Posted in Finance Articles, Total Reads: 1925
, Published on 19 June 2012
Cost-plus financial contracts refer to contracts when the contractor gets paid for all expenses incurred to fulfill the contractual requirements along with fixed percentage or additional amount. Such contracts have to be closely monitored by the part offering the contract since contractors generally have a tendency to increase the expenses which increases the commission for them.
Often cost-plus contracts lead to inefficiency and over-spending by the contractor. The contractor does not take efforts to reduce the cost since that translates to reduction of profit for the contractor itself. In a fixed price contract, the profit for contractor is difference between cost and total contract amount. While in cost-plus contract, profit is proportional to cost. Hence, there is no motivation for the contractor to spend efficiently.
To motivate the contractor to complete the contractual requirements within estimated budgets, often incentives at low spending are introduced. For example, if a contractor spends under a certain amount, additional 1% commission is paid. This increases the profit margin of the contractor. However, this additional commission is often not enough motivation for the contractor to avoid over spending. Another way to reduce it is to have competition in contracts.
If same contract for different region or same contract divided into different jobs is awarded to competing contractors with a condition that complete contract would be transferred to better performing party, the sense of competition drives efficiency. Such a situation does not ensure high quality and in case of very high skilled contracts, contractors enjoy monopoly. Hence, even this method is not always successful.
Considering these facts, it is important to note why cost-plus contracts are adopted if they are so flawed. Cost-plus contracts have benefits for both the contracting party and the contractor. When it comes to high quality project, cost-plus is generally preferred as contractor does not use sub-standard material to save costs. This also reduces risk in a project since contractor is able to get financial reimbursement for all expense and so is financially secure at all times.
Cost-plus contracts in Iraq War
Iraq War (Gulf War 2) was fought between Iraq and United States of America in Iraq from March 20, 2003 to December 15, 2011. Iraq was claimed to be with possession of Weapons of Mass Destruction and Iraqi President Saddam Hussein was accused of harbouring and supporting terrorist organization Al-Qaeda.
Iraq war was fought in a unique way as it was the first time ever when private contractors were extensively used. Some of the private contractors were:
KBR – “LOGCAP” (Logistics Civil Augmentation Program to house, feed and transport troops)
Blackwater – Private security
Agility – Logistics
DynCorp – Logistics
Titan – Translator services
All these contractors had cost-plus contracts with US Military. According to Competition in Contracting Act of 1984, the contracts are offered with proper competitive bidding, however, as an exception contracts may be offered in limited competition or sole source basis of the in urgent situations competitive bidding is impracticable. Such process of sole source or limited competition bidding on basis of credibility of contractors is done after justification and necessary approvals. Such bidding was used for awarding several wartime contracts during Iraq War.
Overspending by Private Contractors
According to Commission of Wartime Contracting (CWC) report to congress, Iraq and Afghanistan operations had at least $31 billion to a possible $65 billion overspending due to wastage or fraud in contracts. Total contracts amounted to more than $200 billion for America’s contingency operations in these two countries.
Several whistleblowers and activists came forward against overspending by wartime contractors. They were accused of wasting taxpayer money for higher profits. While several instances came out where contractors only overcharged, others were much severe. It was testified against Halliburton that often $85000 transportation trucks were torched when they had flat tyres since it was under cost-plus contract that the expenses were reimbursed with additional profit.
Cost-plus contracts are ideal when best services with high quality have to be taken from contractors with reduced failure risk. The cost of projects/services generally increases due to overspending or lack of motivation to save on costs for such contracts. There are laws and methods to award contracts and govern efficient spending by contractor in cost-plus contracts.
However, in exceptional circumstances like war, there are provisions that allow awarding contracts in limited competition or sole source basis. During war, it also becomes difficult to monitor spending by contractors. Taking into consideration the conditions during war and support available from contractual services, it becomes necessary to enter into such contracts. Hence, it is in nature of cost-plus contracts that contracting party needs to forgo cost factor for the quality of services.
In modern warfare, while private contractors make war expensive, their services are necessary for parties in war. As per recommendations by CWC report, it becomes necessary to follow appropriate procedures and tighten the monitoring of spending by contractors.
This article has been authored by Varun Arora from LBSIM.