Incentive Contract Use in Military Construction

by Clayton K. S. Chun

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This dissertation explores the replacement of the firm fixed price contract with the fixed price incentive (FPI) contract for the Air Force's military construction program. The study uses a simulation based on an optimal contract scheme developed by R. Preston McAfee and John McMillan. This simulation provides hypothetical values for FPI contract payments. The Air Force builds facilities for its forces that range from hangars to research laboratories. Congress appropriated about $1.5 billion in FY 1992 for Air Force military construction projects. This study examines military construction projects built in the United States, excluding military family housing. The McAfee and McMillan model calculates an estimated optimal share rate between the Air Force and the firm that minimizes contract payments. It uses the number of bidders, the firms' estimated costs, an estimated moral hazard rate, and risk measure. This model consists of three effects: the moral hazard, the bid competition, and the risk sharing effects. As the optimal share rate rises, the moral hazard effect raises the contract payment. Conversely, contract payments fall as the optimal share rate rises due to the bid competition and risk sharing effects. The use of FPI contracts for military construction projects can reduce the Air Force's payments by 9.1 percent. Payments fall as the number of bidders decreases and the variance between firms' estimated costs (and bids) increases. The projects that most exhibit these characteristics and result in lower contract payments include medical and utilities and energy projects. Additionally, projects acquired through the small business set aside program also result in higher savings. If the Air Force decides to use FPI contracts, it must consider certain impacts. The government must ensure its internal organizations and private firms will accept this new contract policy. It also must examine how the use of FPI contracts might apply to other procurements, other federal agencies application, reduced profitability for firms, increased competition, and the potential spread of private firm use. The Air Force can implement the FPI contract by allowing contracting officers to calculate individual share rates by computer program.

This report is part of the RAND Corporation note series. The note was a product of the RAND Corporation from 1979 to 1993 that reported other outputs of sponsored research for general distribution.

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