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Performance-based payments: FASA's stepchild grows up; Despite its early successes, critics still debate the pros and cons of PBPs.

Introduction

Created by the Federal Acquisition Streamlining Act of 1994 (FASA), performance-based payments (PBPs) are the latest type of contract financing available to federal government contractors. FASA mandated a number of far-reaching regulatory changes primarily designed to "streamline the acquisition process and minimize burdensome government-unique requirements." (1) Among other things, the implementation of FASA created a new Federal Acquisition Regulation (FAR) Subpart 32.10, effective October 1, 1995, to provide regulatory guidance on the use of PBPs. Effective with the implementation of Federal Acquisition Circular (FAC) 97-16 on March 27, 2000, PBPs became the federal government's preferred method of providing contract financing for competitively awarded fixed-price acquisitions of noncommercial items and services. (2)

PBPs are FASA's "stepchild" because nobody was pushing for this type of reform, and nearly everybody was surprised when it arrived. One historian has noted, "Neither the original administration-supported Senate bill nor the similar House-passed procurement reform legislation ... addressed performance-based payments.... From industry's perspective, performance-based payments had not been a priority reform." (3) Another commentator reported that "[U]nlike most of FASA's other reforms ... contract financing was not a major target for legislative action.... No ardent constituency existed for broad statutory reform in that area." (4)

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Before the advent of PBPs, available contract financing methods largely were limited to progress payments based on a percentage or stage of completion or progress payments based on costs incurred by the contractors. (5) Despite its surprising delivery in the FASA reform legislation, the U.S. Department of Defense (DOD) now considers use of PBPs to be superior to the other available contract financing methods--so much so that in 2000 the DOD set a goal of using PBPs on the majority of its qualifying contracts by 2005. (6) That DOD's five-year goal was achieved four years early is nothing short of astonishing and reflects the benefits that DOD and its contractors expect to achieve from use of PBPs. (7) More recently, DOD issued a call for public input into the PBP process, in an attempt to increase usage even more. (8)

Despite the benefits use of PBPs promises to provide to both industry and government, detractors have continued to highlight problems associated with this FASA "stepchild." Critics point out that FASA did not, in fact, direct that PBPs were to become the "preferred" method of contract financing. (9) Industry expressed early concerns that use of PBPs was likely to be problematic and stated that some companies would prefer use of flexible progress payments instead. (10) A 2003 DOD inspector general report alleged that DOD was not adequately administering contracts that used PBPs, claiming that billions of dollars worth of contracts "had poorly defined event schedules,... lacked performance criteria, or did not document event dependence." (11)

This article will discuss the pros and cons of PBPs and when the use of PBPs should be considered, as well as compare and contrast use of PBPs with use of progress payments based on costs. Finally, the article will discuss the trade-off between the relative ease of post-award payment administration and the efforts of pre-award analysis and negotiation.

What Are Performance-Based Payments?

PBPs are contract-financing payments based on attainment of individual, objective contract milestones. The contract milestones--and their billing values--that trigger the PBP payments are the subject of negotiation between the contracting parties and may consist of any objective, quantifiable measurement of progress or results. (12) As a trigger event is accomplished, the contractor is permitted to submit a contract financing payment request equal to the event's negotiated value, regardless of costs it has incurred to accomplish the event.

A PBP trigger event can be either "severable" or "cumulative." A typical PBP plan will contain both kinds of trigger events. Severable events are stand-alone events or accomplishments that do not depend on successful completion of any prior event or action. An example of a severable trigger event might be "submission of software development plan." On the other hand, cumulative events require the prior or concurrent completion of other events. An example of a cumulative trigger event might be "completion of system integration testing," where successful accomplishment is dependent on passing subsystem testing before integration.

PBPs are not payments for accepted items, nor are they progress payments based on costs incurred by the contractor. Instead, PBPs are a form of contract financing intended to facilitate stable contractor cash flow without the administrative burdens associated with other contract financing methods. (13) PBPs' payment requests are not based on partial or final acceptance of the contractor's work; instead, as delivery is made and government acceptance is received, the contractor will submit separate delivery invoices and will "liquidate" its accumulated PBP payments using a contractually specified formula. In the event of a default termination, any unliquidated PBP balance must be repaid to the government. (14)

PBPs are not progress payments based on a percentage or stage of completion. Use of PBPs need not be associated with performance-based service contracts. To clarify, there is no regulatory relationship between performance-based payments and performance-based contracts.

When a contractor agrees to their use, PBPs can be used on any fixed-price contract, other than those awarded by use of the sealed bidding procedures of FAR Part 14. Contracting officers may use PBPs on a contract-wide basis, a contract line-item number (CLIN) basis, or even on a subline item (SLIN) specific basis. (15) While a single contract can contain CLINs that used PBPs and CLINs that do not, a single contract or individual CLIN cannot use both PBPs and other forms of contract financing, except in circumstances where advance payments or guaranteed loans are authorized. (16) PBPs may even be used on fixed-price subcontracts by prime contractors that have cost-type prime contracts. (17) Finally, it is possible to use PBPs on undefinitized contract actions (UCAs). (18)

The FAR provides guidance to contracting officers regarding appropriate use of contract financing such as PBPs or customary progress payments. (19) Contract financing may be provided to contractors when all of the following conditions are met:

(1) The contractor will not be able to bill for the first delivery of products for at least six months (for large businesses) and will make expenditures for contract performance during the pre-delivery period that will have a significant impact on the contractor's cash flow. (For small businesses, the time period is "normally four months or more.")

(2) The contractor demonstrates an actual financial need or the unavailability of private financing.

(3) For large businesses, the contract value must be at least $2 million. In the case of indefinite delivery contracts, basic ordering agreements, or similar vehicles, the contracting officer must expect the value of orders or contracts that individually exceed $100,000 to have an aggregate value of at least $2 million. (Orders or contracts valued at less than $100,000 cannot receive contract financing.)

Benefits of Using PBPs

In the "User's Guide to Performance-Based Payments," the DOD has identified several benefits to use of PBPs, including:

* Enhanced technical and schedule focus,

* Reinforced roles of (government) program managers and integrated product teams (IPTs), and

* Broadened contractor participation.

Government contractors should expect to see significant benefits as well. Among the potential benefits to contractors are

* Enhanced cash flow. FAR Part 32.10 currently permits PBPs to equal up to 90 percent of the contract's (or CLIN's) price--which includes the negotiated profit component. Contrast this with customary cost-based progress payments, where the limit for large businesses is currently 80 percent of incurred costs. (20)

* Reductions to administrative burdens associated with cost-based billings. Since PBP trigger events are a "yes-or-no" technical decision, there are no associated costs to review. For instance, compliance with FAR Part 31 cost principles or the Cost Accounting Standards is not a requirement for PBP payment requests. The contractor does not need to develop a government-specific accounting or billing system that is subject to audit and adequacy determination. The substantial resources normally devoted to complying with government-unique accounting rules can be applied elsewhere. (21)

Evaluating Offers When PBPs Are Proposed

Use of PBPs affects the evaluation of contractor proposals. When performing evaluations in which use of PBPs is being proposed, if use of PBPs will have "a significant impact on determining the best value offer," government contracting officers are directed to adjust the contractor's proposed price "to reflect the estimated cost to the government" in accordance with FAR Part 32.205(c). (22) In such cases, the contracting officer will include an adjustment factor for "the time-value of proposal-specified contract financing arrangements." (23)

Use of PBPs also affects profit analysis. Under DOD's revised "weighted guidelines" approach to a structured profit analysis for firm fixed-price contracts, use of PBPs entitles a contractor to a contract type risk profit factor of between 2.5 and 5.5 percent; whereas, use of progress payments based on costs would entitle the same contractor to a contract type risk profit factor of between 2.0 and 4.0 percent. (24)

Negotiating PBP Trigger Events

Once the government and contractor agree to use PBPs for contract financing, then critical steps in finalizing the contract are to (1) define the PBP trigger events, (2) value each event, and (3) determine how accomplishment will be measured and verified. The process is undertaken via bilateral negotiation, generally prior to beginning contract performance. Experience and anecdotal evidence have shown that effective PBP negotiations require significantly more effort--by both government and contractor--than would be expected if other forms of contract financing were used.

Choosing the PBP events is a key step in the negotiating process. Government negotiators will seek to identify trigger events that reasonably correlate to the contractor's progress in accomplishing the statement of work. Government guidance provides that, while PBP trigger events "need not be on the 'critical path' of the overall program plan, they should represent meaningful and essential steps in successfully executing the work...." (25) Government negotiators have discretion in negotiating appropriate PBP trigger events, but "[i]n no case ... should the parties select PBP events that do not require meaningful effort or action." (26)

In theory, valuation of PBP events should be an exercise in pure negotiation; in practice, cash flow and costs continue to play a significant role. Accordingly, while valuation of PBP events theoretically can be based on such subjective methods as "engineering estimates" of their value, in practice, event valuations tend to be based on some type of cash flow or cost-schedule analysis. (27) Contractors that have robust earned value management systems (EVMS) and have made the effort to develop an integrated baseline before negotiating PBP event values will be in a much stronger negotiating position. For contractors lacking such management systems, there are still many alternative valuation methodologies that might be used to reach a negotiated agreement on the value of PBP trigger events. (28)

Government negotiators are likely to use cash flow analysis to evaluate and value trigger events. A contractor's "expenditure profile" might be used to aid negotiators but should be requested by the contracting officer "only if other information in the proposal, or information otherwise available ... is expected to be insufficient" to ensure that PBP values are "commensurate with the value of the performance event or performance criterion." (29)

Government negotiators will seek to avoid over-valuing trigger events. (This objective will likely differ from the contractor's desire to accelerate cash flow.) DOD guidance states,
... event values should have some reasonable relationship to the amount
of working capital the contractor needs in order to achieve the progress
that they represent.... PBP event values should not be established that
are disproportionate to the approximate "value" of the amount of
progress that the underlying events represent. For example, setting PBP
event values that "front-load" the financing payments while still
staying within the regulation's limitations is not in the government's
interest. (30)


Of course, financially savvy contractors will quickly realize that "front-loading" a contractor's financing payments in return for a lower over-all price very often would be in the government's interest--or, at least, in the taxpayers' interests--assuming that the net present value (NPV) of the price reduction achieved would be greater than the NPV of the interest paid by the U.S. Treasury to borrow funds to make the payment(s) to the contractor.

Once the negotiators have agreed upon the PBP events, the triggers (i.e., technical or programmatic completion) must be clearly defined so there is no uncertainty during contract performance as to whether they have been accomplished. Both parties share the objective of establishing trigger events that are objective, precisely defined, and easy to measure.

The PBP trigger events are summarized into a PBP plan or schedule and are appended to the contract. To avoid later confusion, the PBP schedule should include the following information:

(1) PBP event identifier;

(2) Brief description of the event, including identification of the event as severable or cumulative; if cumulative, the associated events should be listed;

(3) The CLIN or SLIN to which the event applies;

(4) Funding information, such as ACRN number;

(5) Event valuation amount; and

(6) The approximate date of planned occurrence.

Finally, if subsequent contract modifications are issued, the PBP schedule must be adjusted accordingly, including the negotiation of new event triggers, valuations, and metrics.

Processing PBP Requests

Once PBP trigger events have been successfully negotiated, it is important to obtain agreement regarding how payment requests will be processed during contract performance. Problems can arise when trigger events are not adequately defined during negotiations, such that accomplishment cannot be easily determined or verified. Similarly, problems can arise when the government customer places unnecessarily stringent controls on the process.

Unlike progress payment requests or other government invoices, there is no standard form on which to submit requests for PBP payments. Consequently, the government and contractor must also establish agreement on the payment request format as well as appropriate documentation to support event accomplishment. (31) The DOD "User's Guide to Performance-Based Payments" (available at www.acq.osd.mil/dpap_archive/Docs/PBPGuideNov2001.pdf) provides a best practice example of a PBP payment request format in Appendix E.

The parties should be aware that regulations and guidance do not require confirmation of PBP trigger event accomplishment before approval of the related payment. (32) The contracting officer has discretion in establishing the PBP payment review process. When determining the appropriate payment process, the contracting officer should evaluate various factors, including the contractor's performance record, financial strength, and adequacy of administrative controls to determine the overall risk to the government. While pre-payment reviews are permitted if the contracting officer determines them to be necessary, "post-payment reviews and verifications should normally be arranged...." (33) Obviously, contractors should exert efforts to convince the contracting officer that pre-payment reviews are unnecessary, so receipt of financing payments will not be unduly delayed.

DOD guidance provides clear direction to the contracting parties:
The parties must clearly establish the payment submission, review, and
approval procedures at the time of contract formation and be as
innovative as possible in designing processes that provide for expedited
review and payment times while adequately protecting the government's
interests. (34) (emphasis added)


Normally, DOD contractors should expect to receive payment not more than 14 days after the government receives the payment request. (35) However, it should be noted that, as contract financing payments, PBP payments are not subject to the Prompt Payment Act. (36) The Defense Finance and Accounting Service (DFAS) will accept electronic PBP payment requests through the new Wide-Area Workflow-Receipt and Acceptance (WAWF-RA) system. Use of WAWF-RA may require the contractor to use a standardized PBP payment request form but should increase payment processing accuracy and reduce cycle time.

PBPs Versus Progress Payments: Assessing Risk and Reward

The federal government can request that contractors propose use of PBPs by inserting the clause 52.232-28 ("Invitation to Propose Performance-Based Payments") into solicitations. Contractors have the choice of accepting or declining the government's request. The contractor can choose to have no contract financing, PBPs, or some other financing method--such as customary progress payments based on costs incurred. Before deciding which option is best, the contractor should assess (1) performance risk and (2) compliance risk.

Performance Risk: Using PBPs on the Wrong Contract

PBPs are best used when there is a high probability of making progress, such as follow-on contracts or for work that is very similar to prior contracts. Likely candidates for use of PBPs are contracts where "the process or product is known, the contractor has had experience with manufacturing the product or performing the service, and the technical and financial risk is low." (37) Contractors need to keep in mind the inescapable fact that a failure to make progress means that the PBP events will not be achieved as planned and that the PBP triggers won't be activated. Simply put, no progress means zero cash flow. (38)

In contrast, when progress payments are used, a contractor generally can count on receiving a payment equal to 80 percent of its incurred costs (as adjusted), regardless of whether the program is on schedule. (39) Obviously, if a contractor is unsure of its ability to make adequate progress, PBPs may not be the best choice.

Compliance Risk: Reduced Risk Is Not Zero Risk

Contractors that choose to use PBPs rather than progress payments are clearly operating in a lower-risk compliance environment. For example, a contractor that does not have an "adequate" government accounting system need not establish one to record costs associated with a fixed-price contract that uses PBPs, whereas it would need such a system if progress payments based on costs were used. However, contractors using PBPs should be aware of the following compliance risks:

* The contractor must "maintain records and controls adequate for administration" of the various requirements associated with PBPs. (40) Additionally, contractors that use PBPs "shall have no entitlement to performance-based payments during any time the contractor's records or controls are determined to be inadequate for administration of [the PBP clause]." (41) In other words, a contractor that is other-wise entitled to make PBP requests because of successful technical performance may lose the entitlement if its administrative systems related to PBPs are deemed deficient.

* PBPs are similar to progress payments in that title to contractor-acquired or contractor-produced property--including such items as parts, materials, inventories, work in process, special tooling, and special test equipment--passes to the government while financing payments are being made to the contractor. (42)

* When PBPs are used, during contract performance, the contractor bears the risk for any loss, theft, destruction, or damage (except for normal spoilage), unless the government has expressly assumed the risk. (43) (Commonly, government. property that is stolen, lost, damaged, or destroyed is called "LDD" property.) While the contractor's liability for LDD property generally is the same whether it chooses to use PBPs or progress payments, its monetary exposure may be significantly higher if PBPs are used. When progress payments are used, the contractor's potential loss is limited to the LDD property's share of allocable contract costs associated with unliquidated progress payments. But when PBPs are used, the potential loss is the entire value of all PBP events--whether liquidated or not--in which accomplishment was tied to use of the LDD property. (44)

* Contractor cash flow analyses, EVMS plans, and other such information may be "cost or pricing data" as defined in the Truth-in-Negotiations Act (TINA) and related regulations, such as FAR 15.403. (45) Accordingly, for contract actions subject to TINA, contractors should consider whether such analyses, plans, or information should be disclosed to the contracting officer.

* Each PBP request must be accompanied by a certification. (46) Among other things, the certification covers such issues as whether payments to subcontractors and suppliers under the contract have been paid, or will be paid, when due in the normal course of business; that there are no encumbrances against property acquired or produced for, and allocated or charged to the contract, that would impair the government's title; whether there has been any materially adverse change in the financial condition of the contractor; and whether, after making the requested PBP payment, the cumulative amount of all payments will not exceed any contractual limitation. Contractors should take care to ensure their certifications are accurate and complete in all particulars.

Conclusion

Performance-based payments offer a method of contract financing that can reduce administrative oversight and streamline the payment process. By tying financing payments to technical or programmatic accomplishment, rather than to incurred costs, PBPs offer the ability to reduce administrative costs associated with cost-based billing systems and, perhaps, the intrusion of accountants and auditors into the payment process. By creating a vehicle for increasing contractor cash flow, it has made PBPs attractive for government contractors and for those entities considering entry into the federal marketplace.

Performance-based payments can represent an improvement over the burdens associated with customary progress payments based on costs. On the other hand, contractors that fail to understand the requirements associated with use of PBPs, or that fail to properly negotiate their PBP plans before beginning performance, are not going to see the promised benefits. They run the risk of seeing cash flow dwindle or dry up altogether.

The key to successfully working with PBPs is understanding the effort that must be expended in negotiations during contract formation. The parties must reach agreement on proper identification of PBP trigger events, event completion criteria, reasonable valuation of each event, and the payment request process if the full benefits that PBPs offer are to be realized.

Endnotes

1. FAC 90-33, implementing FASA in the FAR System. Supplementary comments.

2. See Federal Acquisition Regulation (FAR) 32.1001(a). ("Performance-based payments are the preferred government financing method when the contracting officer finds them practical, and the contractor agrees to their use.")

3. W.R. Stoughton, "FASA's Contract Financing Provisions: More Glitter Than Gold?" Federal Contract Report (February 3, 1997).

4. R.A. Gustin and R.J. Wall, "FASA Contract Financing Reforms: An Offer You Can't Refuse?" Government Contract Costs, Pricing and Accounting Report (October 1995).

5. See FAR 32.102 (1994). Other methods available included advance payments, loan guarantees, and payments for partial deliveries. It should be noted that progress payments based on percentage or stage of completion were typically reserved for shipbuilding or construction contracts and, thus, not available for use by contractors providing other types of items or services.

6. Memorandum for Secretaries of Military Departments, Component Acquisition Executives and Directors, Defense Agencies, from Then-Undersecretary of Defense (Acquisition, Technology, and Logistics) J.S. Gansler, November 11, 2000. (Hereinafter "Gansler Memo.")

7. On July 18, 2000, Deirdre Lee (director, Defense Procurement and Acquisition Policy) stated that, as of Fy2001, PBPs were being used on more than 50 percent of the qualifying contracts administered by the Defense Contract Management Agency (DCMA), based on contract financing dollars actually paid to contractors (not on dollar value of contracts awarded), in an industry briefing. Lee also noted that in FY2001, 60 percent of all contract financing payments were being made via use of PBPs.

8. 69 FR 174, page 54,651, dated September 9, 2004.

9. See, for example, the Council of Defense and Space Industry Associations (CODSIA) comment in response to FAR Case 98-400, dated April 19, 1999. (CODSIA Case 2-99.)

10. See, for example, CODSIA comment in response to DFARS Case 98-D400, dated November 12, 1998. (CODSIA Case 11-98.)

11. DOD Inspector General Report D-2003-106, Administration of Performance-Based Payments Made to Defense Contractors. June 25, 2003. DOD management comments emphasized that the contract actions criticized in the DOD IG report were negotiated before issuance of current guidance documents.

12. See FAR 31.102(f).

13. See DOD's "User's Guide to Performance-Based Payments," January 2001, Revised November 2001, pages 1-4. (Hereinafter, "User's Guide.")

14. See the clause at 52.232-32 ("Performance-Based Payments") (FEB 2002), especially 52.232-32(j).

15. See FAR Part 31.1004. ("Performance-based payments may be made either on a whole contract or an a deliverable item basis, unless otherwise prescribed by agency regulations. Financing payments to be made on a whole contract basis are applicable to the entire contract and not to specific deliverable items. Financing payments to be made on a deliverable item basis are applicable to a specific individual deliverable item.") See also "User's Guide" pages 7-8.

16. See FAR Parts 32.1003 and 32.1004, as well as "User's Guide" pages 7-8. Both the FAR and "User's Guide" direct that, if any other form of contract financing is being used on the contract, then PBPs may not be used.

17. Gansler Memo, citing FAC 97-16, 65 FR 59, pages 16,276-16,285, March 27, 2000.

18. See FAC 2001-10, implementing FAR Case 2000-007. 67 FR 226, pages 70,520-70,522, November 22, 2002.

19. See FAR 32.104(a).

20. Customary progress payment limits are found at FAR 32.501-1(a); PBP payment limits are found at 32.1004(2)(b)(2).

21. See the Gansler Memo. "Both parties [government and contractor] should be able to reduce non-value-added cost-based oversight."

22. See FAR 32.232-1003(e)(ii)(2).

23. See FAR 32.205(c)(3) and (4). The discount adjustment factor will be calculated in accordance with OMB Circular A-94, "Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs."

24. See DFARS 215.404-71-3(c), implementing DFARS Case 99-D001.

25. "User's Guide," 11.

26. Ibid, 11.

27. See FAR 32.1004(b)(4). ("Unless agency procedures prescribe the bases for establishing performance-based payment amounts, contracting officers may establish them on any rational basis, including (but not limited to) ... engineering estimates of stages of completion [or] engineering estimates of hours or other measures of efforts to be expended ...") (Emphasis added.)

28. See note 27, supra. "Any rational basis" may be used.

29. See FAR 32.1004(b)(3)(ii).

30. "User's Guide," 15.

31. But contractors may have to use a standardized DFAS format in order to access WAWF-RA.

32. "User's Guide," 17. (Original January 2001 edition.)

33. See FAR 32.1007(c).

34. "User's Guide," 17-18. (Original January 2001 edition.)

35. See DFARS 232.1001(d).

36. See FAR 32.1001(e).

37. "User's Guide," 5.

38. The government also reserves its right to reduce or suspend PBPs in various circumstances, including "failure to make progress," "unsatisfactory financial condition," or when the contractor "is delinquent in payment of any subcontractor or supplier ... in the ordinary course of business." (See the clause at 52.232-32(e), (November 2002)).

39. Of course, progress payments can be reduced or suspended just as PBPs can. (See note 38, supra.)

40. See FAR 52.232-32(h).

41. Ibid.

42. See FAR 52.245-2(c). Generally, a contractor retains title for property acquired in performance of fixed-price contracts, unless contract financing is used or unless the contract specifically identifies any item of property as being reimbursable.

43. See FAR 52.232-32(g).

44. Compare the requirements of the progress payment clause (52.232-16(e)) with the requirements of the PBP clause (52.232-32(g)). When PBPs are used, the contractor is obligated to repay to the government any PBPs related to the LDD property that is needed for performance. Furthermore, any PBP trigger events associated with LDD property "shall be deemed to be not in compliance with the terms of the contract and not payable (if the property is part of or needed for performance), and the Contractor shall refund the related performance-based payments ..."

45. "Cost or pricing data" is defined as FAR 2.101.

46. See FAR 52.232-32(1) and (m).

About the Author

NICHOLAS SANDERS, CGFM, is director of the goverment contracts practice group at PricewaterhouseCoopers LLP in Irvine, California. He is a member of the San Gabriel Valley Chapter. Send comments on this article to cm@ncmahq.org.
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