Are Cost-Plus Defense Contracts (Justifiably) Out of Favor?

Federal government spending on contracts more than doubled in the eight years of President George W. Bush's administration. In 2008, U.S. taxpayers paid more than $500 billion to contractors, and the Department of Defense (DoD), the largest contracting agency, spent $315 billion on contracts. As DoD contracting outlays grew, critics called for fixing the defense procurement system that was alleged to be wasteful and lacking proper oversight. A recent study (Government Accountability Office [GAO] 2009) found that in 2008, approximately 70 percent of 96 Major Defense Acquisition Programs (MDAPs)¹ were experiencing significant cost overruns, reaching over $295 billion (a 26 percent overrun) over the life of the projects.

Shortly after taking office, President Barack Obama (2009) issued the “Memorandum on Government Contracting,” urging federal contracting agencies to improve the effectiveness of their acquisition practices and contracting performance. The presidential memorandum explicitly stated that “there shall be a preference for fixed-price type contracts” (Obama 2009; emphasis added). Ashton Carter, the Pentagon's top weapons buyer, in a September 14, 2010, interview with Bloomberg, echoed support for “increasing the use of fixed-price contracts” (Carter 2010). The latest and most significant legislative response to the acquisition system reform was the passage of the Weapons Systems Acquisition Reform Act (WSARA), which was unanimously supported by Congress and signed into law by President Obama on May 22, 2009. One primary initiative of WSARA is to encourage competition to reduce sole-source contracting (often cost-plus-based) and pave the way for greater use of fixed-price contracts.

When expressing their preference for the fixed-price contracts, the president, the Congress, and DoD officials implicitly blame the increasing use of cost-plus contracts as a key contributing factor to large and frequent cost overruns.² President Obama (2009) stated that “The days of giving defense contractors a blank check are over,” and pledged that his reforms would end unnecessary no-bid, cost-plus contracts. The notion that the fixed-price contract is better than the cost-plus contract is shared by some academics, as well (Berrios 2006).

Our concern about the ongoing policy push toward fixed-price contracts motivates this study. The key research question relates to the type of contract in the MDAP settings. Specifically, does dissatisfaction with cost-plus contracts in the context of MDAP necessarily justify switching to fixed-price arrangements?

We caution policy-makers on three unintended negative consequences that potentially result from the use of fixed-price contracts for MDAPs. First, risk-sharing is vital to motivate private contractors to engage in complex defense projects. Fixed-price contracts provide no or little risk-sharing.³ Thus, the first unintended consequence of promoting the use of fixed-price contracts in the MDAP context is the “no-deal” scenario, in which important projects are forgone because the risk is too high to be borne by the contractors.⁴

Second, despite a preconceived notion that fixed-price contracts save taxpayers' dollars relative to cost-plus contracts for the “deal” cases, we nevertheless argue that this view is incorrect in the MDAP context. To the contrary, a fixed-price contract in a typical major weapon acquisition likely leads to a higher, not lower, payment from the government than under a cost-plus contract. This is because in negotiating a fixed-price contract with less-informed government, contractors demand “risk premium” for bearing risk. Moreover, contractors can extract “information rents” to exploit their information advantage.

Third, policy-makers are calling for a more competitive industry structure to pave the way for fixed-price contracts. We argue that, although well intended, the implementation of this policy could promote an inefficient industry structure.⁵

Aiming for better defense acquisition practices, we make two recommendations to policy-makers. First, for MDAP contracting, a general cost-plus framework is preferred to a fixed-price one in order to keep risk-sharing benefits. Second, realizing that cost-plus contracts are not immune to information asymmetry and agency problems that fundamentally contribute to cost overrun problems, we recommend a “Budget-Based Cost-Plus Scheme” for MDAP contracting practice. We demonstrate that under this structure, the contracting firm voluntarily and truthfully reveals its unbiased cost estimates. This reduces information asymmetry and abuse of the system due to the conflict of interest between the contractor and the government, which ultimately reduces the cost inefficiency.

Our paper makes several contributions. First, we point out that the current U.S. policy focus on the change of contract form is misplaced. Second, within the cost-plus contracts framework, we make implementable, efficient contract design recommendations. While the theory of “truth-telling” exists in the literature, few prior studies provide practical strategies. Finally, our research generates implications for the optimal defense industry structure. Specifically, we are concerned about the policy push toward a less-consolidated defense industry by those who advocate fixed-price contracts.⁶ In contrast with conventional economic wisdom, which usually prefers competition to oligopoly or monopoly, we argue that the current concentrated defense industry structure is likely the result of economic Darwinism and, hence, may be the best possible outcome. Consequently, efforts to reverse the consolidation trend and deviate from the status quo are likely to be counterproductive.

The remainder of the paper is organized as follows. The second section begins with a general review of procurement and contracting literature, and then discusses the uniqueness of the specific MDAP contracting environment. Based on the second section, the unintended negative consequences of advocating the use of fixed-price contracts are elaborated in the third section. The fourth section presents our policy recommendations for designing optimal defense contracts. Concluding remarks are in the fifth section.

Procurement is typically characterized as the scenario in which the government is the only buyer. This is particularly true in defense procurement as, almost without exception, the government purchases items for defense through contracts. The literature regarding incentive contracts in a procurement setting presumes both adverse selection (i.e., information asymmetry between the seller, the defense contractor, and the buyer, the government) and moral hazard (i.e., hidden action, the fact that the defense contractor's cost-saving effort is not observable to the government). These problems are addressed by designing contracts that include contract-type choice, contract-scheme design, and contract pricing. The following structure is typically assumed: (1) A benevolent dictator, that is, the government, seeks to maximize social welfare; (2) The government is risk-neutral, while the contractor is usually risk-averse;⁷ (3) The government (the principal) designs the contract; (4) The defense contractor can refuse to participate; that is, the firm's reservation utility level has to be achieved or exceeded; (5) Some incurred costs are verifiable with the existence of auditors, but the minimum achievable cost is not observable, or at least not verifiable; and (6) Although the government can face either a competitive or a sole-source environment, the latter is more common in DoD practice.

Loosely put, the government's “benevolent” role translates to two objectives: encourage cost reduction and limit the contracting firm's rent. Moral hazard gives rise to the contractor's reluctance to exert effort to minimize cost, and adverse selection (information asymmetry) leads to information rents to the contractors. When little information asymmetry is present, the optimal contract is Firm-Fixed-Price (FFP), so the contractor has an incentive to reduce cost. On the other hand, Cost-Plus-Fixed-Fee (CPFF) should be employed if extreme information asymmetry prevails. More specifically, when a mixture of moral hazard and adverse selection exists, various forms of incentive contracts that lie between FFP and CPFF achieve the best balance.

Loeb and Surysekar (1994) state that “the relative severity of the moral hazard and adverse selection issue leads to the relative domination of the fixed-price contract and the cost-plus contract and that the optimal linear procurement contract approaches a fixed-price (cost-plus) contract as the adverse selection problem decreases (increases) relative to the moral hazard problem.” In the context of MDAP, the adverse selection problem (i.e., information asymmetry) is a far more serious concern than moral hazard, as most contracts in place today include incentive provisions that motivate contractors to contain cost. The combination of the prediction from Loeb and Surysekar (1994) and the insight that adverse selection dominates moral hazard in the MDAP scenario naturally leads to the policy implication that cost-plus contracts should be favored over fixed-price contracts.

One legitimate concern over the preference toward cost-plus contracts is that while fixed-price contracts have drawbacks relative to cost-plus contracts, they do have one potential advantage. That is, there is no incentive to engage in opportunistic “overhead-cost-shifting” behavior under fixed-price contracts. Such a cost-shifting behavior can exist among the defense contractors who are largely reimbursed under the cost-plus scheme.

According to the cost-shifting hypothesis (Rogerson 1992; Thomas and Tung 1992), a typical defense contractor has two types of revenues: the first stream of revenue derives from DoD products whose prices are cost-based and, hence, are cost-sensitive; the other source of revenue is from typical commercial products whose prices are competition-based and, therefore, are cost-insensitive. Rogerson (1992) argues that a firm with the combination of defense products and commercial products shifts common overhead costs from cost-insensitive segments to cost-sensitive segments. Since government contracts are typically reimbursed based upon costs, and the price is determined based on negotiation between the two parties and often subject to renegotiation, this cost-shifting strategy results in higher contractor profitability at the expense of taxpayers.

Early evidence is consistent with the cost-shifting hypothesis. For instance, Thomas and Tung (1992) find that pension plans are overfunded when employees work on government contracts, but excess pension assets are withdrawn when employees work on non-DoD products. Rogerson (1992) not only documents the excess profitability of defense contractors, but also finds that the defense product segments are significantly less capital-intensive than less government-oriented segments. This is consistent with the cost-shifting hypothesis that predicts an input substitution effect (between capital and direct labor). That is, the defense sector uses excessive direct labor, since the overhead allocation is frequently based upon direct labor-based measures.

A more recent study, however, casts doubt on the validity of the cost-shifting hypothesis. McGowan and Vendrzyk (2002) confirm that defense contractors enjoyed excess profit on their government work, yet find no evidence of common overhead cost-shifting. Specifically, they compare return on assets (ROA) among three types of segments within defense contracting firms: (1) commercial segments, (2) government segments, and (3) mixed segments. The main testable hypothesis is as follows: if the cost-shifting theory leads to the excess profitability of defense contractors, then one expects the highest profit in the mixed segment, where managers have the most opportunities to shift common overhead costs. In contrast with this expectation, McGowan and Vendrzyk (2002) either find that the government segments (not the mixed segments) significantly outperform the other two types or find no significant difference across the three categories, depending on the time period. Such evidence suggests that unusually high profitability for government segments is more likely due to nonaccounting explanations than to strategic cost allocation.

Therefore, despite the theoretical appeal of the cost-shifting hypothesis, the empirical support is, at best, mixed. A possible explanation is that in practice, defense acquisition, especially MDAP, is heavily regulated and highly scrutinized.⁸

Hence, while not all “opportunistic cost-shifting” in cost-plus contracts is challenged, detected, and penalized, we speculate that regulatory scrutiny effectively mitigates the cost-shifting problem. As a result, the advantage of fixed-price contracts over cost-plus ones is limited in this regard.

To recap, the primary inference from the aforementioned literature review is that cost-plus contracts dominate fixed-price contracts, because the main concern is adverse selection (i.e., information asymmetry) rather than moral hazard. The unique features of MDAPs, as elaborated in the following subsection, support this insight.

The DoD is both the biggest and the most unique federal contracting agency. At the center of its activities are big-ticket purchases called Major Defense Acquisition Programs (MDAPs). According to the Government Accountability Office (2010a), MDAPs are designated to “acquire, modernize, or extend the service life of major military equipment such as aircrafts, ships, tanks, and self-propelled weapons.” From 2003 to 2010, the DOD's portfolio “increased from 77 to 98 MDAPs and the overall investment in these programs grew from approximately $1.2 trillion to $1.7 trillion.”

In contrast with a typical commercial contracting scenario, in which bidders compete to make an objective market price readily available, the MDAP contracting environment is characterized by the following features:

1. (1)

   MDAPs normally involve substantial business risk. Such risk stems from difficulty and uncertainty in major weapon systems' design, development, and production. Other contributing factors are changing DoD requirements and integrating between the development and manufacturing, as well as between the prime contractor and the subcontractors. Additional risks arise from the compliance costs associated with federal acquisition policies and the scrutiny from federal agencies. The cost burden for complying with the government's unique infrastructure and disclosures of costs, pricing data, and other sensitive business information further elevate the contractors' risk.

2. (2)

   The DoD is typically the sole purchaser of major weapon systems. This feature has two implications. First, defense contractors' technological investments and capital expenditures, often very large due to the complexity of the tasks, produce only non-transferable assets and, hence, add even more risk. Second, economies of scale, usually achieved through a large base of demand, are unlikely. In the last two decades, the consolidation of the defense industry⁹ is an indication of the contracting firms' struggles to achieve greater economy of scale¹⁰ through the supply side.

3. (3)

   The complexity, uncertainty, and long-term commitment in major weapon systems often result in a “sole-source contractor” situation, in which only one or a few contractors are capable of undertaking the contract. Other contributing factors to the sole-source or near sole-source situation include the DoD's need for secrecy, expediency, and/or safeguarding human resources. We emphasize that the DoD's unique sole-source contracting environment is unlikely to change soon. MDAP spending on single-source contracts in recent years has increased considerably, from 76 percent in 2004 to 87 percent in 2008 (Center for Strategic and International Studies [CSIS] 2010). The economic downturn since 2008, coupled with ongoing DoD cost-saving initiatives (fueled by the pressure of reducing the federal budget deficit) will likely induce a new wave of mergers and acquisitions and, in turn, reduce competition. Hence, the industry consolidation trend witnessed during the past two decades (e.g., Boeing acquired McDonnell Douglas, Lockheed acquired Martin Marietta, and Northrop acquired Grumman) will likely continue, despite the WSARA effort to promote competition.

To summarize, the MDAP contracting environment is unique in the sense that an MDAP contract is typically a sole-buyer-and-sole-seller case, in which market competitive forces rarely exist and significant information asymmetry and potential agency problems prevail. On the contractor side, the business risk is too high to be borne by contractors themselves. On the government side, the major concern is the potential abuse of the system that results from information asymmetry.

The pros and cons of cost-plus versus fixed-price contracts are extensively investigated in the extant literature (Chapman and Ward 1994a, 1994b; Loeb and Surysekar 1994). In general, fixed-price contracts are optimal where little uncertainty exists in technological requirements and developments. The scenario that best justifies the use of fixed-price contracts is the procurement of commercial off-the-shelf (COTS) assets, in which a competitive market price is readily available and the technological characteristics are well specified. To the point, the FAR explicitly requires Firm-Fixed-Price (FFP) contracts or fixed-price contracts with economic price adjustment¹¹ for the acquisition of commercial items. Moreover, a contracting firm working under a fixed-price contract bears all or the majority of the risks and has an incentive to save cost, since cost savings increase profit and cost overruns reduce profit.

While a fixed price works well in a COTS scenario, fixed prices are not an optimal contracting form when significant uncertainty exists about technological requirements. As examples, the Army Future Combat System (FCS) (U.S. Department of Defense 2009) illustrates a system of complex electronic weapon systems that proved too difficult to design and implement within pre-specified budgets. Similarly, the Navy's modular Littoral Combat Ship (LCS) (GAO 2010b) is in an ongoing struggle to merge functionality and technology, yet remains within cost estimates.

In the examples above, cost-plus contracts can provide risk-sharing benefits for the contractors, which are absent from fixed-price contracts. Absent risk-sharing from the government, important, yet risky, major weapon projects are forgone and, as a consequence, social welfare is suboptimal.

In the case of MDAPs, in which the project risk is inherently high, coupled with very few competitors and significant information asymmetry, a sole-source contractor who is forced to accept a fixed-price contract has two incentives. First, a risk-averse contractor demands a risk premium to compensate for risk level. Hence, even in the absence of opportunistic behavior, the contractor submits a higher-than-expected cost to the government as a basis for fixed-price determination. We argue that this behavior costs taxpayers unnecessarily and incurs a deadweight welfare loss. The reason is that while the individual contractors tend to be risk-averse, the federal government contracts with many contractors and, hence, can diversify across a portfolio of MDAP providers. That is, it is more efficient for the government, rather than the contractor, to bear the risk.

Second, due to information asymmetry, the contractor has both motive and ability to artificially inflate the cost estimate to command additional “information rents.” The demand for risk premium and the desire to extract information rents means that there is no guarantee that taxpayers are better off in a fixed-price contract than a cost-plus contract. We expect that, in general, a fixed-price contract in the absence of a market-established price and information symmetry leads to higher cost to the government than under a cost-plus contract. Note that a critical assumption of our argument is that the government does not possess the necessary information to form accurate cost estimates ex ante and, therefore, relies on the contractor, often sole-source, to provide a cost estimate as the basis for determining the fixed-price.

A widely held view is that fixed-price contracts cannot be justified without competition among potential contractors. Driven by this belief, and fixated with the mindset that fixed-price contracts should be preferred to cost-plus contracts, policy-makers promote a more competitive defense industry structure. The intent is good: a market price established by the competitive forces needs to be present for fixed-price contracts to work. For instance, the Weapon Systems Acquisition Reform Act (2009), in Section 202, requires the Secretary of Defense to take measures to ensure competition at both the prime contract level and the subcontract level throughout the lifecycle of a program “as a means to improve contractor performance.” As examples, (1) competitive prototyping (at system or subsystem level) is required prior to moving to the engineering and manufacturing development phase (i.e., Milestone B), (2) dual-sourcing, (3) unbundling of contracts, (4) using modular, open architectures to enable competition for upgrades, and (5) licensing additional suppliers. Prime contractors are also required to ensure that “make or buy” decisions give “full and fair consideration” to qualified sources other than themselves for major subsystems and components (WSARA 2009).

The Weapon Systems Acquisition Reform Act (2009) also promotes competition by restricting Organizational Conflict of Interest (OCI). OCI refers to the scenario in which a contractor is in a better position to compete for future government contracts due to its current relationship with the government. For example, a contractor may be hired by the government to define the terms of future competitions, while the same contractor is not excluded from the pool of potential contenders (WSARA 2009, Section 207). While concern about inappropriate conflict of interest is justifiable, overreaction to OCI can create significant unintended adverse consequences. A notable critique comes from Goure (2010): “The pool of expertise in sophisticated system engineering and technical analysis for complex, often highly classified defense areas is quite limited. There is only one Skunk Works¹² for example. But if a company such as Lockheed Martin is barred from working on the next stealth fighter or SR-71 because it has helped in the initial research and development effort, the nation will be the loser.”

All the efforts above, although well intended, can promote inefficient industry structure. Conventional economic wisdom that a competitive industry structure is better than a more concentrated industry structure may be untrue in the case of the defense industry. Policy-makers need to be reminded that the single-source contracting environment is a natural result of long-term competition among contractors and evolution of the free market economy. Therefore, a concentrated industry structure can be an optimal response to the unique features of the defense contracting environment. One such feature is that the lack of economies of scale opportunities from the demand side makes industry consolidation the only option to achieve cost efficiency from the supply side.

The evolution of the French defense industry structure in the past two decades potentially offers insight into the industry structure issue. Starting in the late 1980s, the French government gradually shifted away from cost-plus contracts to fixed-price contracts, in response to cost overruns and defense budget reductions similar to what the U.S. is experiencing now. For institutional reasons (Kapstein and Oudot 2009), French-style full-range migration to fixed-price contracts is generally viewed to be a success. What is interesting is that during this process, the French government actually encouraged, rather than discouraged, industry consolidation, which resulted in usually only one firm, a “national champion,” at the prime-contract level in a specific sector. Although more comprehensive analysis is needed to draw inferences, the French case is consistent with our point that more concentrated structure in the defense industry is desirable.

To conclude, the present industry structure is an outcome of economic Darwinism and perhaps is the best choice given the unique DoD contracting setting. Efforts to change the status quo and the policy push to reverse the industry consolidation trend are potentially counterproductive.

In this section, we offer two policy recommendations. The first, built upon previous sections, is that the federal government should retain cost-plus contracts as the major contracting type for designing defense contracts. Next, using a principal-agent framework, we recommend a particular type of cost-plus contract that addresses the information asymmetry problem. In a nutshell, the proposed contract induces truth-telling behavior from self-interest-motivated contractors (Reichelstein 1992). Hence, information asymmetry is reduced and greater cost efficiency is achieved.

As an alternative to a fixed-price contract, the cost-plus contract has various forms; the standard cost-plus arrangements, CPFF, fully reimburse the actual reported costs and further add a fixed fee as the contractor's profit. This leaves little incentive for the firm to control costs because the cost-saving behavior requires contractor effort and, in turn, generates disutility for them. To alleviate this incentive problem, the Cost-Plus-Incentive-Fee (CPIF) contract is more commonly used in practice. The standard CPIF contract takes the form as follows:

where:

Note that is the price paid by the government to the contract or, is the actual reported cost as agreed by the auditor, and is the contractor's profit, which includes a target profit, ⁠, and an incentive term for cost overruns (or underruns) above (below) a pre-specified target cost, ⁠. The parameter (a positive coefficient between 0 and 1) is the cost share parameter. Since the contractor is penalized (rewarded) when there exists a cost overrun (underrun), the contractor is motivated to be more cost-efficient.

The primary drawback of the standard CPIF contract is that the government frequently does not possess the necessary information to form a basis for estimating target cost, ⁠, due to significant information asymmetry. If is set too high, the contractor receives windfall bonuses at the expense of taxpayers. On the other hand, if is set too low, such that the cost overrun is unavoidable, the contractor is unfairly penalized.

Contractors (firms) usually have superior information concerning the expected cost of the project, yet the government cannot rely on the firms' estimates since contractors, as agents, may not truthfully reveal their beliefs. A possible remedy to this dilemma is to introduce incentive contracts that ensure that the contractors (who have an information advantage) voluntarily and truthfully reveal their beliefs about the project's estimated cost. The theoretical setting is the principal-agent paradigm, in which the risk-neutral principal (i.e., the government) designs the contract format such that profit-maximizing agents (i.e., the contractors) behave in the way that the principal desires.

Under Budget-Based Cost-Plus Scheme (BBCPS), the task of estimating target cost shifts from the government to the better-informed contractor; that is, the contractor is invited to submit a “budget cost,” which, in turn, is used to decide their profit via a specifically designed formula. Consider a modification of Equation (2) due to Reichelstein (1992):

where TC is the target cost submitted by the contractor. An important modification relative to standard CPIF (Equation (2)) is that both (target profit) and (cost share parameter) are not constants. Instead, they vary with TC to provide the correct incentives for the contractors to truthfully reveal their unbiased cost estimate.

Reichelstein (1992) imposed the following restrictions to the functional forms of α(TC) and β(TC), such that:

The curvature of α(TC) specified by Restriction (4) is a downward-sloping convex function, as shown in Figure 1.

From Equation (4), one can infer that β′ = −α″<0. Hence, both (target profit) and (cost share parameter) vary inversely with the budget cost, TC. This feature of the function provides a disincentive for overstating the budget cost, which is a major concern for the less-informed government. To demonstrate that the contracts characterized by Equations (1), (3), and (4) induce contractors to voluntarily submit their unbiased cost estimates in maximizing profitability, assume that the contractor has private information (which is unknown to the government) that the expected project cost is (i.e., ⁠). If the contractor submits ⁠, the unbiased estimate, as the target cost (i.e., telling the truth), the firm's expected profit is according to Equation (3). Reichelstein (1992) points out that deviating from truthful reporting yields lower expected profit than ⁠. Therefore, telling the truth is the optimal choice for a profit-maximizing contractor.

Refer to Figure 2: without losing any generality, suppose the contracting firm chooses to submit E as the budget target cost, where (over-reporting).

Applying geometry to the triangle ΔBCD implies the following is true for the line segment BC:

Moreover, the line segment:

Since ⁠, substituting (5) and (6) into the inequality BC<AC yields:

The Inequality (7) can be transformed to:

Restriction (4) implies:

Substituting Equation (9) into Equation (8) yields:

Note that by Equation (3), the left-hand side of Inequality (10) exactly represents the expected profit of the contracting firm if the firm reports E as the estimate of their target cost. Furthermore, Inequality (10) shows that this expected profit associated with over-reporting behavior is less than ⁠, the expected profit by telling the truth. Thus, an over-reporting strategy is dominated by telling the truth.

In a similar fashion, under Equations (1), (3), and (4), we can also show that any under-reporting strategy is also dominated by truth-telling.¹³

In summary, a menu of contracts¹⁴ characterized by Equations (1), (3), and (4) induces faithful disclosure of expected costs that is desirable under information asymmetry.¹⁵

Consider an example to demonstrate how BBCPS can be implemented in practice. In particular, we propose a two-stage execution. In the first stage, truth-telling behavior is induced by an incomplete contract that satisfies Equations (1), (3), and (4). The contract is incomplete because not all parameters are clearly specified. However, the satisfaction of Equations (1), (3), and (4) is sufficient to generate truth-telling behavior. In the second stage, the principal (the government) fully specifies the contract (i.e., to make it complete) by using the newly revealed unbiased cost estimate to achieve better cost control and efficiency.

Consider:

where the positive constant N is not specified until the second stage. It can be confirmed that the above functional form of satisfies Restriction (4). Moreover, Equations (4) and (11) imply:

By (3), the contract presented to the firm by the government is:

Without loss of generality, assume that the contracting firm has the following private information, which is unknown to the government: c, as a random variable, has three equally probable outcomes: 50, 100, and 150. Therefore, the unbiased cost estimate is 100. The contractor has three choices in terms of submitting the budget (target cost): either tell the truth (i.e., ⁠, under-report (without loss of generality, assume ⁠), or over-report (without loss of generality, assume ⁠).

The decision problem for the contracting firm facing this particular BBCPS reduces to Exhibit 1, where the firm's profit under each combination of and c is calculated based on Equation (13). Then, for each ⁠, the probability-weighted expected profit is computed. The firm chooses to maximize its expected profit.

The last column of Exhibit 1 indicates that the contractor's expected profit is maximized by submitting ⁠, which is the firm's unbiased cost estimate. Stated another way, the firm voluntarily and truthfully reveals private information and, therefore, reduces information asymmetry.

This completes stage one. The agent (the firm) voluntarily revealed the true belief about the expected cost, and submitted ⁠.

Now the principal (the government) takes the contract into the second stage. The profit utilizing Equation (13) is:

Therefore, we can calculate the firm's expected profit as follows:

To complete the analysis, suppose the government wants the contractor to have an expected profit of 10 (i.e., 10 percent of its expected cost); the government can complete the contract and achieve that goal by choosing N = 1,000. So the final contract is:

where:

Under this design, the total expected government payment is 110.

Note that if the government wants to use a fixed-price contract in the same setting, as we argued before, it is likely that the risk-averse and better-informed contractor submits a bid much higher than 100 to demand risk premium, as well as command information rents. As for the CPIF alternative, the government lacks information to propose a realistic target profit, sharing parameter, and, most importantly, target cost. Hence, the less well-informed government relies on the better-informed contractor.

A trend in recent defense acquisition reform is the strong preference for fixed-price contracts over cost-plus contracts. Our study cautions DoD policy-makers that the premise that fixed-price contracts are better than cost-plus contracts in promoting cost efficiency is debatable, and potentially counterproductive. Consequently, we recommend that cost-plus contracts remain as a major contracting tool for MDAPs. Moreover, building on existing literature (e.g., Reichelstein 1992), we demonstrate that the contractors' opportunistic cost misbehavior under traditional cost-plus incentive contracts can be mitigated by using the budget-based cost-plus scheme. The lack of use of this type of truth-inducing scheme in practice, in our view, suggests an opportunity for improvement.