THE RATIONALE FOR INCENTIVE CONTRACTING*

Abstract

ABSTRACTThe incentive‐type fee function (which has supplanted the Cost‐Plus‐Fixed‐Fee arrangements of a decade ago) provides an excellent medium for achieving “fee flexibility” or, more exactly, for increasing the fee outcome on government contracts. The originators of incentive contracting stumbled unwittingly on a method for negotiating acceptable fee arrangements under conditions of uncertainty, and the primary purpose of this paper is to establish apodictically that incentive contracts (whether single or multiple) can and do provide the contractor with a method for securing a fee arrangement preferable to that obtainable through a CPFF or a FP (Fixed‐Price) contract. Furthermore, this characteristic of incentive contracts can be demonstrated through the use of elementary decision theory.The incentive fee structure provides the contractor with a long‐needed procedure for optimizing the expected utility of the fee outcome, and an appreciation of this property should be of value to both contractors and procurement officials with the authority for designing new contract fee arrangements. The paper does not investigate procedures for the optimal negotiation of contracts; rather, it identifies a feature of the incentive contract which appears to be the primary basis for its use and popularity.Our thesis is applicable to both single and multiple incentive contracts. For reasons of simplicity, however, the analysis has been largely confined to the former type of fee arrangement.