Enhancing Cost Realism through Risk-Driven Contracting: Designing Incentive Fees based on Probabilistic Cost Estimates

A risk-driven contract structure is proposed to enhance the cost realism of competitive proposals for the Engineering and Manufacturing Development (EMD) phase of the acquisition lifecycle. An economic theory framework is employed to discuss how the cost-plus contracts typically used during this phase have inadvertently motivated contractors to provide optimistic cost estimates in an attempt to win competitive source selections. By directly mapping probabilistic cost estimates to profit distributions, risk-driven contracts offer a structured method to impose more cost risk sharing on contractors during EMD. Holding contractors accountable for their cost estimates and cost performance should enhance the realism of their cost proposals and ultimately reduce the cost growth that continues to plague the defense acquisition system.