Mr. KILDAY. I suppose that you took up, on Thursday and Friday, the manner of arriving at the target price?

Mr. VINSON. Well, we did it just about as well as they do it themselves. It was just a mere estimate of the figures that you gave. That is the only way you arrived at it; is it not?

Secretary BANTZ. Mr. Chairman, to answer Mr. Kilday's question, if you will recall, on Friday, I said that most of our negotiatingand that is true of all our major, larger contracts-is done under what we described as the team concept, where we have several men. There is on one man responsible for the pricing out of a contract. It is done by a team, which is the negotiator, the contracting officer, the technical people and lawyers, and so on, sir.

Friday, after tht hearing, why, we went back, and on Saturday morning we worked up what I think is a pretty good, reasonable statement as to why we used different types of contracts.

It would take about 8 to 10 minutes to read, and I would like to read it, sir, and then put a copy in for the record, if it meets with your approval.

Mr. VINSON. Well, I suggest that you give the committee that information right now. Go ahead and take the 10 minutes. That is very pertinent.

Secretary BANTZ. You have a copy of it.

This statement is headed "Types of Contracts Used by the Navy." Mr. Chairman, because of the interest your committee has shown in the various types of contracts we use, we have prepared a brief statement on that subject which it is hoped will be helpful to you. I should like to read it to you now, and provide a copy for the record.

It is important to realize that we have several major kinds of pricing situations, and that for each of these situations we need a contract especially tailored to fit.

These pricing situations differ primarily in the degree to which it is possible to estimate costs accurately and dependably in advance. It is easy to see the two extreme situations:

(1) Cases where we have full and dependable pricing information or true and ample competition. Here we can use firm fixed-price contracts. Illustrations are clothing, subsistence, and off-the-shelftype items. For these kinds of items, costs are well established or competition is keen.

(2) At the far extreme are situations like research and development where it is difficult to estimate costs accurately or dependably. Here we can use only cost-type contracts. The cost-type contract is used when no other more advanced type fits the situation.

Between those two extremes are several intermediate situations in which we have some information, including some cost data, but not as much as we need. For each of these several well-defined intermediate situations we need appropriate types of contracts.

Nearest to the firm fixed-price contract is the fixed-price contract with escalation for specified items of cost, such as certain labor costs or certain material costs. Steel for ships is the best illustration of the need for escalation in some fixed-price contracts.

Two other intermediate pricing situations require appropriate contracts. For these we have developed fixed-price incentive contracts and fixed-price redeterminable contracts.

The fixed-price incentive contract is used where these conditions exist-(1) a firm fixed-price contract cannot be used, because we do not yet have competition or reasonably complete cost information; but (2) sufficient cost information is available that a realistic estimate can be made. Suppose, for example, that previous experience and our current estimates of costs indicate to us that the price for an aircraft engine should be $1 million. However, the contractor is apprehensive of possible unknown costs and insists upon contingencies which would bring its proposed price for a fixed-price contract to $1,200,000. Under these circumstances, the target price (including target cost and target profit) would probably be $1 million. The overall ceiling in the final contract price would be established at about $1,200,000. If he were awarded a firm fixed-price contract, the contractor would receive all profit resulting from cost savings under $1,200,000, but if we use an incentive contract, the Government receives the lion's share of the savings with the contractor receiving the balance as his incentive profit.

The advantage of incentive contracts lies in the pressure they put on the contractor to cut his costs as deeply as he can. This is particularly important if there is to be a follow-on contract, because reducing the costs on the first contract provides a base for negotiating a low price on the later contract. This can give us an additional saving.

Again, an incentive contract can help us if we are dealing with a company which insists on a price we consider unreasonably high, and if no competition is available. By offering him the incentive of a bigger profit ratio if he cuts his costs, in most cases we can wind up with a lower total cost to the Government.

This leads to a very important point. Costs form a vast bulk of the price we must pay; profit is only a small fraction of this price. It is far better for the Government to allow the profit rate to rise, if by so doing we can cut total costs significantly.

Fixed-price redeterminable contracts are the other major type for intermediate pricing situations. As soon as enough basic development has been accomplished under a cost-plus-fixed-fee contract, we utilize the resulting cost experience to set a ceiling on the price the Government must pay. In many cases, the available cost information is insufficient to permit the establishment of firm target costs which would permit the use of an incentive contract. Under these circumstances we use redeterminable contracts. In this type of contract, the ceiling reflects the contingencies and the unknowns of initial production; the contract also provides for the redetermination of cost at some point in the production process-say at completion of the 40th unit out of a total of 100 units earlier if prior experience is available-or in the case of a ship at 40 percent of completion.

Until the contract has been redetermined, the contractor does not have the incentive to keep costs low which he would have under an incentive contract. As a matter of fact, there is the possibility that unnecessary costs may be incurred in the early stage of the redeterminable contract. This would generate relatively high costs which the contractor might feel would help him to negotiate the highest possible final price. After redetermination, such a contractor might then effect cost savings in order to improve his profit position. In

that situation, the contractor receives all the benefit of such savings. That is one reason we much prefer incentive contracts if they can appropriately be used.

In summary, because of the variety of pricing situations, we have developed five major types of contracts. These can be listed as follows, in their order of preference:

1. Firm fixed-price_‒‒‒‒‒

2. Fixed-price with escalation____

3. Fixed-price incentive_---

4. Fixed-price redeterminable.... 5. Cost-type‒‒‒‒‒‒

Adequate cost data or truly competitive.

Where specified costs are likely to change.

Puts ceiling on costs, and gives the contractor a monetary incentive to reduce costs.

Puts ceiling on costs.

Used where sufficient cost information is not available to use any other type of contract.

Every one of these contracts serves a real need.

Now, let us examine the use of incentive contracts more intensively. Competition and monetary incentives are the important factors which motivate a contractor to put forth his best efforts.

If adequate competition is not available, it is important that we utilize a monetary incentive in order to generate a cost saving. To do so, we proceed as follows:

The negotiator uses cost auditors, technicians, facilities advisers, and other experts to acquire and analyze cost information, manufacturing data and other pertinent information, to develop a realistic target cost. With the contractor we then agree to a ceiling above which the contractor will absorb all costs. We also develop a profit formula which reflects the accuracy of the target and the profit share required to motivate the contractor to save all he can. This type of contract has been used primarily in the aircraft and ship programs. Some may hold the opinion that a contractor's costs are the same regardless of whether a redeterminable contract or an incentive contract is used. Experience we have accumulated indicates that the additional profits available to the contractor through incentive contracts have reduced costs and have produced for the Navy the most economical result.

It is sometimes contended that a fixed-price contract could be negotiated at the same figure as the target price. We have found that normally the contractor insists upon a fixed price equal or close to the ceiling of the incentive contract. Under these circumstances, to fix a firm price would result in the inclusion of substantial contingencies, and all savings achieved would accrue to the contractor. Usually we can negotiate an incentive target price significantly lower than a firm fixed-price would be.

The General Accounting Office has been critical of some fixedprice contracts being used prematurely, before sufficient cost data was available. This is consistent with our strong conviction that we must be free to use escalation, incentive, and redeterminable contracts wherever they are appropriate.

Various questions have been asked about our ability to estimate accurately costs for incentive contracts. We would like to make the following points

Mr. VINSON. Now read this very carefully.

Secretary BANTZ. Ability to estimate accurately is even more important for firm fixed-price and fixed-price escalation contracts than for incentive contracts, because with them the contractor keeps all of his savings.

Second, we do not use an incentive contract unless we have enough information to estimate the target reasonably accurately.

Third, we do not rely on just one or two persons for our estimates. The negotiator is responsible for seeing that independent data for our estimates is obtained from our technical people and auditors, from records of previous purchases, from the company itself, and often from its competitors. The company's performance on prior contracts and the validity of its prior estimates are important considerations. All members of our negotiating team coordinate their varied skills in setting the target price. We also review the team's proposal, first within the Bureau and later in the Office of Naval Material. The Assistant Secretary of the Navy personally reviews some proposed contracts. This is usually the case in very major ones. The point is that the estimate is not that of a single individual, but rather a cooperative product of a team of specialists in various divisions of the Navy.

We consider the incentive contract to be vital to the interests of the Navy Department, in order to procure complex equipment at the least cost. We feel strongly that if this type of contract were not available, we would be forced into greater use of redeterminable and cost-type contracts which, in our opinion, are not as effective in controlling costs.

In conclusion, we wish to stress that we use the fixed-price incentive contract only where a realistic estimate of the costs can be made. This is all of the statement, sir.

Mr. VINSON. Mr. Courtney, get a copy of that statement, please, sir.

So there is justification, set out in your statement, as to why you think you are warranted in continuing to use the incentive contract. Now, Mr. Secretary, what has the Comptroller General had to say about your estimate on incentive contracts? Is there anything in these documents that we submitted here from the Comptroller General as to his views on the estimates that you make as a basis for your incentive contracts, in fixing the target price?

Secretary BANTZ. Specifically, I don't know of any, sir. I am going to ask Mr. Steger if he knows of any.

Mr. VINSON. I couldn't understand you, sir.

Secretary BANTZ. I don't know of any statement that the General Accounting Office has made, sir, in line of what you just asked, the question.

Mr. VINSON. Is there anything, Mr. Courtney, in the comments of the Comptroller General in reference to the estimates they used for their target price, the method by which they obtain the information?

Mr. COURTNEY. Mr. Chairman, there were six, as I recall it, contracts reported on last fall which were discussed with the committee by the Comptroller General

Secretary BANTZ. I remember those very well. Mr. Jones is thoroughly familiar with them.

Mr. COURTNEY. Six, am I right?

Mr. JONES. Mr. Vinson, I might say that this is one of the reasons why we changed our policies and procedures to tighten up our procurement.

The General Accounting Office indicated specific situations or instances in which we had not evaluated the cost information submitted by the contractor to the extent that we were able to negotiate accurate targets in those instances. We do no believe, sir, that those instances are general or that they represent what we are normally able to do in negotiating an incentive contract.

Mr. VINSON. Then up to that time, the Comptroller General was somewhat critical as to your estimate of your target prices, the method by which you arrived at it.

Mr. JONES. On some contracts; yes, sir.

Mr. VINSON. On some individual contracts.

Mr. JONES. Yes, sir.

Mr. VINSON. Six of them. Now how many have you passed on? Is that the only number passed on by the Comptroller?

Mr. JONES. We are of the opinion that this represents a small portion of the total number which were actually evaluated by the General Accounting Office. I do not have the figure. But, in general, we feel that the vast majority of these contracts were properly priced. Mr. VINSON. And how did it happen, then, that you did not have the proper evaluation of these six?

Mr. JONES. There were instances in which the information which was available had not been thoroughly evaluated and there were instances in which information should have been obtained which was not obtained.

Mr. VINSON. Now the same team, and the team that makes these evaluations, was passing on it at that time, were they not?

Mr. JONES. There was at that time the team operation.

Mr. VINSON. It was the same. And the Comptroller, in examining these six, concluded that the evaluation had not received the careful scrutiny and surveillance and attention it should have?

Mr. JONES. Yes, sir.

Mr. VINSON. Is that correct?

Mr. JONES. That is correct; yes, sir.

Mr. VINSON. Well, from that conclusion, why wouldn't it follow that he probably did not pass on the others, or else that you were sort of tired and worn out and didn't give it as close scrutiny as you should? That happens. We are all human. Sometimes we slow up at the end of the year. We start off pretty vigorously.

Mr. JONES. I should correct this, Mr. Vinson, because these six which were pointed out by the General Accounting Office were incurred, as I recall, during the years from about 1952 to 1957. It is over a period of about 5 years. So that the same individuals would not necessarily have been involved.

Mr. VINSON. Now let's go back a little. When was the incentivetype contract brought into being and who originated it?

Mr. JONES. It is my understanding that the incentive-type contract was originated by the Navy during the Second World War.

Mr. VINSON. Was it brought on the suggestion of the Navy or the suggestion of the manufacturer?