Defense Acquisitions: DOD Has Paid Billions in Award and	 
Incentive Fees Regardless of Acquisition Outcomes (19-DEC-05,	 
GAO-06-66).							 
                                                                 
Collectively, the Department of Defense (DOD) gives its 	 
contractors the opportunity to earn billions of dollars through  
monetary incentives--known as award fees and incentive fees.	 
These fees are intended to motivate excellent contractor	 
performance in areas deemed critical to an acquisition program's 
success, with award fees being appropriate when contracting and  
program officials cannot devise objective incentive fee targets  
related to cost, technical performance, or schedule. GAO was	 
asked to determine whether award and incentive fees have been	 
used effectively as a tool for achieving DOD's desired		 
acquisition outcomes. To do this, GAO selected a probability	 
sample of 93 contracts from the study population of 597 DOD	 
award- and incentive-fee contracts that were active and had at	 
least one contract action valued at $10 million or more from	 
fiscal year 1999 through 2003.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-66						        
    ACCNO:   A43337						        
  TITLE:     Defense Acquisitions: DOD Has Paid Billions in Award and 
Incentive Fees Regardless of Acquisition Outcomes		 
     DATE:   12/19/2005 
  SUBJECT:   Awards						 
	     Contract performance				 
	     Contractor payments				 
	     Defense procurement				 
	     Department of Defense contractors			 
	     Pay for performance				 
	     Performance measures				 
	     Policy evaluation					 
	     Award fees 					 
	     Incentive fees					 
	     Performance-based contracting			 
	     Comanche Helicopter				 
	     DOD Airborne Laser Program 			 
	     DOD Space-Based Infrared System High		 
	     Component						 
                                                                 
	     F/A-22 Aircraft					 
	     Joint Strike Fighter				 

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GAO-06-66

Report to the Subcommittee on Readiness and Management Support, Committee
on Armed Services, U.S. Senate

United States Government Accountability Office

GAO

December 2005

DEFENSE ACQUISITIONS

DOD Has Paid Billions in Award and Incentive Fees Regardless of
Acquisition Outcomes

DOD's Use of Monetary Incentives DOD's Use of Monetary Incentives DOD's
Use of Monetary Incentives DOD's Use of Monetary Incentives DOD's Use of
Monetary Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives DOD's Use of Monetary
Incentives DOD's Use of Monetary Incentives

GAO-06-66

Contents

Letter 1

Results in Brief 3
Background 6
Award and Incentive Fees Are Not an Effective Tool for Achieving DOD's
Desired Acquisition Outcomes 14
DOD Has Little Evidence That Monetary Incentives Improve Results as
Intended 31
Conclusions 33
Recommendations for Executive Action 33
Agency Comments and Our Evaluation 34
Appendix I Scope and Methodology 37
Appendix II Comments from the Department of Defense 42
Appendix III Contracting Definitions 46
Appendix IV Sample Characteristics 48
Appendix V GAO Reports on the Weapon Systems Acquisition Environment 49

Tables

Table 1: General Process for Determining Award-Fee Amounts 8
Table 2: General Process for Determining Incentive-Fee Amounts 9
Table 3: Products and Services, Dollars Obligated, and Contract Types in
GAO's Sample, Fiscal Years 1999-2003 11
Table 4: Award Fees as a Percentage of Contract Value 12
Table 5: Base Fees as a Percentage of Contract Value 13
Table 6: Program Performance and Award-Fee Payments on Selected DOD
Development Programs 27

Figures

Figure 1: Prevalence of Award- and Incentive-Fee Contracts, Fiscal Years
1999-2003 10
Figure 2: Weaknesses in DOD's Use of Award and Incentive Fees 16
Figure 3: Percentage of Available Award Fee Paid to Date for 63 Award-Fee
Contracts in GAO's Sample 18
Figure 4: Percentage of Available Award Fee Earned for 572 Evaluation
Periods in GAO's Sample 20
Figure 5: DOD's Use of Rollover on 32 Contracts in GAO's Sample 22
Figure 6: Maximum Percentage of Award Fee Available for "Acceptable,
Average, Expected, Good, or Satisfactory" Performance and the Estimated
Percentage of DOD Contracts That Paid These Percentages 24

Abbreviations

DOD Department of Defense

FAR Federal Acquisition Regulation

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United States Government Accountability Office

Washington, DC 20548

December 19, 2005

The Honorable John Ensign Chairman The Honorable Daniel K. Akaka Ranking
Minority Member Subcommittee on Readiness and Management Support Committee
on Armed Services United States Senate

The Department of Defense (DOD) contracts with various companies,
institutions, and organizations to provide products and services that
include everything from spare parts for aircraft to ship maintenance to
the development of major weapon systems. With federal discretionary
spending, including defense spending, facing serious budget pressures in
the coming years, fiscal realities demand that DOD maximize its return on
investment for these acquisitions. Each of these acquisitions poses unique
risks and challenges for DOD and its contractors. In an effort to
encourage defense contractors to perform in an innovative, efficient, and
effective way in areas deemed important to an acquisition's success, DOD
gives its contractors the opportunity to collectively earn billions of
dollars through monetary incentives known as award fees and incentive
fees. Award fees and incentive fees can be used alone or together in
contracts, with award fees being appropriate when contracting and program
officials cannot devise predetermined objective incentive-fee targets
applicable to cost, technical performance, or schedule.

Award and incentive fees operate in an environment where actions taken by
both DOD and the contractor contribute to acquisition outcomes. Prior GAO
work has shown how fundamental acquisition problems within DOD, especially
a lack of key product knowledge at critical junctures, have contributed to
such issues as cost increases, schedule delays, and performance shortfalls
in weapons programs. See appendix V for a list of GAO reports on weapon
systems acquisition. These overarching problems, along with the selection
of an unqualified supplier or inadequate funding, among other reasons, can
negatively affect acquisition outcomes.

In this context, DOD has looked to monetary incentives as one of the ways
it can promote its desired acquisition outcomes. However, senior DOD and
service acquisition officials have raised concerns about how effectively
these fees are being used because DOD programs have paid contractors large
amounts of fee on acquisitions that are falling behind schedule,
overrunning costs, and experiencing significant technical problems.
Because of these concerns, you requested that we determine whether award
fees and incentive fees have been used effectively as a management tool
for achieving DOD's desired acquisition outcomes.

To address this objective, we selected a probability sample of 93
contracts from the study population of 597 DOD award-fee and incentive-fee
contracts that were active between fiscal years 1999 and 2003 and had at
least one contract action coded as cost-plus-award-fee,
cost-plus-incentive-fee, fixed-price-award-fee, or fixed-price incentive
valued at $10 million or more during that time. Unless otherwise noted,
the estimates in this report pertain to (1) this population of award- and
incentive-fee contracts, (2) the subpopulation of award-fee contracts, or
(3) the evaluation periods associated with contracts described in (1) or
(2) that had been completed at the time of our review. Estimates of total
award fees earned and total award fees that contractors received at least
two chances to earn are based on all evaluation periods held from the
inception of our sample contracts through our data collection phase, not
just those from fiscal years 1999 through 2003. Because the estimates in
this report are derived from a probability sample, they are subject to
sampling error. All percentage estimates from our review have margins of
error not exceeding plus or minus 10 percentage points unless otherwise
noted. All numerical estimates other than percentages (such as totals and
ratios) have margins of error not exceeding plus or minus 25 percent of
the value of those estimates. See appendix I for more details about the
probability sample and associated sampling error. Fifty-two contracts in
our sample contained only award-fee provisions; 27 contracts contained
only incentive-fee provisions; and 14 included both award- and
incentive-fee provisions. The types of products or services associated
with contracts in our sample include research and development projects,
aircraft and aircraft-related procurements, ship construction, and
non-research-and-development services, among others. For each of the 93
contracts in our sample, we interviewed contracting and program officials
about the development, implementation, and effectiveness of the award- and
incentive-fee structures using a standard questionnaire and analyzed their

responses. We also reviewed contract documentation related to these areas
and examined fee payments in the context of program performance. Program
performance was assessed using GAO's body of work on DOD weapon systems
acquisitions.1 Finally, we interviewed acquisition policy officials and
consulted recent policy initiatives, reports, and audits related to DOD's
use of award and incentive fees. See appendix I for additional details on
scope and methodology. We performed our review from February 2004 to
November 2005 in accordance with generally accepted government auditing
standards.

                                Results in Brief

Award fees have generally not been effective at helping DOD achieve its
desired acquisition outcomes. DOD programs engage in practices that
undermine efforts to motivate contractor performance and that do not hold
contractors accountable for achieving desired acquisition outcomes, such
as meeting cost and schedule goals and delivering desired capabilities.
DOD programs frequently pay most of the available award fee for what they
describe as improved contractor performance, regardless of whether
acquisition outcomes fell far short of DOD's expectations, were
satisfactory, or exceeded expectations. Based on our sample, we estimate
that for the study population of DOD contracts, the median percentage of
available award fee paid to date (adjusted for fees that were deferred)
was 90 percent, representing an estimated $8 billion in award fees. DOD
programs also provided about half of its contractors multiple
opportunities to earn fees that the contractors did not earn when the fees
were first made available. Based on our sample, we estimate that, to date,
contractors for DOD contracts in our study population received at least
two chances to earn $669 million in fees that were not initially earned or
deferred. In addition, DOD programs regularly paid contractors a
significant portion of the available fee for what award-fee plans describe
as "acceptable, average, expected, good, or satisfactory" performance when
federal acquisition regulations and military service guidance state that
the purpose of these fees is to motivate excellent performance. These
practices reduce the effectiveness of award fees as motivators of
performance and compromise the integrity of the fee process. DOD does

1 GAO, Defense Acquisitions: Assessments of Selected Major Weapon
Programs, GAO-05-301 (Washington, D.C.: Mar. 31, 2005).

not define contractor performance in terms of acquisition outcomes. Rather
than focusing on acquisition outcomes, such as delivering a fielded
capability within established cost and schedule baselines, DOD often
places emphasis on such things as the responsiveness of contractor
management to feedback from DOD officials, quality of contractor
proposals, or timeliness of contract data requirements. Some programs,
most notably the Missile Defense Agency's Airborne Laser program, have
structured fees to focus on acquisition outcomes, such as successfully
demonstrating the system, which can help ensure that fee payments are more
representative of program results. Incentive-fee contracts link contractor
performance to acquisition outcomes more explicitly; however, about half
of the 27 incentive-fee contracts that we reviewed failed or are projected
to fail to meet a key measure of program success-completing the
acquisition at or below the target price. In the one case in which
significant savings were realized through the successful use of an
incentive fee, program officials were able to leverage the knowledge
gained about program costs on a previous contract. However, when contracts
have identified seemingly effective award- and incentive-fee strategies,
contracting officials have stated that DOD has few mechanisms to share
lessons learned and innovative practices outside the local level.

The effectiveness of award and incentive fees as a management tool has
also been limited by DOD's failure to examine the basis for their use,
assess how well they are working, and account for various factors that
arise in the complex acquisition environment. Although DOD has paid
billions in fees over time, the department has little evidence to support
its contention that the use of award and incentive fees results in the
intended effect on contractor performance and acquisition outcomes. While
DOD officials have told us that they believe these fees improve contractor
performance and program outcomes, DOD has not conducted overall
evaluations or compiled data on the effectiveness of award and incentive
fees. In addition, DOD has not developed performance measures to evaluate
whether contracts utilizing these fees actually produce better outcomes
than other contract types. Research on incentive fees by GAO, Harvard
University, and the RAND Corporation going back decades has concluded that
these types of fees do not consistently motivate contractors to control
cost. Other research by Air Force personnel has shown that award fees are
not always implemented in a way that is consistent with the intent of
improving contractor performance.

To strengthen the link between monetary incentives and acquisition
outcomes and by extension increase the accountability of DOD programs for
fees paid and of contractors for results achieved, we recommend that the
Secretary of Defense direct the Undersecretary of Defense for Acquisition,
Technology, and Logistics to take the following seven actions. DOD can
immediately improve its use of award fees on all new contracts by (1)
instructing the military services to move toward more outcome-based
award-fee criteria that are both achievable and promote accountability for
acquisition outcomes; (2) ensuring that award-fee structures are
motivating excellent contractor performance by only paying award fees for
above satisfactory performance; and (3) requiring the appropriate
approving officials to review new contracts to make sure these actions are
being taken. DOD can improve its use of award fees on all existing
contracts by (4) issuing DOD guidance on when rollover is appropriate. In
the longer term, DOD can improve its use of award and incentive fees by
(5) developing a mechanism for capturing award- and incentive-fee data
within existing data systems, such as the Defense Acquisition Management
Information Retrieval system; (6) developing performance measures to
evaluate the effectiveness of award and incentive fees as a tool for
improving contractor performance and achieving desired program outcomes;
and (7) developing a mechanism to share proven incentive strategies for
the acquisition of different types of products and services with
contracting and program officials across DOD.

DOD's Office of Defense Procurement and Acquisition Policy provided
written comments on a draft of this report. In its comments, DOD concurred
with three of our seven recommendations-moving toward more outcome-based
award-fee criteria, issuing guidance on rollover, and developing a
mechanism to share proven incentive strategies-and agreed to address them
in a policy memorandum and communications plan that it indicated will be
issued on March 31, 2006. DOD partially concurred with four of our
recommendations-only paying award fees for above satisfactory performance,
requiring the appropriate officials to make sure these recommendations are
implemented in new contracts, collecting award- and incentive-fee data,
and developing performance measures to evaluate the effectiveness of award
and incentive fees in improving acquisition outcomes. Concerning our
recommendation related to the payment of award fees for satisfactory
performance, DOD stated that it was both fair and reasonable to pay a
portion of the award fee for this level of performance, but agreed that
the preponderance of fee should be

paid for excellent performance and that it would reinforce existing
policies in its March memorandum. We continue to believe that award fees
should be primarily reserved for above satisfactory performance, which as
pointed out in this report is not the current practice for most contracts.
On the remaining three recommendations, DOD indicated that it would
conduct a study to determine the appropriate actions to address these
recommendations. DOD plans to complete the study by June 1, 2006. While
this study may provide additional insights, we encourage DOD to use it as
a mechanism for identifying the specific steps the department will take to
fully address our recommendations, not to determine whether the department
will take action. Between fiscal years 1999 through 2003, the department
obligated $157 billion through award- and incentive-fee contracts and used
these contracts on some of its largest weapons programs. Given the dollars
involved, DOD needs to collect data and develop performance measures on
the use of award and incentive fees to help it effectively manage these
contracts and assure its resources are well-spent. DOD's comments are
reprinted in their entirety in appendix II of this report.

                                   Background

Federal agencies, including DOD, can choose among numerous contract types
to acquire products and services. One of the characteristics that varies
across contract types is the amount and nature of the fee that agencies
offer to the contractor for achieving or exceeding specified objectives or
goals. Of all the contract types available, only award- and incentive-fee
contracts allow an agency to adjust the amount of fee paid to contractors
based on the contractor's performance.2 Typically, award-fee contracts
emphasize multiple aspects of contractor performance in a wide variety of
areas, such as quality, timeliness, technical ingenuity, and
cost-effective management. Incentive-fee contracts usually focus on cost
control, although they can also be used to motivate contractors to achieve
specific delivery targets or performance goals in areas such as missile
range, aircraft speed, engine thrust, or vehicle maneuverability.

2 Other contract types do not provide this same level of control over fees
and profits. The two most prevalent DOD contract types (based on the
number of contract actions) are firm-fixed-price and cost-plus-fixed-fee.
Under firm-fixed-price contracts, DOD and the contractor agree on a price
and the contractor assumes full responsibility for all costs and the
resulting profit or loss. Under cost-plus-fixed-fee contracts, the
contractor receives a fee that was negotiated and fixed at the inception
of the contract.

Regardless of differences between award- and incentive-fee contracts,
federal acquisition regulations state that these contracts should be used
to achieve specific acquisition objectives, such as delivering products
and services on time or within cost goals and with the promised
capabilities. For award-fee contracts, the assumption underlying the
regulation is that the likelihood of meeting these acquisition objectives
will be enhanced by using a contract that effectively motivates the
contractor toward exceptional performance. The reason or basis for
selecting an award- or incentive-fee contract can vary, depending on the
type of work a contractor is expected to perform. The acquisition
environment, including the knowledge DOD has prior to starting an
acquisition program, the adequacy of resources, and the soundness of
acquisition practices, can also be a critical factor that affects how well
contractor performance translates into acquisition outcomes.

Award-Fee Contracts

The development and administration of award-fee contracts involve
substantially more effort over the life of a contract than incentive-fee
contracts.3 For award-fee contracts, DOD personnel (usually members of an
award-fee evaluation board4) conduct periodic-typically
semiannual-evaluations of the contractor's performance against specified
criteria in an award-fee plan and recommend the amount of fee to be paid.5
Because award fees are intended to motivate contractor performance in
areas that are susceptible to judgmental and qualitative measurement and
evaluation (e.g., technical, logistics support, cost, and schedule), these
criteria and evaluations tend to be subjective.6 After receiving the
recommendation of the award-fee evaluation board, a fee-determining
official7 makes the final decision about the amount of fee the contractor
will receive. The fee-determining official can also decide to move
unearned award fee from one evaluation period to a subsequent evaluation
period or periods, thus providing the contractor an additional opportunity
to earn previously unearned fee-a practice called rollover. Table 1
provides a general look at the process for evaluating and determining
award fee amounts.

3 The Federal Acquisition Regulation (FAR) requires that the expected
benefits of using an award-fee contract must exceed the additional
administrative effort and cost involved (FAR Part 16.404(b)(1) and
16.405-2(b)(1)(iii)).

4 Award-fee evaluation board members may include personnel from key
organizations knowledgeable about the award-fee evaluation areas, such as
engineering, logistics, program management, contracting, quality
assurance, legal, and financial management; personnel from user
organizations and cognizant contract administration offices; and the local
small business office in cases where subcontracting goals are important.
On major weapons programs, the boards are generally made up of personnel
from the program office.

5 Award-fee contracts are intended to be flexible, so award-fee plans
allow contracting and program officials to change fee criteria and the
weight given to each criterion from evaluation period to evaluation
period.

6 The Navy Award Fee Guide suggests that objective measures also be
utilized, to the maximum extent possible, to support the subjective
evaluation of the contractor's performance.

Table 1: General Process for Determining Award-Fee Amounts

1 DOD officials provide input on the contractor's performance for an 
     evaluation period that just ended.                                 
2 Program officials compile data and prepare a briefing or summary   
     for the award-fee evaluation board.                                
3 Award-fee evaluation board convenes meeting; contractor has the    
     option to submit a self-assessment and brief the board.            
4 Award-fee evaluation board considers all the input and recommends  
     a fee rating for the contractor.                                   
5 Fee-determining official (usually outside the program) makes an    
     initial fee determination and notifies the contracting officer.    
6 Contracting officer notifies contractor of initial determination;  
     contractor has the option to appeal the decision to the            
     fee-determining official.                                          
7 Fee-determining official makes a final determination, including    
     whether to rollover unearned fee, and notifies contracting         
     officer.                                                           
8 Contracting officer issues final determination to contractor and   
     processes a contract modification authorizing payment.             

Sources: Air Force Award Fee Guide, Army Contracting Agency Award Fee
Handbook, Navy/Marine Corp Award Fee Guide (data); GAO (analysis).

Incentive-Fee Contracts

Incentive-fee contracts use what is considered to be an objective
evaluation of the contractor's performance to adjust the fee paid. DOD's
evaluation usually involves the application of a fee-determination formula
that is specified in the contract. Evaluations occur at the end of the
contract or, in the case of a performance or delivery incentive, at
program milestones. The evaluations do not require an extensive evaluation

7 The fee-determining official is generally at a higher level
organizationally than those directly involved in the evaluation of the
contractor (e.g., award-fee board members). For instance, this official
can be the program executive officer for a weapons system acquisition
contract or a garrison commander on a base support services contract.

process or the participation of a large number of contracting or program
personnel. Table 2 provides a general look at the process for evaluating
and determining the amount of incentive fee paid for a contract with a
cost incentive.

Table 2: General Process for Determining Incentive-Fee Amounts

1 At the conclusion of the contract, DOD contracting officer         
     compares the contractor's actual cost to complete the contract     
     with the target cost specified in the contract.                    
2 a. If contractor's actual cost matches the target cost, DOD awards 
     the contractor an amount called the target fee or target profit.a  
                                                                        
     b. If contractor's actual cost falls below the target cost, the    
     contracting officer applies a formula with a share ratio that      
     specifies how much the contractor's target fee or profit is        
     increased for every dollar the actual cost is below the target     
     cost.                                                              
                                                                        
     c. If contractor's actual cost exceeds the target cost, the        
     contracting officer applies a formula with a share ratio that      
     specifies how much the contractor's target fee or profit is        
     reduced for every dollar the actual cost is above the target cost. 
3 Contracting officer processes a contract modification authorizing  
     payment.                                                           

Sources: Federal Acquisition Regulation, DOD Contract Pricing Guide
(data); GAO (analysis).

aIn federal contracting, the terms "profit" and "fee" refer to the amount
of money paid to the contractor above and beyond either a fixed price or a
contractor's reimbursable costs. The term "profit" is associated with
fixed-price contracts, and the term "fee" is associated with
cost-reimbursable contracts.

Contracts Discussed in This Report

For this report, we examined fixed-price and cost-reimbursable award- and
incentive-fee contracts, as well as contracts that combined aspects of
both of these contract types. (See app. III for an explanation of various
contract types.) Our probability sample of 93 contracts was drawn from a
total of 597 DOD award- and incentive-fee contracts that were active from
fiscal years 1999 through 2003 and had at least one contract action coded
as cost-plus-award-fee, cost-plus-incentive-fee, fixed-price award-fee, or
fixed-price-incentive valued at $10 million or more during that time.
Among the sample, 52 contracts contained only award-fee provisions, 27
contracts contained only incentive-fee provisions, and 14 contracts
included both. (App. I contains additional information on our scope and
methodology.)

From fiscal year 1999 through fiscal year 2003, award- and incentive-fee
contract actions8 accounted for 4.6 percent of all DOD contract actions
over $25,000. However, when taking into account the dollars
obligated-award- and incentive-fee contract actions accounted for 20.6
percent of the dollars obligated on actions over $25,000, or over $157
billion, as shown in figure 1.9 Our sample of 93 contracts includes $51.6
billion, or almost one-third, of those obligated award- and incentive-fee
contract dollars.

Figure 1: Prevalence of Award- and Incentive-Fee Contracts, Fiscal Years
1999-2003

DOD utilized the contracts in our sample for a number of purposes. For
example, research and development contracts accounted for 51 percent (or
$26.4 billion) of the dollars obligated against contracts in our sample
from fiscal years 1999 through 2003, while non-research-and-development
services accounted for the highest number of contracts in our sample.

8 Contract actions include any action related to the purchasing, renting,
or leasing of supplies, services, or construction. Contract actions
include definitive contracts; letter contracts; purchase orders; orders
made under existing contracts or agreements; and contract modifications,
which would include the payment of award and incentive fees.

9 These obligations include award- and incentive-fee payments as well as
other contract costs.

Table 3 shows the dollars obligated and the types of contracts by product
and service. Appendix IV contains a breakdown of the contracts in our
sample by contract type and military service.

Table 3: Products and Services, Dollars Obligated, and Contract Types in
GAO's Sample, Fiscal Years 1999-2003

                                                   Number of                     
                    Number of                      contracts Number of           
                    contracts     Total                 with contracts Number of 
                    according   dollars                award      with contracts 
                           to  in GAO's Percentage  fees and incentive with both 
                      product    sample of dollars        no  fees and award and 
  Product or               or       (in   in GAO's incentive  no award incentive
  service             service billions)     sample      fees      fees      fees
  Research and                                                                   
  development              32     $26.4      51.2%        20         7         5
  Aircraft and                                                                   
  aircraft- related                                                    
  procurement               7       8.5       16.5         2         5         0
  Ship construction         6       8.3       16.0         0         2         4 
  Non-research-and-                                                              
  development                                                          
  services                 36       6.0       11.6        23         9         4
  Other                    12       2.4        4.7         7         4         1 
  Total                    93     $51.6       100%        52        27        14 

Sources: Federal Procurement Data System (data); GAO (analysis).

Note: The sample cases include 12 contracts that were selected with
certainty: 7 for research and development, 3 for ship construction, 1 for
aircraft procurement, and 1 for non-research-and- development services.
Seven of the contracts selected with certainty had award-fee provisions, 2
had incentive-fee provisions, and 3 contained both award- and
incentive-fee provisions.

DOD has the flexibility to mix and match characteristics from different
contract types. The risks for both DOD and the contractor vary depending
on the exact combination chosen, which, according to the Federal
Acquisition Regulation, should reflect the uncertainties involved in
contract performance. Based on the results from our sample, about half of
the contracts in our study population were cost-plus-award-fee contracts.
The theory behind these contracts is that although the government assumes
most of the cost risk, it retains control over most or all of the
contractor's potential fee as leverage. On cost-plus-award-fee contracts,
the award fee is often the only source of potential fee for the
contractor. According to defense acquisition regulations, these contracts
can include a base fee-a fixed fee for performance paid to the
contractor-of anywhere from 0 to 3 percent of the value of the contract;
however, based on our sample results, we estimate that about 60 percent of
the cost-plus-award-fee contracts in our study population included zero
base fee.10 Tables 4 and 5 show the estimated percentage of DOD award-fee
contracts that had a particular percentage of the value of the contract
available in award fees and base fees.

Table 4: Award Fees as a Percentage of Contract Value

                                     Estimated percentage of award fee 
Percentage of value of contract      contracts with this percentage 
available in award fees                                   available 
1                                                                 0 
2                                                                 4 
3                                                                10 
4                                                                 2 
5                                                                 4 
6                                                                 4 
7                                                                23 
8                                                                 4 
9                                                                 6 
10                                                               15 
11                                                                4 
12                                                                7 
13                                                                4 
14                                                                0 
15                                                               14 
20                                                      Less than 1 

Sources: DOD submissions to GAO and contract documentation (data); GAO
(analysis).

Notes: While there is no limit on the maximum percentage of the value of
the contract that can be made available in award fee, the 20 percent
included in the Space-Based Infrared System High development contract was
outside the norm. Percentages do not add to 100 due to rounding. Sampling
errors for percentages in this table do not exceed plus or minus 12
percentage points.

10 The 95 percent confidence interval surrounding this estimate ranges
from 46 percent to 73 percent.

Table 5: Base Fees as a Percentage of Contract Value

                                      Estimated percentage of award fee 
Percentage of value of contract       contracts with this percentage 
available in base fees                                     available 
0                                                                 63 
1                                                                  0 
2                                                                  8 
3                                                                 26 
4                                                                  2 

Sources: DOD submissions to GAO and contract documentation (data); GAO
(analysis).

Notes: The two F/A-22 development contracts in our sample included a 4
percent base fee. The program office received a deviation from the Defense
Federal Acquisition Regulation Supplement, which allows for a maximum of 3
percent base fee. Percentages do not add to 100 due to rounding. Sampling
errors for percentages in this table do not exceed plus or minus 13
percentage points.

Based on the results from our sample, an estimated 16 percent of the
contracts in our study population were fixed-price incentive contracts,
and an estimated 13 percent were cost-plus-incentive-fee contracts. In
both of these cases, the government and the contractor share the cost
risks. However, on fixed-price incentive contracts, the contractor usually
assumes more risk because if the contract reaches its ceiling price, the
contractor absorbs the loss. Under a cost-plus-incentive-fee contract,
when costs increase to the point where the contractor will only earn the
minimum fee, no further fee adjustments occur and the government continues
to pay the contractor's reimbursable costs.

DOD Acquisition Practices and Program Success

When discussing award- and incentive-fee contracts, it is important to
acknowledge the acquisition environment in which they are used. For
instance, based on our sample results, we estimate that most of the
contracts and most of the dollars in our study population are related to
the acquisition of weapon systems. Since 1990, GAO has designated DOD
weapon system acquisition as a high-risk area.11 Although U.S. weapons are
the best in the world, DOD's acquisition process for weapon programs
consistently yields undesirable consequences-cost increases, late
deliveries to the warfighter, and performance shortfalls. These problems

11 GAO, High-Risk Series: An Update, GAO-05-207 (Washington, D.C.: January
2005).

occur because DOD's weapon programs do not capture early on the requisite
knowledge that is needed to efficiently and effectively manage program
risks. For example, programs move forward with unrealistic program cost
and schedule estimates, lack clearly defined and stable requirements, use
immature technologies in launching product development, and fail to
solidify design and manufacturing processes at appropriate junctures in
development. As a result, wants are not always distinguished from needs,
problems often surface late in the development process, and fixes tend to
be more costly than if made earlier. When programs require more resources
than planned, the buying power of the defense dollar is reduced, and funds
are not available for other competing needs.

The persistence of these problems reflects the fact that the design,
development, and production of major weapon systems are extremely complex
technical processes that must operate within equally complex budget and
political processes. A program that is not well conceived, planned,
managed, funded, and supported may easily be subject to such problems as
cost growth, schedule delays, and performance shortfalls. Even properly
run programs can experience problems that arise from unknowns, such as
technical obstacles and changes in circumstances. In short, it takes a
myriad of things to go right for a program to be successful but only a few
things to go wrong to cause major problems.

 Award and Incentive Fees Are Not an Effective Tool for Achieving DOD's Desired
                              Acquisition Outcomes

DOD has not structured and implemented award-fee contracts in a way that
effectively motivates contractors to improve performance and achieve
acquisition outcomes. DOD practices-such as routinely paying its
contractors nearly all of the available award fee, amounting to billions
of dollars, regardless of whether the acquisition outcomes fell short of,
met, or exceeded expectations; rolling an estimated $669 million in
unearned or withheld award fees to future evaluation periods; and paying a
significant portion of the available fee for what award-fee plans describe
as "acceptable, average, expected, good, or satisfactory" performance-all
lessen the motivation for the contractor to strive for excellent
performance. In addition, DOD award-fee plans have not been structured to
focus the contractor's attention on achieving desired acquisition
outcomes. DOD generally does not evaluate contractors on criteria that are
directly related to acquisition outcomes, and the link between the

elements of contractor performance that are included in award-fee criteria
and acquisition outcomes is not always clear. While incentive-fee
contracts are more directly linked to select acquisition outcomes, DOD has
not fared well at using these types of contracts to improve cost control
behavior or meet program goals. However, when contractor performance does
not result in the desired acquisition outcome under an incentive-fee
contract, the reduction of fees is usually automatic and based on the
application of a predetermined formula. Figure 2 summarizes our findings
within the general framework of issues surrounding DOD's use of award and
incentive fees.

Figure 2: Weaknesses in DOD's Use of Award and Incentive Fees

Award-Fee Contracts: DOD Practices Do Not Maximize Contractors' Motivation to
Perform

DOD's practice of routinely paying its contractors nearly all of the
available award fee puts DOD at risk of creating an environment in which
programs pay and contractors expect to receive most of the available fee,
regardless of acquisition outcomes. Based on our sample, we estimate that
for DOD award-fee contracts, the median percentage of available award fee
paid to date (adjusted for rollover)12 was 90 percent, representing an
estimated $8 billion in award fees for contracts active between fiscal
years 1999 through 2003.13 The lowest percentage of available fee paid to
date for contracts in our sample was 36 percent, and the highest was 100
percent. Figure 3 shows the percentage of available fee earned for the 63
award-fee contracts in our sample and the lack of variation, especially
across the contracts in the middle of the distribution.

12 When calculating the percentage of award fee paid (i.e. percentage of
award fee paid = total fee paid to date / (total fee pool - remaining fee
pool)), we included rolled-over fees in the remaining fee pool when those
fees were still available to be earned in future evaluation periods.

13 Our estimate is based on award fee periods that were held from the
inception of the contracts in our sample through the data collection phase
of our review. The oldest award fee contracts in our sample were signed in
fiscal year 1991.

Figure 3: Percentage of Available Award Fee Paid to Date for 63 Award-Fee
Contracts in GAO's Sample

The pattern of consistently high award-fee payouts is also present in
DOD's fee decisions from evaluation period to evaluation period. This
pattern is evidence of reluctance among DOD programs to deny contractors
significant amounts of fee, even in the short term. We estimate that the
median percentage of award fee earned for each evaluation period was 93
percent and the level of variation across the evaluation periods in our
sample was similar to the trend shown in figure 3. On DOD award-fee
contracts, we estimate that the contractor received 70 percent or less of
the available fee in only 9 percent of the evaluation periods and none of
the available fee in only 1 percent of the evaluation periods. Figure 4
shows the percentage of available fee earned by evaluation period for the
award-fee contracts in our sample. There were 572 evaluation periods
overall for these contracts.

Figure 4: Percentage of Available Award Fee Earned for 572 Evaluation
Periods in GAO's Sample

In addition to consistently awarding most of the available award fee on an
evaluation period-by-evaluation period basis, the use of "rollover" is
another indication of DOD's reluctance to withhold fees. Rollover is the
process of moving unearned available award fee from one evaluation period
to a subsequent evaluation period, thereby providing the contractor an
additional opportunity to earn that unearned award-fee amount. DOD and
program officials view rollover as an important mechanism for maintaining
leverage with contractors; however, award-fee guidance issued by the Air
Force, Army, and Navy in the last 3 years states that this practice should
rarely be used in order to avoid compromising the integrity of the
award-fee evaluation process. We estimate that 52 percent of DOD award-fee
contracts rolled over unearned fees into subsequent evaluation periods.14
We estimate that unearned fees were rolled over in 42 percent of
evaluation periods of contracts that used this practice.15 Further, we
estimate that the mean percentage of unearned fees that were rolled over
in these periods was 86 percent, and in 52 percent16 of these periods at
least 99 percent of the unearned fee was rolled over. Consequently, in
many evaluation periods when rollover was used, the contractor still had
the chance to earn almost all of the unearned fee, even in instances when
the program was experiencing problems. Across all the evaluation periods
for the 32 contracts in our sample that used this practice, the amount
rolled over was almost $500 million, or an average of 51 percent of the
total unearned fees. (See fig. 5 for a depiction of DOD's use of rollover
on the contracts in our sample.) Overall, for DOD award-fee contracts
active between fiscal years 1999 through 2003, we estimate that the total
dollars rolled over across all evaluation periods that had been conducted
by the time of our review was $669 million.

14 The 95 percent confidence interval for this estimate ranges from 40
percent to 64 percent.

15 The 95 percent confidence interval for this estimate ranges from 31
percent to 53 percent.

16 The 95 percent confidence interval for this estimate ranges from 34
percent to 69 percent.

Figure 5: DOD's Use of Rollover on 32 Contracts in GAO's Sample

Several of the contracts in our sample routinely rolled over 100 percent
of a contractor's unearned award fee into fee pools for use later in the
programs. For example, the Joint Strike Fighter program has rolled over
100 percent of the unearned award fee for its development contracts into a
reserve award-fee pool that the program uses to target areas not covered
in the award-fee plan, such as encouraging the contractor to track awards
to small businesses and improving communications with countries that are
partners in the development program.17 However, the program has also used
the reserve award-fee pool to provide additional money to motivate cost
control, even though this area is already a focus of the award-fee plan.
If the contractor does not earn the fee in the targeted area, the program
keeps rolling the unearned fee back into the reserve pool. The practical
effect of this is that the Joint Strike Fighter program's prime
contractors still have the ability to earn the maximum award fee despite
the cost and technical issues the program has experienced.

17 In its technical comments on a draft of this report, DOD stressed that
while the Joint Strike Fighter program office has rolled over unearned fee
to a reserve award fee pool, it is under no obligation to make any of this
reserve award fee pool available to the contractor.

DOD may also be diluting the motivational effectiveness of award fees by
paying significant amounts of fee for satisfactory performance. Although
DOD guidance and federal acquisition regulations state that award fees
should be used to motivate excellent contractor performance in key areas,
most DOD award-fee contracts pay a significant portion of the available
fee from one evaluation period to the next for what award-fee plans
describe as "acceptable, average, expected, good, or satisfactory"
performance.18 Figure 6 shows the maximum percentage of award fee paid for
"acceptable, average, expected, good, or satisfactory" performance and the
estimated percentage of DOD award-fee contracts active between fiscal
years 1999 through 2003 that paid these percentages. Some plans for
contracts in our sample did not require the contractor to meet all of the
minimum standards or requirements of the contract to receive one of these
ratings. Some DOD award-fee contracts in our sample also allowed for a
portion of the available award fee to be paid for marginal performance-a
rating lower than satisfactory. Even fixed-price-award-fee contracts,
which already include a normal level of profit in the price, paid out
award fees for satisfactory performance. Six of the eight fixed-price
contracts with award fee provisions in our sample paid out 50 percent or
more of the available award fee for satisfactory performance.

18 For the 53 contracts in our sample that paid at least a portion of the
available fee if the contractor received a rating of "acceptable, average,
expected, good, or satisfactory," there were 40 different fee ranges
associated with these categories.

Figure 6: Maximum Percentage of Award Fee Available for "Acceptable,
Average, Expected, Good, or Satisfactory" Performance and the Estimated
Percentage of DOD Contracts That Paid These Percentages

Note: Sampling errors for percentages in this figure do not exceed plus or
minus 13 percentage points.

The amount of award fee being paid for performance at or below the minimum
standards or requirements of the contract appears to not only be
inconsistent with the intent of award fees (as explained in DOD guidance
and federal acquisition regulations19) but also is inconsistent with the
reasons contracting and program officials cited on our questionnaire for
their use. According to responses to our questionnaire, rewarding
satisfactory performance was one reason that award or incentive fees were
used on an estimated 29 percent of DOD award- and incentive-fee contracts.
However, rewarding better than satisfactory performance was one reason
that these fees were used on an estimated 77 percent of these contracts.20

19 According to FAR 16.404(a)(1), in a fixed-price-award-fee contract, the
fixed price (including normal profit) will be paid for satisfactory
contract performance. Award fee earned (if any) will be paid in addition
to that fixed price. According to FAR 16.405-2(a)(2), a
cost-plus-award-fee contract should include an award amount that is
sufficient to provide motivation for excellence in such areas as quality,
timeliness, technical ingenuity, and cost-effective management.

The responses provided to our questionnaire also seem to rule out the
administration of award fees as one of the reasons for their general lack
of effectiveness. Several key elements related to development and
administration of award-fee contracts were present on almost all
contracts. Specifically, contracting and program officials' questionnaire
responses showed that the appropriate people were involved in the
development and administration of award-fee contracts, and there was
adequate guidance and training in place. We estimate that for 91 percent
of DOD award-fee contracts, there were designated performance monitors
responsible for evaluating specific areas described in the award-fee plan.
On an estimated 88 percent of DOD award-fee contracts, award-fee
evaluation board members received training on their roles and
responsibilities. We further estimate that on 85 percent of DOD award-fee
contracts, performance monitors also received training. Evaluation boards
were held as planned for an estimated 86 percent of DOD award-fee
contracts, and some programs conducted interim assessments of contractor
performance to support the end-of-period evaluations. Based on
questionnaire responses from contracting and program officials, an
estimated 95 percent of DOD award-fee contracts had rating category
descriptions that provided enough detail to distinguish between
categories. An estimated 79 percent of the contracting officers
responsible for developing and administering award-fee contracts and an
estimated 80 percent of the contracting officers responsible for
incentive-fee contracts believed the training was adequate. Finally, the
contracting and program officials on an estimated 94 percent of DOD award-
and incentive-fee contracts felt that the guidance they used to develop
and administer the contract was adequate.

Award-Fee Contracts: Fee Criteria and Payouts Not Routinely Linked to
Acquisition Outcomes

DOD programs do not structure award fees in a way that motivates
contractors to achieve or holds contractors accountable for achieving
desired acquisition outcomes. In several contracts we evaluated, DOD
established award-fee criteria that were focused on broad areas, such as
how well the contractor was managing the program. This can result in
award-fee plans and criteria that seemingly have little to do with
acquisition outcomes, such as meeting cost and schedule goals and
delivering desired capabilities. For example, on a Navy ship construction
contract, 50 percent of the award-fee money, or $28 million, was based on
management criterion including how responsive the contractor was to the
government customers, the quality and accuracy of contract proposals, and
the timeliness of contract data requirements. Elements of the award-fee
process, such as the frequency of evaluations, may also limit DOD's
ability to effectively evaluate the contractor's progress toward
acquisition outcomes. For instance, while holding award-fee evaluations
every quarter was successful for three Pentagon Renovation Management
construction contracts because the contractor's short-term progress could
easily be assessed, a similar strategy might not be effective for a
long-term development effort because quarterly or even semiannual
evaluations may not generate meaningful information about progress.

20 The sum of these estimates exceeds 100 percent because respondents to
our questionnaire were provided seven potential reasons as to why award
and incentives fees were used in the contract and were asked to choose all
that applied.

High award-fee payouts on programs that have fallen or are falling well
short of meeting their stated goals are also indicative of DOD's failure
to implement award fees in a way that promotes accountability. Several
major development programs-accounting for 52 percent of the available
award-fee dollars in our sample and 46 percent of the award-fee dollars
paid to date-are not achieving or have not achieved their desired
acquisition outcomes, yet contractors received most of the available award
fee. The Comanche helicopter, F/A-22 and Joint Strike Fighter aircraft,
and the Space-Based Infrared System High satellite system, have
experienced significant cost increases, technical problems, and
development delays, but the prime systems contractors have respectively
received 85, 91, 100, and 74 percent of the award fee made available to
date (adjusted for rollover), totaling $1.7 billion (see table 6).

Table 6: Program Performance and Award-Fee Payments on Selected DOD
Development Programs

                                                           Joint              
                                                          Strike              
                                         F/A-22 Raptor   Fighter              
                               Comanche       tactical  tactical  Space-Based
Acquisition           reconnaissance        fighter   fighter     Infrared
outcomes           attack helicopter       aircraft  aircraft  System High
Research and        $3.7 billion41.2          $10.2     $10.1         $3.7 
development cost             percent    billion47.3   billion  billion99.5 
increase over                               percent      30.1      percent 
baseline                                              percent 
Acquisition cycle      33 months14.8  27 months13.3 11 months More than 12 
time increase over           percent        percent       5.9      monthsa 
baseline                                              percent 
Number of program                 1b             14         1            3 
rebaselines                                                   
Total award fee               $202.5 $848.7 million    $494.0       $160.4 
paid to prime            millionpaid                  million     millionc 
systems contractor      through 2004                          
Percentage of           85 percentof     91 percent       100   74 percent 
award fee paid to      available fee                  percent 
prime systems                                                 
contractor                                                    
(adjusted for                                                 
rollover) d                                                   
Total award fee            No engine           $115     $35.8    No engine 
paid to prime             contractor    millionpaid   million   contractor 
engine contractor                      through 2004           
Percentage of                    N/A   89 percentof       100          N/A 
award fee paid to                     available fee   percent 
prime engine                                                  
contractor                                                    
(adjusted for                                                 
rollover) d                                                   

Sources: DOD submissions to GAO, contract documentation, and GAO-05-301
(data); GAO (analysis).

a The Air Force Space Command has not specified the acquisition cycle time
for the Space-Based Infrared System High program; however, the delivery of
the first two satellites has been delayed by more than a year.

b Overall, there were five rebaselines for the Comanche program; however,
only one occurred after development start. The Comanche program was
canceled in 2004.

c The program also utilizes incentive fees tied to cost and mission
successes. The award fee paid does not include fees earned through mission
success incentives. To date, the contractor has earned $3 million in these
fees and could earn over $70 million over the life of the contract.

d When calculating the percentage of award fee paid to date (i.e.,
percentage of award fee paid to date = total fee paid to date / (total fee
pool - remaining fee pool)), we included rolled-over fees in the remaining
fee pool when those fees were still available to be earned in future
evaluation periods. For instance, even though the Joint Strike Fighter
prime contractor has not been paid 100 percent of the award fee that was
made available for each evaluation period, it retains the ability to
potentially earn all of this unearned fee at a later date. By reflecting
the continued availability of this unearned fee in the percentage
calculation, it becomes clear that the contractor has, in essence, earned
100 percent of the total award fee to date.

DOD can ensure that fee payments are more representative of program
results by developing fee criteria that focus on its desired acquisition
outcomes. We found two notable examples in which DOD's Missile Defense
Agency attempted to hold contractors accountable for program outcomes. In
the case of the Airborne Laser program, DOD revised the award-fee plan in
June 2002 as part of a program and contract restructuring. The award-fee
plan was changed to focus on achieving a successful system demonstration
by December 2004. Prior to the restructuring, the contractor had received
95 percent of the available award fee, even though the program had
experienced a series of cost increases and schedule delays. The contractor
did not receive any of the $73.6 million award fee available under the
revised plan because it did not achieve the key program outcome-successful
system demonstration.21 Similarly, the development contract for the
Terminal High Altitude Area Defense program, a ground-based missile
defense system, contains a portion of the award fee tied specifically to
desired program outcomes-conducting successful flight tests, including
intercepts of incoming missiles. This $50 million special award-fee pool
is separate from and in addition to the subjective award-fee portion of
the contract, which is worth more than $524 million (of which $275 million
has already been paid). If one of the first two test flights is
successful, the contractor will receive $25 million. If the missile misses
the target, the contractor provides DOD with a cost credit of $15 million.
The first of these flight tests is scheduled to occur before the end of
calendar year 2005.

Other programs have utilized different fee strategies to focus the
contractor's attention on specific acquisition outcomes. However,
contracting officials have stated that there are few mechanisms to share
lessons learned and innovative practices outside the local level. These
approaches include conditional fees and linked incentives.

           o  Conditional fees stipulate that certain requirements must be
           met for a contractor to earn and keep fees. For example, we
           reviewed an Intercontinental Ballistic Missile program award-fee
           plan that included an "After Discover Performance Deficiencies"
           provision to ensure that award-fee payouts were consistent with
           program outcomes. This provision allowed the program to retrieve
           funds paid during prior award-fee periods if the program
           experienced overruns or if performance deficiencies were
           discovered after the award fee has been paid.

           o  Linked incentives evaluate cooperation across multiple
           contracts and contractors. For example, after initial
           interoperability problems, the Cooperative Engagement Capability
           program added award-fee criteria to evaluate how well the system
           integrated with the Aegis destroyer.

21 According to DOD, the contract was restructured again in May 2004 and
the cost ceiling was increased from about $2 billion to $3.6 billion and
the period of performance of the contract was extended more than 3 years,
from June 2005 to December 2008.

Incentive-Fee Contracts: Many Contracts Not Meeting Cost or Performance Targets

Contracts with incentive fees have also not fared well at motivating
cost-control behavior or meeting program targets; however, fee payments
are more consistent with acquisition outcomes. According to DOD
contracting and program officials, contractors overran or were expected to
overrun the target price on 52 percent of the 27 incentive-fee contracts
in our sample. In these cases, the contractor does not earn the target fee
but may earn a minimum fee, if one is specified in the contract. For
example,

           o  the Navy's cost-plus-incentive-fee contract for the LPD 17, an
           amphibious transport dock ship, is projected to overrun the target
           price of $644 million by at least 139 percent;
           o  on the Army's Brilliant Anti-Armor Submunition program, a
           fixed-price incentive contract for test hardware, overran the $75
           million target cost by 27 percent ($20 million); and
           o  the fixed-price incentive contract for the Navy's P-3C
           Sustained Readiness Program initially called for 50 kits to be
           produced, but only 13 were delivered before contract funding was
           exhausted.

Incentive-fee contracts that also included performance and delivery
incentives similarly have not met those key objectives, as shown in the
examples below.

           o  Even though the system received approval from the Navy in June
           2005 for low-rate initial production, the contracting officer and
           program manager stated that the cost, delivery, and technical
           incentives in the Airborne Laser Mine Detection System program did
           not improve contractor performance. During the course of the
           effort, the contractor experienced several cost overruns, as well
           as technical performance shortfalls. In addition, because of
           government delays, program officials decided to eliminate the
           delivery incentive included in the initial contract.

           o  According to the contracting and program officials responsible
           for administering and managing one of the Army's chemical
           demilitarization contracts, performance milestones with incentive
           fees were an important part of the Army's effort to accelerate the
           destruction of chemical weapons stockpiles after the events of
           September 11, 2001. However, these incentives did not keep the
           contract on schedule. The contractor missed the target completion
           date for the third of its four performance incentive milestones
           and the program was delayed by over a year. According to DOD, the
           failure to meet this milestone was due to unforeseen technical
           difficulties, and could not have been ultimately influenced by any
           type of contractual language.

In contrast, the successful use of fee is supported by the level of
product knowledge attained by officials and their ability to leverage this
knowledge. For example, DOD contracting officials for the Patriot Advanced
Capability-3 missile had a well-developed knowledge of the acquisition's
cost risks and were able to reduce costs by $42 million for the low-rate
initial production contract. Contracting officials stated that the
favorable outcome was due to the use of a cost model that was developed
and matured on the previous production contract.

Unlike award-fee contracts, incentive-fee contracts are based on
formula-like mechanisms that determine the amount of fee earned. When a
contractor misses a target in an incentive-fee contract, the reduction of
fees is usually automatic and based on the application of a predetermined
formula.22 The nature of the fee criteria in these contracts also
eliminates most of the subjectivity in the evaluation process. Cost,
schedule or delivery, and performance incentives are all based on targets
that can be evaluated against actual costs, actual dates, and actual
performance. In addition, negative incentives allow for fee reductions if
the contractor does not meet certain criteria. For example, on one of the
Navy's carrier refueling and overhaul contracts, the contractor's fee
could be reduced if its overhead rate exceeded a certain target. Since
incentive fees, especially those related to cost, are primarily evaluated
at the conclusion of the contract, the officials applying the evaluation
criteria or fee formula have a clear sense of the contractor's
performance.

22 We found one instance of DOD using the equivalent of rollover for
incentive-fee contracts. When the contractor missed the third program
milestone on the Army chemical demilitarization contract, the program
delayed the milestone by 14 months and offered the contractor a chance to
earn 80 percent of the available fee. According to program officials, the
performance incentive milestone was rescheduled to re-incentivize the
contractor.

  DOD Has Little Evidence That Monetary Incentives Improve Results as Intended

DOD's use of monetary incentives is based on the assumption that such
incentives can improve contractor performance and acquisition outcomes;
however, past studies have challenged the validity of this assumption.
Research on incentive fees going back to the 1960s has concluded these
incentive fees are not effective in controlling cost.23 Studies conducted
by GAO, Harvard University, and the RAND Corporation, among others, have
concluded that these incentives do not motivate cost efficiency, in part
because profit is not the contractor's only motivation. Other
considerations, such as securing future contracts with the government, can
be stronger motivators than earning additional profit. More recently,
research on award fees revealed that while these fees are an intuitively
appealing way to improve contractor performance, they do not always
operate that way in practice. Contractor respondents in one study stated
that award fees motivate performance to some extent; however, the
consensus was that they do not in and of themselves increase performance
significantly. Research has also pointed to recurring disconnects between
the intent and the administration of award-fee contracts. Award-fee
criteria were not applied as intended; and many award-fee board members
and fee-determining officials approached the process with the assumption
the contractors should earn the full amount unless there were specific
instances of poor performance that warranted deductions, instead of
starting at zero and considering the actions the contractor had taken to
earn the available fee. Finally, the lack of explicit rationale and
documentation in support of performance ratings has led some researchers
to conclude that fees were being paid without adequate justification.24

Despite these findings and the concerns raised by senior DOD officials
about the amounts of award fee paid to contractors on acquisitions that
were not performing to their established baselines, very little effort has
gone into determining whether DOD's current use of monetary incentives is
effective. Over the past few years, officials including the Undersecretary
for Acquisition Technology and Logistics and the Assistant Secretary of
the Air Force for Acquisition expressed concerns that contractors
routinely earn high percentages of fee while programs have experienced
performance problems, schedule slips, and cost growth.25 In 1999,
following a report by a DOD-led integrated process team addressing
contractor incentives, the Undersecretary of Defense also issued a
memorandum for all service secretaries specifically noting that
contractors do not always have an incentive to focus their attention on
the government's desired outcomes and offered several principles for
structuring future contract incentives. However, according to the lead of
the integrated process team from the Office of the Secretary of Defense,
the effort did not result in any new policy directives, changes in
guidance, or new training. In addition, DOD did not assess the results of
the study.

23 GAO, Incentive Contracts: Examination of Fixed-Price Incentive
Contracts, GAO/NSIAD-88-36BR (Washington, D.C.: November, 1987). Frederic
M. Scherer, The Weapons Acquisition Process: Economic Incentives (Boston:
Harvard University, 1964). Irving N. Fisher, A Reappraisal of the
Incentive Contracting Experience (Santa Monica: The RAND Corporation,
1968).

24 Thomas J. Snyder, Analysis of Air Force Award Fee and Award Term
Contract Implementation (Air Command and Staff College: Air University,
2001).

In contrast to the concerns expressed by DOD's senior acquisition
leadership, we gathered testimonial evidence that indicates DOD
contracting and program officials believe that these monetary incentives
are effective for improving contractor performance. Based on responses to
our questionnaire, an estimated 77 percent of DOD award- and incentive-fee
contracts had improved performance because of the incentive provisions, in
the opinion of contracting and program officials. On award-fee contracts,
officials pointed to increased responsiveness or attention from the
contractor at the management level as evidence of this improvement, even
if this increased responsiveness did not result in overall desired program
outcomes being achieved.

One of the potential reasons for this disconnect between statements at the
policy level and the opinions of practitioners is the lack of a DOD-wide
system for compiling and aggregating award- and incentive-fee information
and for identifying resulting trends and outcomes. DOD has not compiled
information, conducted evaluations, or used performance measures to judge
how well award and incentive fees are improving or can improve contractor
performance and acquisition outcomes. The lack of data is exemplified by
the fact that DOD does not track such basic information as how much it
pays in award and incentive fees. Such information collection across DOD
is possible. For instance, DOD is implementing the Defense Acquisition
Management Information Retrieval system to collect data on acquisition
costs and variances, schedules, and program baseline breaches on major
acquisition systems. This system provides DOD policymakers with readily
available information they can use to oversee program performance across
the department. If DOD does not begin to collect similar information on
award and incentive fee payments, it may not be able to measure progress
toward meeting one of the goals listed in its fiscal 2004 performance and
accountability report, that is, invigorating the fiscal well-being of the
defense industry by rewarding good performance.

25 In its technical comments on a draft of this report, DOD stated that
the Air Force's Acquisition Transformation Action Council is currently
analyzing award- and incentive-fee contracts and aggressively pursuing
solutions to the problems outlined in the draft report. A Transformation
Initiative Group was assembled to provide recommendations back to the
Acquisition Transformation Action Council for implementation.

                                  Conclusions

The existence or application of a well-developed and well-implemented
monetary incentive alone does not determine the overall success or failure
of an acquisition. DOD acquisition programs operate in an environment with
underlying pressures and incentives that drive both program and contractor
behavior. Competition for funding and contracts leads to situations,
especially in major system acquisitions, in which costs are underestimated
and capabilities are overpromised. Resulting problems require additional
time and money to address. At the same time, DOD customers are tolerant of
cost overruns and delays in order to get a high-performance weapon system.
DOD's current approach toward monetary incentives reflects these realities
and has resulted in a failure to hold contractors accountable for
delivering and supporting fielded capabilities within cost and schedule
baselines. While DOD and contractors share the responsibility for program
success, award and incentive fees, to be effective, need to be realigned
with acquisition outcomes. Awarding large amounts of fee for satisfactory
or lesser performance and offering contractors multiple chances to earn
previously withheld fees has fostered an environment in which DOD expects
to pay and contractors expect to receive most of the available award fee
regardless of outcomes. In addition, DOD's lack of information on how well
award and incentive fees are achieving their intended purpose leaves the
department vulnerable to millions of dollars of potential waste. Successes
do exist at the individual contract level, but DOD will need to leverage
this knowledge if it hopes to identify proven incentive strategies across
a wide variety of DOD acquisitions.

                      Recommendations for Executive Action

To strengthen the link between monetary incentives and acquisition
outcomes and by extension increase the accountability of DOD programs for
fees paid and of contractors for results achieved, we recommend that the
Secretary of Defense direct the Undersecretary of Defense for Acquisition,
Technology, and Logistics to take the following seven actions. DOD can
immediately improve its use of award fees on all new contracts by (1)
instructing the military services to move toward more outcome-based
award-fee criteria that are both achievable and promote accountability for
acquisition outcomes; (2) ensuring that award-fee structures are
motivating excellent contractor performance by only paying award fees for
above satisfactory performance; and (3) requiring the appropriate
approving officials to review new contracts to make sure these actions are
being taken. DOD can improve its use of award fees on all existing
contracts by (4) issuing DOD guidance on when rollover is appropriate. In
the longer term, DOD can improve its use of award and incentive fees by
(5) developing a mechanism for capturing award- and incentive-fee data
within existing data systems, such as the Defense Acquisition Management
Information Retrieval system; (6) developing performance measures to
evaluate the effectiveness of award and incentive fees as a tool for
improving contractor performance and achieving desired program outcomes;
and (7) developing a mechanism to share proven incentive strategies for
the acquisition of different types of products and services with
contracting and program officials across DOD.

                       Agency Comments and Our Evaluation

DOD's Office of Defense Procurement and Acquisition Policy provided
written comments on a draft of this report. These comments are reprinted
in appendix II. DOD also provided separate technical comments, which we
have incorporated as appropriate.

DOD concurred with three of our seven recommendations-moving toward more
outcome-based award-fee criteria, issuing guidance on rollover, and
developing a mechanism to share proven incentive strategies. The
department indicated that it would implement these recommendations by
issuing a policy memorandum on award fees and completing a communications
plan for sharing incentive strategies on March 31, 2006.

DOD partially concurred with four of our seven recommendations. Concerning
three of the four recommendations-requiring the appropriate officials to
make sure these recommendations are implemented in new contracts,
collecting award and incentive fee data, and developing performance
measures to evaluate the effectiveness of award and incentive fees in
improving acquisition outcomes-DOD indicated that the Director of the
Office of Defense Procurement and Acquisition Policy, in collaboration
with the military departments and defense agencies, would conduct a study
to determine the appropriate actions to address them. The office plans to
complete the study by June 1, 2006. While this study may provide
additional insights, we encourage DOD to use it as a mechanism for
identifying the specific steps the department will take to fully address
our recommendations, not to determine whether the department will take
action. For instance, in its response to our recommendation on developing
a mechanism for capturing award and incentive fee data, DOD raises the
issue of cost. We agree that the potential cost of implementing this
recommendation should be considered, while deciding on an appropriate
course of action. However, given that the department paid out an estimated
$8 billion in award fees on the contracts in our study population
regardless of outcomes, we believe that a reasonable investment in
ensuring that these funds are well-spent in the future is warranted.
Collecting this data is also necessary to support the development of
meaningful performance measures, which can be used to evaluate the costs
and benefits of continuing to use these contract types and determine if
they are achieving their goal of improving contractor performance and
acquisition outcomes. Further, without data and performance measures, DOD
will not be in a position to measure the effectiveness of any actions it
takes to address the issues identified in this report.

DOD also partially concurred with our recommendation related to only
paying award fees for above satisfactory performance. Specifically, the
department stated that it is fair and reasonable to allow the contractor
to earn a portion of the award fee for satisfactory performance. However,
we believe that this use of award fee should be the exception, not the
rule. Fixed-price-award-fee contracts already include a normal level of
profit in the price which is paid for satisfactory performance. In
addition, the inclusion of base fee in a cost-plus-award-fee contract may
be a more appropriate mechanism for providing fee for satisfactory
performance. According to the Army Contracting Agency's Handbook for Award
Fee Contracts, base fee (not exceeding three percent of the estimated
contract cost) can be paid to the contractor for acceptable performance
and is designed to compensate the contractor for factors such as risk
assumption, investment, and the nature of the work. DOD also stated that
award fee arrangements should be structured to encourage the contractor to
earn the preponderance of fee by providing excellent performance.
According to its comments, DOD plans to address this issue in the March
2006 policy memorandum on award fees. While DOD may conclude that it needs
the flexibility to pay a portion of the award fee for satisfactory
performance, especially for high risk efforts, current practice on most
award fee contracts is to pay a significant portion of the available fee
for "acceptable, average, expected, good, or satisfactory" performance. We
would encourage DOD to consider limiting the maximum percentage of fee
available for this level of performance to, consistent with its comments,
keep the preponderance of fee available for excellent performance.

We are sending copies of this report to interested congressional
committees; the Secretary of Defense; the Secretaries of the Air Force,
Army, and Navy; the Commandant of the Marine Corps; and the Director,
Office of Management and Budget. We will provide copies to others on
request. This report will also be available at no charge on GAO's Web site
at http://www.gao.gov.

If you have any questions about this report or need additional
information, please call me at (202) 512-4841 ([email protected]).
Contact points for our Offices of Congressional Relations and Public
Affairs may be found on the last page of this report. Other staff making
key contributions to this report were Thomas J. Denomme, Assistant
Director; Robert Ackley; Heather Barker; Lily J. Chin; Aftab Hossain;
Julia Kennon; John Krump; Jerry Sandau; Sidney Schwartz; Ron Schwenn;
Najeema Davis Washington; and E. Chris Woodard.

Ann M. Calvaresi-Barr Director Acquisition and Sourcing Management

Appendix I: Scope and Methodology  Appendix I: Scope and Methodology

Our objective was to determine whether award and incentive fees are an
effective management tool for achieving the Department of Defense's (DOD)
desired outcomes. To conduct our work, we selected a sample of 93 award-
and incentive-fee contracts, interviewed contracting and program
officials, analyzed contract documentation related to incentive
provisions, collected and analyzed data on award-fee payments, reviewed
DOD and military service guidance on award and incentive fees, and
examined the results of initiatives related to improving the use of these
fees.

Our sample for this review was based on contract data from the Federal
Procurement Data System. We extracted information from this database on
all DOD contracts active between fiscal years 1999 through 2003 that had
at least one contract action coded as cost-plus-award-fee,
cost-plus-incentive-fee, fixed-price-award-fee, or fixed-price incentive
valued at $10 million or more during that time. These criteria gave us a
study population of 597 unique contracts, which were associated with 2,474
award- and incentive-fee contract actions.

To ensure the validity of the database from which we drew our sample, we
tested the reliability of the contract type field in the Federal
Procurement Data System.1 We selected a sample of 30 contracts from the
population of DOD contracts active between fiscal years 1999 through 2003
and asked DOD and the military services to provide data on the contract
type(s) for each one using data sources other than the Federal Procurement
Data System or Individual Contracting Action Reports (DD Form 350). We
also requested that DOD and the military services verify that at least one
contract action between fiscal years 1999 through 2003 was valued at over
$10 million. Of the 30 contracts, DOD and the military services reported
that 10 were either incorrectly coded or omitted information on a relevant
contract type in the Federal Procurement Data System. Of these 10 errors,
only 3 would have caused a contract to be mistakenly included or excluded
in the population from which our sample was selected. Based upon these
responses and the exclusion of only one contract from our sample because
of miscoding in the Federal Procurement Data System, we determined that
the data were sufficiently reliable for the purposes of this report.

1 See GAO, Reliability of Federal Procurement Data, GAO-04-295R
(Washington D.C.: Dec. 30, 2003), for more information on the reliability
of the data.

To select the sample for this review, we stratified the population of 597
contracts based on the total dollar value of award- and incentive-fee
contract actions associated with the contract during this period. We
included all 12 contracts in the sample for which the total value of the
award- and incentive-fee contract actions during this period exceeded $2
billion. We used probability sampling techniques to select 85 contracts
from the remaining 585 contracts in the population, ensuring that the
number of contracts from the Navy, Army, Air Force, and all other defense
agencies and organizations combined were proportional to their
representation among the 585. During our work, we discovered that 2 of the
85 contracts we sampled from the stratum of 585 contracts were outside of
the scope of this review. These contracts were removed from the sample. We
also discovered that for 2 other in-scope contracts in this stratum, the
officials involved in developing and administering the contract and the
contract documentation were not available. We excluded these contracts
from our analysis. We randomly selected a total of 4 additional contracts
from the same stratum to include in our analysis.

Because we followed a probability procedure based on random selections,
our sample is only one of a large number of samples that we might have
drawn. Since each sample could have provided different estimates, we
express our confidence in the precision of our particular sample's results
as 95 percent confidence intervals (for example, plus or minus 7
percentage points). These are the intervals that would contain the actual
population values for 95 percent of the samples we could have drawn. As a
result, we are 95 percent confident that each of the confidence intervals
in this report will include the true values in the study population. All
percentage estimates from our review have margins of error (that is,
confidence interval widths) not exceeding plus or minus 10 percentage
points, unless otherwise noted. All numerical estimates other than
percentages (such as totals and ratios) have margins of error not
exceeding plus or minus 25 percent of the value of those estimates. Our
analysis also tested the extent to which statistically significant
relationships existed between such factors as contract type, reasons an
incentive contract was chosen, types of officials involved in developing
the incentive structure, use of rollover, training, and guidance; and
contracts that contracting and program officials have cited improved
contractor performance because of the use of incentive.

To determine whether award and incentive fees are an effective management
tool, we conducted structured interviews with contracting and program
officials about the development, implementation, and effectiveness of the
incentive structure for 92 of the 93 award- and incentive-fee contracts in
our sample; analyzed contract documentation related to incentive
provisions; and collected and analyzed data on award-fee payments for 63
of the 66 contracts with award-fee provisions in our sample. For one
contract, the office responsible for administering the contract could not
identify any contracting or program personnel who could address our
interview topics and all questions were coded as "no response." For three
contracts, the office responsible for administering the contract could not
provide complete documentation on award-fee payments.

To conduct our structured interviews on the development, implementation,
and effectiveness of the incentive structure, we used a questionnaire that
was a combination of open- and close-ended questions. When possible, these
interviews were held in person. We visited the Defense Threat Reduction
Agency Headquarters; Joint Strike Fighter Program Office; Los Angeles Air
Force Base; Missile Defense Agency (Navy Annex); Patuxent Naval Air
Station; Pentagon Renovation and Construction Program Office; Redstone
Arsenal; U.S. Army Contracting Agency's Information Technology, E-Commerce
and Commercial Contracting Center; U.S. Navy's Strategic System Program
Office; Warner Robins Air Force Base; Washington Navy Yard; and Wright
Patterson Air Force Base for this purpose. The remaining interviews were
held by video teleconference or by telephone. All interviews were
conducted between October 2004 and April 2005.

We also reviewed contract documentation related to the development and
implementation of the contracts' incentives, including the basic contract,
statement of work, acquisition planning documents, modifications related
the incentive structure, award-fee plan, documentation describing fee
criteria for specific evaluation periods, contractor self-assessments,
award-fee board evaluation reports, and fee-determination documents. We
used this information to corroborate and supplement the information
provided in the structured interviews, determine the extent to which
linkages exist between fee criteria and the desired program outcomes
identified by contracting and program officials, and examine fee payments
in the context of program performance. When possible, we evaluated program
and contract performance using GAO's body of work on DOD systems
acquisitions, including the annual assessment of selected major weapon
programs and annual status report on the ballistic missile defense
program.

For each of the 66 award-fee contracts in our sample, we collected and
analyzed data on the base fee and maximum award fee, expressed as a
percentage of the estimated cost, exclusive of the cost of money; the
award fee available and paid for each evaluation period; the amount of
unearned fee rolled over into subsequent evaluation periods; the total
award-fee pool; and the remaining award-fee pool, which included any
rolled-over fee still remaining to be potentially earned. In most cases,
contracting and program officials submitted the data on a standard
template we provided. In cases where the program did not submit data in
the requested format, we gathered this information from fee-determination
letters and contract modifications. We also used these documents to verify
the reliability of the data that were submitted by contracting and program
officials. From this data, we calculated the percentage of the available
fee that was awarded for individual evaluation periods, entire contracts
to date, and the overall sample. We included rollover amounts available
and earned in our calculations of fee awarded for individual evaluation
periods. When calculating the percentage of fee earned for entire
contracts, we excluded rolled-over fees from the available fee pool when
those fees were still available to be earned in future evaluation periods.
We also calculated the percentage of unearned fee that was made available
to the contractor as rollover for individual evaluation periods, entire
contracts, and the overall sample. Estimates of total award fees earned
and total award fees that were rolled over are based on all evaluation
periods held from the inception of our sample contracts through our data
collection phase, not just those from fiscal years 1999 through 2003. We
did not analyze incentive fee payments because most fee determinations are
related to cost and are not complete until the contract is closed out.

We interviewed officials from Defense Acquisition University, Office of
Director of Defense Procurement and Acquisition Policy, Office of the
Deputy Assistant Secretary of the Air Force for Contracting (Policy and
Implementation), Office of Deputy Assistant Secretary of the Army (Policy
and Procurement), Office of the Deputy Assistant Secretary of the Navy for
Acquisition Management, Office of the Air Force Inspector General, and the
U.S. Army Audit Agency, as well as government contracting experts on
recent initiatives and current trends in incentive contracting. We
reviewed previous audit and inspection reports from the Air Force, Army,
and Navy. We analyzed current award- and incentive-fee guidance provided
in the Federal Acquisition Regulation, Defense Federal Acquisition
Regulation Supplement, U.S. Army Audit Agency's report on Best Practices
for Using Award Fees, Air Force Award Fee Guide, Air Force Material
Command Award Fee Guide, and other service-specific policies, as well as
the National Aeronautics and Space Administration's Award Fee Guide. We
identified and reviewed DOD and military service policy memos and
initiatives including DOD's Contractor Incentives Integrated Process Team;
the Assistant Secretary of the Navy for Research, Development, and
Acquisition's policy memo on Contract Incentives, Profits and Fees; the
Deputy Assistant Secretary of the Army for Procurement's report on
Innovation in Contractual Incentives; and the Office of the Undersecretary
of Defense for Acquisition, Technology, and Logistics' "quick look" at DOD
Profit Policy and Defense Industry Profitability. We identified innovative
monetary incentives used on contracts within our sample and the mechanisms
available to share those across DOD.

We performed our review from February 2004 to November 2005 in accordance
with generally accepted government auditing standards.

Appendix II: Comments from the Department of Defense  Appendix II:
Comments from the Department of Defense

Appendix III: Contracting Definitions  Appendix III: Contracting
Definitions

Award fee: An amount of money that is added to a contract and that a
contractor may earn in whole or in part during performance and that is
sufficient to provide motivation for excellence in the areas such as
quality, schedule, technical performance, and cost management.

Base fee: An award-fee contract mechanism that is an amount of money over
the estimated costs (typically in the range of 0 to 3 percent of the
contract value), which is fixed at the inception of the contract and paid
to the contractor for performance in a cost-plus-award-fee contract. A
base fee is similar to the fixed fee paid to a contractor under a
cost-plus-fixed- fee contract that does not vary for performance.

Ceiling price: A prenegotiated maximum price that may be paid to the
contractor.

Cost contract: A cost-reimbursement contract in which the contractor
receives no fee. A cost contract may be appropriate for research and
development work, particularly with nonprofit educational institutions or
other nonprofit organizations, and for facilities contracts.

Cost-plus-award-fee contract: A cost-reimbursement contract that provides
for a fee consisting of a base amount (which may be zero) fixed at
inception of the contract and an award amount, based upon a judgmental
evaluation by the government, sufficient to provide motivation for
excellence in contract performance.

Cost-plus-incentive-fee contract: A cost-reimbursement contract that
provides for an initially negotiated fee to be adjusted by a formula based
on the relationship of total allowable costs to total target costs.

Cost-reimbursable contract: A contract that provides for payment of the
contractor's allowable cost to the extent prescribed in the contract not
to exceed a ceiling.

Delivery incentives: A monetary incentive used to motivate the contractor
to meet a particular product or service delivery objective.

Fixed-price contract: A contract that provides for a price that is either
fixed or subject to adjustment obligating the contractor to complete work
according to terms and for the government to pay the specified price
regardless of the contractor's cost of performance.

Fixed-price-award-fee contract: A variation of the fixed-price contract in
which the contractor is paid the fixed price and may be paid a
subjectively determined award fee based on periodic evaluation of the
contractor's performance.

Fixed-price incentive contract: A fixed-price contract that provides for
adjusting profit and establishing the final contract price by application
of a formula based on the relationship of total final negotiated cost to
total target cost.

Incentive contract: A contract used to motivate a contractor to provide
supplies or services at lower costs and, in certain instances, with
improved delivery or technical performance, by relating the amount of fee
to contractor performance.

Linked incentives: Incentives tied to performance in areas across multiple
contracts and contractors and used to motivate contractors to cooperate.

Negative incentives: A method used by the government to allow for fee
reductions if the contractor does not meet certain criteria.

Rollover: The process of moving unearned award fee from one evaluation
period to a subsequent period or periods, thus allowing the contractor an
additional opportunity to earn that unearned award fee.

Share ratio: A fee-adjustment formula written as a ratio of the cost risk
between the government and the contractor.

Target cost: The preestablished cost of the contracted goods/services that
is a reasonable prediction of final incurred costs.

Appendix IV: Sample Characteristics  Appendix IV: Sample Characteristics

GAO's sample of 93 award and incentive contracts comprises the following
contract types:

           o  48 cost-plus-award-fee contracts,
           o  4 fixed-price-award-fee contracts,
           o  12 cost-plus-incentive-fee contracts,
           o  14 fixed-price incentive contracts,
           o  1 cost-plus-incentive-fee / fixed-price incentive contract, and
           o  14 contracts that are combinations of award- and incentive-fee
           contract types.

The sample contracts included the following breakdown by military service
and DOD agency or organization:

           o  37 Navy contracts,
           o  30 Air Force contracts,
           o  18 Army contracts,
           o  3 Missile Defense Agency contracts,
           o  3 Pentagon Renovation Management Office contracts,
           o  1 Marine Corps contract, and
           o  1 Defense Threat Reduction Agency contract.

Appendix V: GAO Reports on the Weapon Systems Acquisition Environment 
Appendix V: GAO Reports on the Weapon Systems Acquisition Environment

Defense Acquisitions: Stronger Management Practices Are Needed to Improve
DOD's Software-Intensive Weapon Acquisitions. GAO-04-393. Washington,
D.C.: March 1, 2004.

Defense Acquisitions: DOD's Revised Policy Emphasizes Best Practices, but
More Controls Are Needed. GAO-04-53. Washington, D.C.: November 10, 2003.

Best Practices: Setting Requirements Differently Could Reduce Weapon
Systems' Total Ownership Costs. GAO-03-57. Washington, D.C.: February 11,
2003.

Best Practices: Capturing Design and Manufacturing Knowledge Early
Improves Acquisition Outcomes. GAO-02-701. Washington, D.C.: July 15,
2002.

Defense Acquisitions: DOD Faces Challenges in Implementing Best Practices.
GAO-02-469T. Washington, D.C.: February 27, 2002.

Best Practices: Better Matching of Needs and Resources Will Lead to Better
Weapon System Outcomes. GAO-01-288. Washington, D.C.: March 8, 2001.

Best Practices: A More Constructive Test Approach Is Key to Better Weapon
System Outcomes. GAO/NSIAD-00-199. Washington, D.C.: July 31, 2000.

Defense Acquisition: Employing Best Practices Can Shape Better Weapon
System Decisions. GAO/T-NSIAD-00-137. Washington, D.C.: April 26, 2000.

Best Practices: DOD Training Can Do More to Help Weapon System Program
Implement Best Practices. GAO/NSIAD-99-206. Washington, D.C.: August 16,
1999.

Best Practices: Better Management of Technology Development Can Improve
Weapon System Outcomes. GAO/NSIAD-99-162. Washington, D.C.: July 30, 1999.

Defense Acquisitions: Best Commercial Practices Can Improve Program
Outcomes. GAO/T-NSIAD-99-116. Washington, D.C.: March 17, 1999.

Defense Acquisition: Improved Program Outcomes Are Possible.
GAO/T-NSIAD-98-123. Washington, D.C.: March 18, 1998.

Best Practices: Successful Application to Weapon Acquisition Requires
Changes in DOD's Environment. GAO/NSIAD-98-56. Washington, D.C.: February
24, 1998.

Major Acquisitions: Significant Changes Underway in DOD's Earned Value
Management Process. GAO/NSIAD-97-108. Washington, D.C.: May 5, 1997.

Best Practices: Commercial Quality Assurance Practices Offer Improvements
for DOD. GAO/NSIAD-96-162. Washington, D.C.: August 26, 1996.

(120326)

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Highlights of GAO-06-66, a report to the Subcommittee on Readiness and
Management Support, Committee on Armed Services, U.S. Senate

December 2005

DEFENSE ACQUISITIONS

DOD Has Paid Billions in Award and Incentive Fees Regardless of
Acquisition Outcomes

Collectively, the Department of Defense (DOD) gives its contractors the
opportunity to earn billions of dollars through monetary incentives-known
as award fees and incentive fees. These fees are intended to motivate
excellent contractor performance in areas deemed critical to an
acquisition program's success, with award fees being appropriate when
contracting and program officials cannot devise objective incentive fee
targets related to cost, technical performance, or schedule.

GAO was asked to determine whether award and incentive fees have been used
effectively as a tool for achieving DOD's desired acquisition outcomes. To
do this, GAO selected a probability sample of 93 contracts from the study
population of 597 DOD award- and incentive-fee contracts that were active
and had at least one contract action valued at $10 million or more from
fiscal year 1999 through 2003.

What GAO Recommends

GAO recommends that DOD improve its use of fees by specifically tying them
to acquisition outcomes in all new award- and incentive-fee contracts,
maximizing contractors' motivation to perform, and collecting data to
evaluate the effectiveness of fees. In its comments on a draft of this
report, DOD concurred or partially concurred with all of the
recommendations.

The power of monetary incentives to motivate excellent contractor
performance and improve acquisition outcomes is diluted by the way DOD
structures and implements incentives. While there were two examples in our
sample in which the Missile Defense Agency attempted to link award fees
directly to desired acquisition outcomes, such as demonstrating a
capability within an established schedule, award fees are generally not
linked to acquisition outcomes. As a result, DOD has paid out an estimated
$8 billion in award fees to date on the contracts in our study population,
regardless of outcomes. The following selected programs show this
disconnect.

Program Performance and Award-Fee Payments on Selected DOD Development
Programs

Sources: DOD submissions to GAO, contract documentation, and GAO-05-301
(data); GAO (analysis).

aWhen calculating the percentage of award fee paid (i.e., percentage of
award fee paid = total fee paid to date / (total fee pool - remaining fee
pool)), we included rolled-over fees in the remaining fee pool when those
fees were still available to be earned in future evaluation periods.

When DOD programs did not pay all of the available award fee, DOD gave
contractors on an estimated 52 percent of award-fee contracts at least a
second opportunity to earn an estimated $669 million in initially unearned
or deferred fees. GAO believes these practices, along with paying
significant amounts of fee for "acceptable, average, expected, good, or
satisfactory" performance, undermine the effectiveness of fees as a
motivational tool and marginalize their use in holding contractors
accountable for acquisition outcomes. They also serve to waste taxpayer
funds. Incentive fees provide a clearer link to acquisition outcomes;
however, a majority of the 27 contracts with cost incentives that GAO
reviewed failed or are projected to fail to complete the acquisition at or
below the target price.

Despite paying billions in fees, DOD has little evidence to support its
belief that these fees improve contractor performance and acquisition
outcomes. The department has not compiled data, conducted analyses, or
developed performance measures to evaluate the effectiveness of award and
incentive fees. In addition, when contracts have utilized different fee
strategies to focus the contractor's attention on specific acquisition
outcomes, contracting officials have stated that DOD has few mechanisms to
share lessons learned and innovative practices outside the local level.
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