition life cyclethat separates technology development and system development. The technology development phase generally begins with paper studies of alternative technology concepts for meeting a mission (concept exploration) and ends with the demonstration of component technology in a relevant environment to reduce the risk of integrating the components or subsystems into a full system (component advanced development). A program is usually initiated at the beginning of system development, at which point the system’s technology should be mature. During system development and demonstration, the subsystems and components are integrated into the system, the design is stabilized, and the system is demonstrated in a realistic environment. The system then enters low-rate initial production, during which the manufacturing capability is established. By the time the system reaches full-rate production, the technology should be mature, the design stable, and the manufacturing processes established. The profit guidelines containing the technology incentive do not apply to most research and development contracts and, therefore, the incentive has limited reach in the phases of DOD’s acquisition cycle where technology innovation is expected to be high. Many contracts awarded in these high innovation phases have technical reports as contract deliverables, and these are appropriately excluded from the incentive. The profit guidelines containing the incentive do not apply to contracts awarded with competition, which is commonly the case for research and development contracts. Also, contracting officers already have available another mechanism–award fees–to reward innovation. Table 2 shows the expected level of innovation and the typical contract deliverable for each phase of DOD’s system acquisition cycle. It also shows what type of profit (fixed/incentive fee versus award fee) is used to reward contractors during each phase—the profit guidelines only apply to fixed/incentive fee contracts. For fixed/incentive fee contracts, the percentage and dollar value of awards made without competition is shown—the profit guidelines only apply to these awards. The table shows that the guidelines (and therefore the technology incentive) do not apply to many contracts in early research and development where innovation is a priority. The profit policy excludes many contracts awarded during technology development (concept exploration and component advanced development). Concept exploration commonly consists of paper studies of alternative concepts for meeting a mission and, therefore, contracts generally have a technical report as their primary deliverable. The technology incentive range does not apply to efforts restricted to studies, analyses, or demonstrations that have a technical report as their primary contract deliverable. Technical reports were excluded from coverage because these efforts do not involve the risk inherent in producing and fielding weapon system hardware. Technology development contracts are typically awarded through competition. DOD’s profit guidelines do not apply to competitively awarded contracts because price reasonableness is established through price competition rather than through use of the guidelines. Contracting officers have available another contracting mechanism— award fees—to reward innovation in research and development. Award fees are used to motivate contractor performance in those areas critical to program success, such as technical, logistics support, cost, and schedule. Contracting officers can use the award fee to encourage contractors to develop innovative new technologies by including these objectives in the criteria for evaluating how much of the award fee the contractor has earned. The definition contained in the policy guidelines of what qualifies for the technology incentive is so broad that it could be applied to almost any contract with enhanced system performance. Our discussions with contracting officials indicate that there is confusion over how and for how long the incentive should be applied. This confusion may lead to inconsistent and possibly inappropriate application of the incentive and could result in contractors being paid more profit for their current level of innovation, not for the intended new technological innovations that significantly enhance performance, improve reliability, or reduce costs. The rule states that contracting officers may use the technology incentive range when a contractor proposes to develop, produce, or apply innovative new technologies during contract performance. It further states that contracting officers are to use the incentive only for the most innovative efforts. The rule defines innovation as “Development or application of new technology that fundamentally changes the characteristics of an existing product or system and that results in increased technical performance, improved reliability, or reduced costs; or New products or systems that contain significant technological advances over the products or systems they are replacing.” Although the rule describes in broad terms when the application of the incentive is appropriate, it leaves many questions unanswered in defining key terms. For example, how “new” must a technology be to qualify? Does “new” mean it is just out of the laboratory and has never been used before on any system, or does it refer to a recently developed technology that has been used on other products but not on the product in question? Should the incentive apply to demonstrated technology or to the promise to develop technology? And if a contractor is awarded additional profit for developing, producing, or applying new innovative technology, when should the reward stop? Should it apply only to the immediate contract, or should a contractor receive the reward throughout some portion of production contracts? By the same token, what measures are to be applied in determining whether a technological advance is “significant” or whether new technology “fundamentally changes” a product or system? Without this information, the rule could be interpreted so that the incentive could apply to almost any program with more demanding performance characteristics than the system being replaced. Although, at the time of our review, the new rule had not been widely used, we discussed with agency officials the circumstances under which they might apply the technology incentive. Air Force, Army, and Navy officials agreed that the technology incentive could apply to both research and development and production contracts, but they did not interpret the rule’s guidance on when to apply the incentive in the same manner. For example, officials at two Air Force program offices judged that upgrades to their systems that included state-of–the-art technology used on other products would not qualify for the technology incentive, but those at an Army office said that similar applications of state-of-the-art technology to their system would qualify. In fact, contracting officials at two Army program offices told us that all weapon systems at their buying command incorporated state-of-the-art, leading edge technology and would, therefore, qualify for the incentive. On the other hand, officials for one Air Force system did not believe a future upgrade to their system that may incorporate brand-new technology developed by another military service would qualify for the incentive because the other service would have developed the new technology. Finally, the contracting officer for a Navy system that incorporated brand-new, never-before-used, technology that allowed the system to exceed performance requirements stated that the system would qualify for the incentive. These examples point to potential confusion over how the rule’s broad definition of technological innovation should be applied. The officials were also uncertain about how long a contractor should be rewarded with the technology incentive for significant, new innovative technology introduced in the research and development phases of the acquisition process. For example, a procurement official for an Army system currently in the latter stages of research and development stated that the system may qualify for the incentive during production, depending on how the language in the rule is interpreted. A technical official for this system at first stated that, hopefully, innovation and risk would be finished before the system enters production, and therefore, the system would not qualify for the incentive at that point. But, after reading the language in the rule (“New products or systems that contain significant technological advances over the products or systems they are replacing”), he said the system may qualify after all. Also, technical officials for the Navy system discussed previously did not disagree with the contracting officer that the system, with new technology that enhanced performance, would qualify for the incentive. However, they stated that, in general, the technology incentive should be awarded during research and development because, by low-rate production, the technology should be set, and, during production, the emphasis should be on making manufacturing processes more efficient and reducing costs. The new profit guidelines do not identify how the incentive relates to the revised policies that guide DOD’s system acquisition process.