Chapter 21 - Performance-Based Contracting and Service Level Agreements

21.9.1 Use of incentive contracts

The agency's obligation is to assess its requirements and the uncertainties involved in contract performance and select a contract type and structure that places an appropriate degree of risk, responsibility and incentives on the supplier. There are various types of incentive contracts including:

• Fixed-price incentive contracts:  the final contract price and profit are calculated based on a formula that relates final negotiated cost to target cost. These may be either firm target or successive targets.
• Fixed-price contracts with award fees:  used to motivate a supplier when supplier performance cannot be measured objectively, making other incentives inappropriate.

Incentives need not be limited to cost, but can vary depending on the procurement and performance goals, requirements and risks. For example, agencies can incorporate delivery incentives and performance incentives - the latter related to supplier performance and/or specific products' technical performance characteristics, such as speed or responsiveness. Incentives should be based on target performance standards instead of minimum contractual requirements. However, the VPPA prohibits the awarding of contract with pricing based on the supplier's cost plus a percentage of cost, so care should be taken in structuring incentives to comply with the statutory requirements. Refer to § 2.2-4331 of the Code of Virginia.

The decision about the appropriate type of contract to use is closely tied to the agency's needs and can go a long way to either motivate superior performance or contribute to poor performance and results. In general, when using PBCs an agency has wide discretion in determining the contract type, pricing structure and degree of risk that will be placed on the supplier. Under PBC, suppliers may propose a range of staffing options and technical solutions, and it is the agency's job to determine which proposal will produce the best results. The decision on contract type is not necessarily either-or. Hybrid contracts, those with both fixed-price and incentives, are becoming more common, especially when procurements are constructed modularly.