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Enhancing Cost Realism Through Risk-Driven Contracting: Designing Incentive Fees Based on Probabilistic Cost Estimates

Research Track




Cost overruns in defense system development efforts do not seem to be caused by a lack of cost estimation tools and best practices. A number of sophisticated cost estimation guides have been published, for example by the Army, Air Force, NASA, GAO, RAND, and SSCAG. There also exist extensive recommendations by professional societies like ISPA, SCEA, SSCAG, SCAF, and EACE. In an unbiased world, applying these best practices would generate reliable and accurate cost estimates. However, the problem is that the cost estimation community tends to focus on the technical variables contributing to cost risk. The current approach has two significant shortcomings: 1) Current cost plus contracting practices indirectly incentivize underbidding of proposals in order to win competitive bids, and 2) There is no straightforward process of translating cost probability distributions into contract incentives. A better method to fairly align contract incentives with risks is needed to produce more realistic cost estimates.

As for-profit corporations, defense contractors strive to maximize profits and minimize risks while delivering a quality product to the government. When cost uncertainty is low (such as for production efforts), contractors will usually agree to fixed price contracts because there is a high probability of a profit with minimal downside risk. However, when cost uncertainty is high (such as for development efforts), contractors will seldom agree to fixed price contracts because the downside risks outweigh the potential profits. Thus, the government normally assumes the cost risk of most development efforts. Competitions are normally held, but since contractors do not have to assume any cost risk, there is a strong motivation to underbid competitors. Under a cost plus contract, even if a contractor earns zero award or incentive fee, they still cover overhead costs, keep their workers employed, and improve their market position by gaining new technology competency. To motivate contractors to provide realistic cost estimates and control expenditures during development efforts, a fair method to share cost risk is needed. This paper proposes a new contract framework targeted at system development efforts to properly align incentives with risks.

Todays high-quality cost estimates take the form of a cumulative probability distribution function (CDF) where each cost has a corresponding probability. Normally, a single value from the cost CDF is used to establish the target cost, such as its 80% confidence level. Unfortunately, this practice ignores the CDFs variance and can lead to large potential losses when using fixed price contracts, thus confirming why they are typically inappropriate for development efforts.

The new contract framework starts by constructing a profit CDF where a fair profit profitability distribution is agreed on by both contracting parties. Unlike in traditional contract incentive design, profits are calculated based on the likelihood of incurring a potential cost. This provides a structured method to fairly expose contractors to a chance for a real loss. Thus, the motivations to underbid competitions or fit within the governments expected budgets will be tempered by the significant but fair loss potential.

With incentives properly aligned by this new contract framework, contractor cost estimates should become more realistic, leading to less overruns during system development and ultimately more predicable acquisition outcomes.

The paper will also present the results of a preliminary verification of the new contract framework based on a number of expert interviews, from both government and industry.

Cost estimation professionals already have the skills to easily understand this new contract framework. By incorporating it into their software tools and presentations, it could expand the cost risk discussion with senior decision makers beyond the technical variables.


Sean P. Dorey, Maj, USAF
Lean Advancement Initiative, MIT
Major Dorey is an Air Force Fellow with the Lean Advancement Initiative at the Massachusetts Institute of Technology. He was commissioned in May 1999 by the Air Force Reserve Officers’ Training Corps at Clarkson University. He has served as a group-level executive officer, deputy flight commander, branch chief, and program manager of several advanced technology developments for next-generation air and space systems. He has extensive experience with radar and infrared signatures, sensors, and countermeasures.

Dr. Josef Oehmen
Lean Advancement Initiative, MIT
Josef is a research scientist with MIT’s Lean Advancement Initiative. His main research interest is risk management in the value chain, with a special focus on lean product development and program management. Before joining LAI, he was the Director for Supply Chain Management at the ETH Center for Enterprise Sciences (BWI) at the Swiss Federal Institute of Technology (ETH Zurich), where he also wrote his PhD thesis on Supply Chain Risk Management with a focus on China. He worked as Assistant to the CTO of SIG Holding AG, where he was intensely involved in corporate-wide technology and innovation management and was responsible for technology projects.

Josef holds a master’s degree in mechanical engineering from the Technical University of Munich, majoring in Product Development and Production Management, as well as an MBA from the Collège des Ingénieurs in Paris. He is a member of the supervisory board of Climate InterChange, a German company developing and implementing projects in developing countries to reduce carbon emission.

Dr. Ricardo Valerdi
Lean Advancement Initiative, MIT
Ricardo Valerdi is a Research Associate at the Lean Aerospace Initiative at MIT and a Visiting Associate at the Center for Software Engineering at USC. He earned his BS in Electrical Engineering from the University of San Diego, MS and PhD in Industrial & Systems Engineering from the University of Southern California. Formerly, he was a Member of the Technical Staff at the Aerospace Corporation in the Economic & Market Analysis Center and a Systems Engineer at Motorola and at General Instrument Corporation. He is the co-Editor-in-Chief of the Journal of Enterprise Transformation.