Progress Payments vs Performance Based Payments On US

Agenda l Contract Financing l Progress Payments n Progress Payments based on Cost n Progress Payments based on Percent Complete l Performance Based (Milestone) Payments l PP vs PBP – A Head to Head Comparison n 2 Case Study l References l Questions Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Contract Financing - Basics FAR Part 32 l Purpose of contract financing is to assist the contractor in the payment of contract costs n FAR 32. 104(a): contracting officer must provide Govt financing only to the extent actually needed for prompt and efficient performance, n FAR 32. 105(a): for financing of contractor working capital 3 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Contract Financing - Basics Government Order of Preference – FAR 32. 106 l Private Financing without Govt Guarantee n Payment upon shipment/change of title l Customary Contract Financing n Progress Payments n Performance Based (Milestone) Payments l Loan Guarantees l Unusual Contract Financing l Advance Payments 4 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Contract Financing - Liquidation of Contract Financing Payments n The Government recoups financing payments through the deduction of liquidations from payments that would be due upon acceptance of contract deliverables. n The contracting officer applies a liquidation rate to the contract price of contract items delivered and accepted. n The ordinary method is that the liquidation rate is the same as the financing method rate. (Financing/Liquidation) – Progress Payments: (80%/20%) – Performance Based Payments: (90%/10%) 5 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Progress Payments 6 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Progress Payments l Two types of Progress Payments n Progress Payments based on Costs n Progress Payments based on Percent Complete l Progress payments based on Costs are contract financing calculated on the basis of contractor cost incurred. Progress Payments based on Percent Complete typically used for construction, shipbuilding & ship conversion. l 7 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Progress Payments based on Costs n Made as Contractor incurs costs during performance. n Designed to provide contract financing and ease strain on USG suppliers’ cash flow. Key Attributes: l l n n 8 80%(LB)/85%(SB)/90%(SDAB) of costs: a) paid or b) if unpaid, have already been invoiced and will be paid within 30 days of the Prime’s payment request to the USG. For Large Businesses: made on FFP or FPI contracts with values >$1, 000 with durations >6 months. For Small businesses: made on FFP or FPI contracts with values > $100, 000 with durations > 4 months. Requires significant oversight and interaction between contractor and US Government personnel. (PCO, DCMA, DCAA, DFAS, etc) Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Progress Payments Progress payments are not payments for finished goods – rather they are USG contract financing. n The USG provides an interest-free loan to the Contractor at a rate of 80% of their incurred costs. n The Contractor promises to “pay back” the progress payment loan by: – Making contractual deliveries/completing CLINs, and – Allocating some portion of the loan proceeds of the delivered unit price to liquidate the loan (liquidation rate) based on the negotiated unit prices. l 9 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Progress Payments l 10 Both the progress payment rate and the liquidation rate are set by statute. – FAR 32. 5 & DFARS 232. 5 n Progress Payments are fully recoverable in the event of contractor default n Responsibility to administer Progress Payments resides with the Buying Organization. Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Progress Payments - Benefits l Benefits of Progress Payments based on Costs: n n n 11 Provide an interest-free loan so the Contractor does not have to seek credit in the open-market. – Contractor cost-of-capital is 0% vs. current market rate. Loan proceeds (progress payments) arrive quickly – For Do. D contracts, COs must insert a standard payment due date of seven (7) days in the contract payment clause Invoices are based on cost-incurred and allows recoupment of 80% of incurred cost on a monthly basis. Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Progress Payments – Risks/Drawbacks l Progress Payment invoices are based on cost incurred and do not allow for the invoicing of Fee/Profit. n l DCMA must inspect and provide oversight for key business processes that can effect Contractor performance: n n n l Contractor would not be able to invoice Profit until they begin making contract deliveries. Business Systems: Accounting, Estimating, Property Cost: Accumulation and allocation of Direct & Indirect Costs Contractor Financial condition Invoicing process (preparation of Progress Payment invoices) Production & QA systems This means greater involvement by DCMA/DCAA throughout the entire execution phase of the program relative to standard FFP terms. 12 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Progress Payments – Risks/Drawbacks l In certain circumstances the USG could stop making progress payments to a contractor. n n n l Failure to comply with any material requirement Failure to make satisfactory progress Contractor Financial status in jeopardy Title: When the USG makes Progress Payments it takes title to all property acquired or produced under the contract. – When all liquidations are completed, the Contractor retains title to all property not delivered to the Government. l Risk of Loss – financing via Progress Payments causes title to immediately vest with the USG; however, the contractor still bears risk of loss 13 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based Payments 14 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based (Milestone) Payments Performance Based Payments: l l 15 Are the preferred USG financing method when the contracting officer finds them practical & the contractor agrees. Allow for contractors to invoice up to 90% of the contract price. Like PPs, PBPs are loans which are liquidated against the value of contract deliveries. Are fully recoverable in the event of default Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based (Milestone) Payments Performance Based Payments: l l 16 Like PPs, Do. D attempts to pay PBPs as quickly as possible. n A typical payment cycle remains Net 30. When the USG makes payments for PBP events it takes title to all property acquired or produced under the contract. n When all liquidations are completed, the Contractor retains title to all property not delivered to the Government. Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based Payments Benefits of Performance Based Payments: l l l 17 Enhanced Technical & Schedule Focus Broadened Contractor Participation Reduced Administrative Cost & Streamlined Oversight Enhanced Involvement of USG Program Managers Enhanced Contractor Cash Flow Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based Payments Benefits of Performance Based Payments: l l Enhanced Technical & Schedule Focus n PBPs link a contractor’s financing payment to critical elements of technical and schedule performance. n Establishing meaningful PBP events requires a thorough understanding of the cost, schedule and technical risks and proactive involvement of both the Contractor & USG. PBP Events should: n Represent meaningful aspects of contract performance n Be clearly and precisely defined using objective metrics based on clearly identifiable performance completion indicators. n May either be severable or cumulative. 18 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based Payments Benefits of Performance Based Payments: l 19 Broadened Contractor Participation n Traditional Progress Payments based on Costs may only be used with contractors with approved accounting systems. n With PBPs, the financing payments are structured on the basis of program performance instead of incurred costs. Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based Payments Benefits of Performance Based Payments: l 20 Reduced Cost of Administration/Streamlined Oversight n Because the financing payments are not based on costs, the Contractor accounting system is no longer an integral part of the financing process. n This reduces the need for USG auditors (DCMA/DCAA) to review payment requests and audit compliance with oversight systems. n Reduced DCMA/DCAA involvement means lower compliance costs = savings to the taxpayer. Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based Payments Benefits of Performance Based Payments: l 21 Enhanced involvement of Gov’t Program Managers n PBP is a management tool that allows the Government program manager (PM) to link financing to performance in fixed price contracts. n The PM gives the “thumbs up” (i. e. , pay the contractor) or “thumbs down” (i. e. , withhold payment) based on their assessment of the contractor’s technical and schedule results. n The contractor receives the negotiated payments only after the PM confirms successful completion of the payment events before the disbursement is made. Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based Payments Benefits of Performance Based Payments: l 22 Potential Improvements to Contractor Cash Flow n Structuring effective performance-based events can provide significant cash-flow advantages for a high performing contractor. n Under FAR 32. 1004, PBPs can be made for up to a specified portion of the contract’s or line item’s price (Up to 90%), n Using PBPs the Contractor can invoice for both Cost & Profit (Fee). This can result in enhanced contractor cash flow. Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based Payments When to use PBPs l 23 Features of Good Candidates for PBP Financing n The underlying item(s) being acquired have a stable design n Production processes are well established n The program plan and program schedule are well defined n Expected outcomes are thoroughly understood by all parties Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Performance Based Payments - Risks l In certain circumstances the USG could stop making performance based payments to a contractor. n n n l Failure to comply with any material requirement of the contract Failure to make satisfactory progress Contractor Financial status in jeopardy Title: When the USG makes Performance Based Payments it takes title to all property acquired or produced under the contract. – When all liquidations are completed, the Contractor retains title to all property not delivered to the Government. l Risk of Loss: regardless of the status of Title, unless expressly stated otherwise, the Contractor bears risk of loss. 24 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Case Study 25 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Case Study l l 26 Firm Fixed Price contract to deliver advanced targeting system to the US Navy. n FFP: $14. 5 M n Po. P: 14 months n Labor/M&S: 60% Labor/40% Subcontracts Key Values: n Price: $14. 5 M n Total Cost: $13. 2 M n Total Profit: $1. 3 M (10%) Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Using Progress Payments l Key Values: n Progress Rate/Liquidation Rate: 80%/20% n Price: $14. 5 M n Total Cost: $13. 2 M n Total Progress Payments: $10. 6 M n Net Invoice @ Delivery: $3. 9 M l Impact to Working Capital: n Min/Max Cash Flow: ($2, 628, 535)/($1, 277, 533) – Working capital recovered upon delivery, acceptance and liquidation of contract financing. 27 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Using Performance Based Payments l Key Values: n Performance Rate/Liquidation Rate: 90%/10% n Price: $14. 5 M n Total Cost: $13. 2 M n Total Milestones: $14. 5 M n Net Invoice @ Delivery: $1. 45 M l PBPs (Milestones) n Month 2 – POs Placed - $4. 25 M n Month 6 – Material Kitted - $4. 25 M n Month 9 – Assembly Start - $2. 75 M n Month 12 – Test Start - $1. 8 M n Month 15 – Final Delivery - $1. 45 M 28 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Using Performance Based Payments l 29 Impact to Working Capital: n Min/Max Cash Flow: (185, 022)/($3, 368, 943) – Positive working capital condition upon initial milestone invoicing. – Contractor remained cash flow positive throughout the contract. Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Using Payment on Delivery l l Key Values: n Performance Rate/Progress Rate: N/A n Liquidation Rate: N/A n Price: $14. 5 M n Total Cost: $13. 2 M n Total Milestones: $0 n Total Progress Payments: $0 n Net Invoice @ Delivery: $14. 5 M Impact to Working Capital: n Min/Max Cash Flow: ($13, 222, 467)/($1, 277, 533) – Working capital recovered upon delivery, acceptance and liquidation of contract financing. 30 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

Side-by-Side Comparison 31 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

References 32 Copyright 2012 Christopher Mikaelian. All Rights Reserved.

References: n n n n 33 Progress Payments based on Costs – FAR 32. 5, DFAR 232. 5, FAR 52. 232 -16, DFAR 252. 232 -16 Performance Based Payments – FAR 32. 10, DFAR 232. 10, FAR 52. 232 -32, DFAR 252. 232 -32 DAU, Progress Payments based on Costs – https: //acc. dau. mil/Community. Browser. aspx? id=381574 DAU, Performance Based Payments – https: //acc. dau. mil/Community. Browser. aspx? id=381576 DAU, Performance Based Payments Analysis Tool – https: //acc. dau. mil/Community. Browser. aspx? id=420492 The Gansler Memo, Undersecretary of Defense , AT&L, 13 Nov 2000 Users Guide to Performance Based Payments, 30 Nov 2001 Subcontract Project Management & Control – Progress Payments, 1991 Copyright 2012 Christopher Mikaelian. All Rights Reserved.