What are Incentive Contracts?

A contract can be drafted in a variety of ways, as long as both parties agree to the terms. Two of the most common types of contract are the fixed price contract, in which a party purchases an item for a set price with no on-going adjustments, and the cost plus contract, which is often used in research and development when it is not possible to ascertain the actual cost in advance. Another group of contract options are incentive contracts, which tie a portion of the fee, or profit received by the contractor, or seller, to certain items such as cost, schedule or performance.

Fixed price incentive contracts are often used when there is some uncertainty in the cost of the work, particularity when a product is being built to unique specifications, and does not use off-the-shelf components. This is common in contracts involving test programs or new technology or processes. Cost-based incentive contracts establish a target price, target profit and a maximum cost. A formula is included to allocate any overrun of the target cost between the buyer and contractor. Once the maximum cost has been reached, the contractor subtracts any additional overruns from his profit, or fee.

Cost-based incentive contracts can also be structured in a positive manner for coming in under budget. In such a case, the cost reduction is shared between the buyer and seller. One of the drawbacks of these contracts is that they carry more administrative burden. In order to maintain integrity, detailed cost accounting and performance tracking is required to determine accurate cost figures.

Other incentive contracts may be tied to schedule rather than cost. The contract specifies a completion date which must be met in order for the contractor to receive his full fee, or profit. Positive incentives can be built in which increase the fee for early completion. Conversely, negative incentives can also be included which reduce the fee through liquidated damages if the schedule date is not met. This can be tied to one final completion date, or can be structured incrementally to a series of timeline milestones.

If a contract has certain performance specifications, then the supplier is expected to meet those for the given price. In some cases, however, the buyer is interested in obtaining a product with better performance than the minimum specifications dictate. To accomplish this, performance incentive contracts may be designed which reward the contractor financially if the product exceeds the specifications in performance areas such as speed, noise reduction, reduced weight, or increased strength. These contracts can give a contractor a financial incentive to invest more capital in additional research and development.

In the case of new technology or research, it is not always possible to come up with target and maximum costs in advance. For these situations, incentive contracts may use a successive target rather than a firm cost. Estimated costs are established at the beginning of contract performance, with an agreement that firm costs will be determined at some future point, such as after a design review or upon test program completion. Regardless of the nature of the work to be done, incentive contracts can be designed to make certain both buyer and seller are adequately protected.