Contract Incentives: Everything You Need to Know
Contract incentives exist to encourage the completion of a contract and an example is a financial reward although other types of rewards can be used.3 min read
Contract incentives exist to encourage the completion of a contract. A financial reward is generally used as a contract incentive, although other types of rewards can be used.
Incentive Contract Facts
The purpose of incentive contracts is to tie a financial reward to the completion of an objective. Incentive contracting typically involves a fixed price or cost reimbursement contract. Upon completion of the contract, the incentive payment will be calculated and paid. A combination of the actual cost of completion and a sliding scale profit determine the incentive payment.
To obtain a specific objective, an incentive contract outlines several issues:
- Targets that are clearly communicated and are reasonably attainable by the contractor.
- Appropriate incentives that will motivate the contractor to complete objectives.
- Discouragement from waste and inefficiency when pursuing objectives.
When using an incentive contract, there are three basic rules to follow:
- Aligning the incentive with cost, performance, or results.
- Ensuring that the cost benefit of completing the objective justifies the incentive.
- Documenting the incentive.
Award fee contracts are different from incentive contracts in that an award fee contract uses subjective, instead of objective, criteria. There is no way to translate the criteria of an Award Fee contract into a concrete formula. It can be costly to administer an Award Fee contract, which is why many organizations prefer incentive contracts.
Fixed-Price Incentive Contracts
A fixed-price incentive contract is one type of fixed-price contract. With these contracts, parties may use a formula to both adjust profits and establish the final price of the contract. The formula used depends on how the total target cost and the final negotiated cost relate to each other. A price ceiling will apply to the final price of a fixed-price incentive contract. Parties should negotiate the price ceiling when forming the contract.
Fixed-price incentive contracts are normally used when hiring a contractor for a construction project. Before entering into the contract, the contractor will estimate how much they will need to spend on labor and materials, and then will include these costs in their bid. Generally, the contractor with the lowest bid will win the contract.
The amount paid to the contractor will cover the costs of labor and materials that the contractor included in their bid. Covering these costs in the final contract price motivates the contractor to both keep their costs low and reduce the time to project completion so that they can maximize their profits.
There are several problems that can occur with a fixed-price incentive contract:
- The contractor incorrectly estimates their costs.
- The project encounters unanticipated delays.
- The price of materials rises during the project.
If any of these issues arise, the contractor will suffer and may have to abandon the project to avoid completely going out of business.
Firm Target Fixed-Price Incentive Contracts
Fixed-price incentive contracts come in two forms. A firm target contract is one of the most common types of fixed-price incentive contracts. Firm target fixed-price incentive contract specifies a variety of issues:
- A target cost and target profit.
- A profit ceiling.
- A profit adjustment formula.
Parties should negotiate these issues at the outset of the contract. Profit ceilings and floors are not specified in firm target fixed-price incentive contracts. The price ceiling is the maximum amount that a contractor can receive. In some cases, a contract can include a clause that allows for adjustment of the price ceiling.
Once the contractor completes the project outlined in the contract, they will meet with the other party to negotiate the final price. This price will be calculated using the profit adjustment formula listed in the contract. If the final cost of the project is less than the listed target cost, the final profit will be more than the target profit. On the other hand, when final costs exceed the target cost, the final cost will be lower than the target cost, and the contractor may experience a net loss.
Contractors may also absorb a loss if the final cost negotiated between the parties is more than the contractual price ceiling. These contracts incentivize contractors to control their costs, as costs can inversely impact their final profit.
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