An application of cost risk in incentive contracts.
McGrath, Christopher Michael
Greer, Willis R. Jr.
Smith, Ray W.
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This paper begins with an examination of the literature concerning incentive contract effectiveness and contractor motivation. Citing the most frequently supported conclusions, the researcher integrates these with a cost risk analysis methodology based upon the Beta distribution. The result is a share curve that automatically adjusts the share ratio based upon estimated cost variance. The researcher suggests that this approach is better at reflecting cost risk than the standard linear design. The share curve provides more risk sharing, especially at higher levels of cost variance, and provides both significant rewards and penalties only for significant deviations from target cost. The final conclusion is that the share curve mitigates the defense contractors' "risk averse" nature, thus allowing the profit motive to become operative in incentivizing the contractor to control or reduce costs.
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