Mr. BANNERMAN. Yes, sir. Secretary LEBOUTILLIER. Yes, sir. Mr. RIVERS. Regardless how they are awarded? Mr. RIVERS. And couldn't the animus pervade the Department that what mistakes we make, either the Renegotiation Board will catch the mistake or the Comptroller General? Haven't people been accustomed to doing that in the military? Mr. BANNERMAN. Mr. Rivers, I have heard that said with respect to the Renegotiation Board. Mr. RIVERS. Yes. Mr. BANNERMAN. The Comptroller General, in our negotiated contracts, has the authority only to report on what they find. There is no recovery that they can order. Mr. RIVERS. No what? Mr. BANNERMAN. No recovery of price that they can order on our negotiated contracts. Mr. RIVERS. They can have a contract voided, though, can't they? Mr. BANNERMAN. They can if they find that it is illegal. I don't think there is any question of illegality involved in these problems. Mr. RIVERS. They proceed on illegality? Mr. BANNERMAN. That is correct. Mr. RIVERS. And then report them? Mr. BANNERMAN. That is correct. Mr. VINSON. Now, is it incumbent upon you to reach a decision and conclusion before you make an incentive-type contract that the article will be less costly to the Government? Isn't that a finding that you must make before you are authorized by the law or by statute to enter into this type of contract? Mr. BANNERMAN. That is correct, Mr. Chairman, that it is likely to be less costly. And that is the reason we enter into these contracts very selectively. Mr. VINSON. Yes. But, nevertheless, as far as volume is concerned and dollars are concerned, it amounts to a great deal, does it not? Mr. BANNERMAN. Well, it amounts to a great deal of money, obviously, but a good deal less than we have in either cost reimbursement or firm fixed-price contracts. Mr. VINSON. Then why is it the Army does not use this contract, if it has such great advantage? Their statement I read, which will be submitted to the committee in a few minutes by Mr. Johnson or his assistants, was that the Army did not use the incentive-type contract very much. I don't think they used it at all. Now, why is that, if it is such a good contract? Mr. BANNERMAN. Mr. Chairman, there is nothing magic about an incentive-type contract or any other type of contract. They have to be used selectively in connection with the things that you are buying. Now, the incentive contract was developed predominantly to take care of a situation where you are buying a relatively newly developed military item, with an extended production run, so that you have an opportunity for the incentives to produce the savings on the production line that it is designed to accommodate. This was found in both the Navy and the Air Force to be peculiarly applicable to the aircraft industry. And it has been used predominantly with or in the purchase of aircraft. Now, this is the reason, I assume, that the Army has not found much use for it, or perhaps any use for it. Mr. VINSON. All right. about the incentive contract. Now, you said there is nothing magical Then I am at a loss to understand why all the aircraft industry was trying to have it separately considered by the Renegotiation Board when they were appearing before the Ways and Means Committee. As a matter of fact, the bill that was introduced-it passed through the House--it was dealt with in a separate fashion from that of the other contracts. So therefore, there must be something magical about the incentive-type contract. And, as you say, the reason the Army does not use it is because it is applicable and being used only in the aircraft industry. Mr. BANNERMAN. Predominantly. Mr. VINSON. To a large extent. But that is where the big money goes. Mr. BANNERMAN. I think the figures that you have, Mr. Chairman, show that approximately 13 percent of our procurement is in incentive-type contracts. I guess it runs to 18 percent when you use cost-plus-incentive-fee contracts. Mr. VINSON. I had this: 15.3 percent of the defense dollars are obligated under these contracts, and they account for only 5.4 percent of procurement actions. Isn't this another way of saying that the large defense contractors, such as, for example, Boeing, Martin, North American, and others, the old plane manufacturers and now the missile manufacturers, are the only ones who enjoy this incentive-type contract? Mr. BANNERMAN. Mr. Chairman, I think, as I said before, that the predominance is in that industry, but it is not exclusively used in that industry. Actually, in that industry, as a trend in recent years, we have been using a far higher percentage than I, for one, like to see, of costplus-fixed-fee contracts. This is brought about by virtue of the vastly changing and advancing nature of the technology. We have, as I think these figures show, something in the neighborhood of 40 percent of all of our contracts that are now going into cost plus fixed fee. Mr. VINSON. Now, get back to the record, so I can make a little note of it here. What type contract would you use if you were not using the incentive-type contract to produce the same article? Now, state that again. I didn't follow you just a while ago. Mr. BANNERMAN. I would say, Mr. Chairman, that if we did not have an incentive-type contract, we would use in most cases either a firm fixed-price or a fixed-price redeterminable. There would undoubtedly be some cases, although I would assume they would be relatively few, where we would use a cost-plus-fixed-fee contract. Mr. VINSON. Now, would the end result be the same if you used these firm fixed-price or a firm redeterminable contract? Mr. BANNERMAN. No, sir. Mr. VINSON. The end result would not be the same? Mr. BANNERMAN. No, sir. Mr. VINSON. What would be the difference? Would the article cost more under those types of contracts than it would under an incentive-type contract, when you are only hoping or expecting or anticipating a reduced cost or profit under an incentive-type contract? Mr. BANNERMAN. Mr. Chairman, we obviously cannot provide you with detailed results on individual contracts as to what would have happened had we made the contract some other way. Mr. VINSON. That is right. Mr. BANNERMAN. However, we can say-and I think I may be getting repetitious on this-that if we made a firm fixed-price contract rather than an incentive contract in a given case, the fixed-price would, I would assume in almost all cases, be identical to the target price in the incentive contract. Now, on the average, we are buying under incentive contractsthe final price under incentive contracts is lower than the target. Mr. VINSON. Now, wouldn't you have the same cost accounting and wouldn't you have the same knowledge of cost and all of the information on a fixed-price contract or a redeterminable contract that you have when you enter into an incentive-type contract? Mr. BANNERMAN. You would have the same information, Mr. Chairman, but the results would be different in the administration and run-out of the contract. In an incentive contract, if there are cost savings made by the contractor during the course of performance of that contract, the preponderance of those cost savings come back to the Government in the form of a reduced price. On the other hand, in a firm fixed-price contract, if there are cost savings, and there are many times, those savings come to the contractor exclusively in terms of an increased profit. Mr. VINSON. Well, now, if what you say is sound and correct, do you not work yourself around to the position where the main type of contract that should be made, then, is an incentive-type contract? Because you say that the end result would be different between the other two type contracts. Therefore, an incentive-type contract is the one that creates and produces the cheaper article. Mr. BANNERMAN. Mr. Chairman, I think we need to get into the record this kind of an analysis, so that it will be firmly understood. A cost-type contract, a cost reimbursement, a cost-plus-fixed-fee contract, on the one hand, at one end of the spectrum, provides probably the least incentive for cost reduction. On a cost-type contract you have what amounts to an incentive contract, with a 100 percent-zero sharing. In other words, all of the risk and all of the rewards-risk for cost overrun and reward for cost underruns are on the Government, in a cost-type contract. It is a 100-zero share. On the other hand, at the other end of the spectrum, you have a firm fixed-price contract. In a fixed-price contract, 100 percent of the risk and 100 percent of the reward is on the contractor. Now, an incentive contract is simply one that is in between these two-80-20 usually, where 80 percent of the risk is on the Govern ment and 20 percent on the contractor. So if costs are underrun, why the Government recovers, by way of a reduced price. If costs are overrun, the contractor gets a reduced profit and the Government pays part of the overrun. So you have this whole spectrum to consider. Mr. LANKFORD. Excuse me, Mr. Chairman. Mr. VINSON. Go ahead. Mr. LANKFORD. If there is an overrun over the target price, the Government pays that overrun? On an incentive-type contract? Mr. BANNERMAN. The Government pays a share of it, Mr. Lankford, up to the ceiling. For instance, if there is a cost overrun, the contractor's target profit is reduced by 20 percent, if it is an 80-20 share, of the amount of the cost overrun. The Government pays the other 80 percent of those costs, up to the target ceiling. Up to the contract ceiling. Mr. LANKFORD. This brings me back to the question that I asked yesterday. The Secretary said in his statement that there is no more chance of a higher target price, or padding the target price, in an incentive-type contract than in any other type contract. I want to know why this is true, particularly in view of the fact that the contractor has everything to gain and nothing to lose, or very little to lose by having his target price high. Mr. BANNERMAN. Mr. Lankford, the necessity for getting close contract pricing at the outset exists in practically every kind of contract we make. The possibilities, or the results of bad estimating result in greater profit under fixed-price contracts than any other kind. In other words, if our estimating is bad and the result is that actual final costs are under, way under, the estimates for reasons other than economy or efficiency, all of that extra profit goes to the contractor. Mr. LANKFORD. That is right. Mr. BANNERMAN. In the incentive contract, only a small portion of it goes to him. The balance comes back to the Government. Mr. LANKFORD. Well, wouldn't that be even more reason for him to try to make the target price as high as possible? Mr. BANNERMAN. There is a basic incentive in any kind of contracting for a contractor to try to make his original estimates high. This is part of the motivation. This is what we are combating all day every day. This is true even in cost-plus-fixed-fee contracts. For instance, if we make a cost-plus-fixed-fee contract, based upon an estimated cost of $1 million with a fee, say, $70,000, or 7 percent, and it turns out that the final costs are only half a million dollars, this contractor will have made a 14 percent profit. Mr. VINSON. Now, Mr. Bannerman, I gave you a line of questions. I am not going to trespass on the committee. I thought these questions out. You put your answers to those questions in the record. Mr. BANNERMAN. Yes, sir. (The questions and answers are as follows:) "Now, Mr. Secretary, on pages 6 and 7 of your statement you spoke about the four types of fixed-price contracts. You stated that the chances for 'windfall' profits under a fixed-price incentive contract are less than under a firm fixed-price contract." Question 1. "I think the members of the subcommittee are most interested in your statement about 'windfall' profits. What do you mean by that?" Answer 1. By "windfall" profits, we refer to the extra profit which would accrue to a contractor were the target costs and prices negotiated unreasonably high as distinguished from the increased profit that accrues because of a contractor's efficiency and economy in reducing performance costs below reasonable target costs and prices. "Windfall" profits would result if the estimating and pricing were poor in negotiating the targets. The reason that the chances for "windfall" profits are less under an incentive type contract than under a firm fixed price contract is simply because the contractor retains all the difference between target and actual costs under firm fixed-price contracts but, under incentive contracts, he only shares the usual split being 20 percent contractor and 80 percent Government-in the savings between target and actual costs. Question 2. "How are such profits possible?" Answer 2. See answer 1. Question 3. "Aren't the Government's contracting officials and procedures adequate to prevent such profits?" Answer 3. The GAO reports made in the last year demonstrated two areas where our regulations needed further strengthening. As testified, these areas were (1) pricing data being furnished by offerors or contractors which were not current, complete, or accurate; and (2) the pricing of subcontracts. We have tightened up our regulations in these two areas and believe that our procedures and contracting personnel are certainly adequate to negotiate reasonable costs and prices. Question 4. "If our officials and procedures are adequate to do the job, how is is possible for the contractor to inflate his cost estimates?" Answer 4. It is always possible for a contractor or offeror to inflate his cost estimates in his proposal. The real question is how is the Government to know the estimate is inflated so that realistic costs and prices are negotiated. We meet this problem by requiring current, complete, and accurate cost and pricing data of the prime contractor, requiring the prime to obtain and utilize the same quality of information from his proposed subcontractors, by reviewing the purchasing systems of proposed prime contractors, by approving subcontracts, by use of cost analysis and price analysis, and by use of our audit services. "Mr. Secretary, on page 7 of your statement, you say that in fiscal 1959, fixedprice incentive contracts accounted for 15.3 percent of our dollars and cost-plus incentive contracts accounted for 3.2 percent of our dollars. That makes a total of 181⁄2 percent of our dollars for procurement under incentive contracts—more than $4 billion, which you will agree is a lot of money." Question 1. "Now, why is it necessary to have to offer a special inducement in the form of an incentive profit when we are spending that much money?" Answer 1. Our aim is solely to save money. Our purpose in using incentive type contracts is to have the contractor spend money as if he were in a market dominated by vigorous price competition, to make all decisions in the light of a critical analysis of probable costs, and to keep false starts and changes to a minimum. The possibility of greater profit is an incentive to the contractor to produce for less than he believed possible and for less than was reasonably first estimated both by him and the Government. Question 2. "If the contractors have already been offered a fair profit, which they have, why does the Department of Defense believe it is necessary in the best interest of the Government to offer an additional profit in order to get lower costs?" Answer 2. See answer 1. Question 3. "Don't these contractors want to do business with the Government?" Answer 3. The implication in this question is that the Government is reluctant to make incentive type contracts and does so because contractors desire this type of contract. This is not the fact. We believe the incentive contract is a good contract. We seek to use it whenever the opportunity arises as where sufficient cost experience exists to make it possible to determine a realistic base or target price and there is a sufficiently long period of performance to permit achievement of substantial cost reductions. Question 4. "Does business generally utilize an incentive contract? If so, what percent is done in that manner?" Answer 4. Practically all contracts made by industry are fixed-price contracts which, since the seller retains all the savings he can effect in his costs, offer the greatest incentive of any type contract. Industry, of course, does not buy the highly experimental types of equipment without background cost experi |