Last updated on July 26, 2016

## Incentive Calculation in a FPIF Contract

In my previous post, I described Fixed Price Incentive Fee Contract (FPIF). In this article, I will discuss the formulas and incentive calculations for an FPIF Contract. Let me summarize the basic nature of the contract before getting into formulas and calculations.

The basic nature of a FPIF Contract is similar to that of a Fixed Price Contract (FP). But in this, the buyer and the seller build a price flexibility into the contract. The price flexibility is achieved through financial incentives. The seller gets additional incentives if it is able to meet or exceed the agreed upon performance criteria. On the other hand, the seller can be penalized if it is not able to meet the performance criteria.

There could be thousands of ways to establish performance criteria in a FPIF Contract. I gave a few examples of establishing performance criteria in my last article. One of the popular ways to establish criteria is to bind the seller to meet the cost objectives of the buyer. In other words the seller is incentivized if it is able to control the costs; otherwise it loses money. Let us discuss how this is achieved.

### Financial Incentives Through Cost Control

The buyer and the seller agree on a **Target Cost**. The seller makes a best effort to complete the contracted work within the Target Cost. If the Actual Cost is below the Target Cost then the seller gets additional incentive from the buyer. Otherwise, seller’s fee is reduced. Let us look at some terms used in this type of contract.

**Target Cost** – A pre-defined goal (cost objective) set by the buyer for the seller.

**Actual Cost** – Actual expenditure of the seller after completing the contracted work.

**Target Fee** – A pre-defined award that is given to the seller if contracted work is done at the Target Cost.

**Target Price** – A pre-defined sum of money that is given to the seller if contracted work is done at the Target Cost.

**Ceiling Price** – A pre-defined maximum sum of money that can be given to the seller under any circumstance. The Ceiling Price is established to limit buyer’s cash outgo.

**Cost Variance** – The difference between Target Cost and Actual Cost. Positive variance is good for both the buyer and the seller.

**Share Ratio** – The ratio of dividing the Cost Variance between the buyer and the seller.

### Formulas for Incentive Calculations

Do you remember the basic FP Contract formula?

**Formula I**

Price = Cost + Fee

This formula is explained in one of my previous articles – PMP Formulas behind Contract Types. The definitions of Price, Cost and Fee are also explained in the same article.

The formula for FPIF Contract is same as a FP Contract formula, but the treatment is slightly different. In FPIF Contract extra Incentive (or Penalty) is also part of the Fee. The Fee is determined only after Actual Cost is known.

**Formula II**

Cost Variance = (Target Cost) – (Actual Cost)

**Formula III & IV**

Buyer’s Share = (Cost Variance) * (Buyer’s Share Ratio)

Seller’s Share = (Cost Variance) * (Seller’s Share Ratio)

**Formula V**

Fee = (Target Fee) + (Seller’s Share)

Going by the definitions and Formula I, we can say that

Target Price = (Target Cost) + (Target Fee)

Let us look at a small example to understand how these formulas are used to calculate incentives.

### Example

Let us assume that following data given to us.

Target Cost = 100K

Target Fee = $20K

Ceiling Price = $130K

Share Ratio = 50:50 (both the buyer and the seller get 50% of the Cost Variance)

We can conclude that

Target Price = $100K + $20K = $120K

Let us consider a two scenarios and calculate the Price.

#### Case I – Actual Cost is less than the Target Cost

Actual Cost = $90K

Referring to the Formula II

Cost Variance = $100K – $90K = $10K

The seller has saved $10K below the Target Cost. The saving will be divided between the buyer and the seller in the ratio of 50:50.

Seller’s Share = 10*50% = $5K

Referring to Formula V

Fee = $20K + $5K = $25K

Referring to Formula I

Price = $90K + $25K = $115K

The buyer will pay $115K to the Seller which is less than Target Price ($120K). The seller will receive $25K as Fee, which is more than the Target Fee ($20K). Both the buyer and the seller get the benefit of cost saving.

#### Case II – Actual Cost is more than the Target Cost

Actual Cost = $110K

Referring to the Formula II

Cost Variance = $100K – $110K = -$10K

The seller has spent $10K more than the Target Cost. The extra cost will be divided between the buyer and the seller in the ratio of 50:50.

Seller’s Share = (-10)*50% = -$5K

Referring to Formula V

Fee = $20K – $5K = $15K

Referring to Formula I

Price = $110K + $15K = $125K

The buyer will pay $125K to the Seller which is more than the Target Price ($120K). The seller will receive $15K as Fee, which is less than the Target Fee ($20K). Both the buyer and the seller are at a disadvantage.

#### Where is the 6th Formula?

There is an additional concept called Point of Total Assumption. I have explained it in my next post. The 6th formula is related to Point of Total Assumption.

I hope you were able to understand the formulas behind FPIF Contract. Please leave a comment if you have a question.

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

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