Federal Contracts: Fixed-Price vs. Cost-Reimbursement

Introduction to Federal Contract Types

There are several kinds of contracts commonly used at the federal level, including fixed-price and cost-reimbursement contracts. In order to understand them clearly and to compare them with other contract types, it is important to examine each one thoroughly. Fixed-price contracts are exactly what their name implies: they are established based on a fixed, agreed-upon price that cannot be changed (Barnett, 2003). There are both benefits and drawbacks from the perspective of the contractor. The most significant benefit is that the contractor knows exactly how much he or she will be paid when the job is completed. The drawback, of course, is the possibility that the job will cost far more than the contractor anticipated. In that case, the contractor may find that the payment does not reflect the true "worth" of the work performed. Even so, there is no recourse, because the price is something upon which both parties have already agreed.

That situation can be a serious issue for a contractor who feels he or she did not bid the contract properly and is now stuck with an arrangement that yields very little profit. Of course, there is more to the issue than just the potential loss of money (Barnett, 2003). If the contractor is able to complete the job for much less than anticipated, he or she will earn a substantial profit — and that can lead the other party to feel that some deception was involved. No one likes to feel cheated, even if the other party had no deceptive intent. If one party feels shortchanged, there may be no further contracts in the future. For companies that work with the federal government frequently, this is a serious concern. It is reasonable to assume that such companies wish to continue doing so — but only if both parties consider the relationship mutually beneficial (Stanberry, 2008).

Fixed-Price Contracts: Benefits and Drawbacks

The mechanics of a fixed-price contract are relatively straightforward. The federal government advertises a job, and one or more contractors submit bids. The best bid — which is not always the lowest, as other factors are considered — is selected, and the contract is created. Once both parties agree to the price and terms, they must abide by them (McKendrick, 2005). If the contractor completes the job for less than anticipated, he or she earns a larger profit. Conversely, even if the actual cost exceeds the estimate, the contractor must still fulfill the contract. This means the contractor could potentially lose money. No contractor would willingly agree to such an outcome, but unanticipated problems can arise and create difficulties for either party. In this respect, the fixed-price contract favors the government: the work will be completed for the stated price, regardless of what the total cost ultimately turns out to be (McKendrick, 2005).

Each contractor who enters into a contract with the federal government is responsible for making a fair and accurate estimate of the cost to complete that contract (Stanberry, 2008). Once a price has been agreed upon, there is no option to revise it. Not all contractors are comfortable with fixed-price contracts for this reason, and some prefer alternative arrangements. One such alternative is a cost-reimbursement contract, in which the contractor is paid based on the actual cost of the work rather than the originally agreed-upon amount (Stanberry, 2008). The total price of the contract may therefore fluctuate depending on whether the contractor over- or under-estimated the job, what problems arose, what changes were requested along the way, and other factors that may not have been determinable during the original negotiations.

With a cost-reimbursement contract, the contractor holds the advantage and the federal government bears greater risk. In these contracts, the government typically agrees to a maximum amount it will pay for the specified work. However, if all contracted funds are paid out before the work is complete, the government is left with an unfinished project and no remaining budget to complete it (Stanberry, 2008). That is, understandably, not a desirable position for the government. The contractor, by contrast, generally fares better in this scenario: work is performed and payment is received. If the government exhausts its funds, work simply stops, yet the contractor has still been paid the full contract amount, regardless of whether all the work was completed. The government then faces two options: accept the incomplete work and stop, or add funds to the contract to resume progress toward completion (Stanberry, 2008).

Cost-Reimbursement Contracts: Risk and Oversight

Contractors tend to favor cost-reimbursement contracts because they provide greater assurance of full payment, even if the job proves more costly than expected and cannot be completed within the original budget. The primary drawback for the contractor is that such contracts are subject to much closer monitoring. If a contractor attempts to overestimate costs in order to generate extra profit, this will be detected relatively easily — and such conduct can jeopardize the contractor's ability to secure future federal work. For contractors who value their ongoing relationship with the government, it is therefore prudent to handle all estimates as fairly and honestly as possible (Stanberry, 2008). Mistakes and necessary changes are understandable, but carelessness or deliberate inflation of costs on the part of either party is difficult to excuse.

The largest problem for contractors in a cost-reimbursement arrangement is the intensity of oversight (Stanberry, 2008). Many contractors habitually include a small buffer in their bids to cover unforeseen expenses and ensure a reasonable profit margin even when incidentals arise that were not anticipated when the contract was first awarded. With cost-reimbursement contracts, this practice is not available to them. The government monitors these contracts closely because it is well aware of the significant risk they carry. If the work is not completed for the originally agreed price, the contract remains valid and payment must still be made (Stanberry, 2008). In other words, the government could be left with a partially completed project, largely because it underestimated the likelihood that costs would exceed the contractor's original bid. While this outcome may seem more problematic for the government, the constant monitoring and scrutiny that contractors endure throughout the life of such a contract is a considerable burden in its own right.

There are other contract types available for federal government procurement as well, including definite quantity contracts (McKendrick, 2005). These contracts can apply to goods, services, or both. They require a specified quantity of supplies or a defined number of services to be delivered within a particular time period. Performance or deliveries occur when ordered, and the goods or services must be consistently available throughout the duration of the contract (McKendrick, 2005). Definite quantity contracts work well for the federal government because the government knows precisely what it will receive for the agreed-upon price. Of course, drawbacks exist here as well. Even when goods or services are expected to be available, there is always a chance that something will be out of stock or otherwise unavailable when needed, which can trigger a chain reaction of complications.