Getting Paid Your Costs Plus a Margin Removes the Reason to Control Costs
Defence procurement chooses between contracts that reimburse cost and contracts that fix a price. Each transfers risk in a different direction and each creates a distinct problem.
The Procurement Problem
A government buying a developed commodity can simply ask for prices and choose the lowest. Buying something that does not yet exist, where the technical challenges are unknown and the development may take a decade, is a different exercise.
Nobody can price such work accurately in advance, including the contractor. Defence procurement therefore uses contract structures that allocate the resulting uncertainty, and the choice of structure is one of the most consequential decisions in the process.
The contract type does not remove the risk that development costs more than expected. It only determines which party pays for it.
The Two Poles
At one end sits cost plus contracting, where the government reimburses allowable incurred costs and pays a fee on top. At the other sits firm fixed price, where the contractor agrees to deliver for an agreed sum and absorbs any overrun.
| Cost plus | Fixed price | |
|---|---|---|
| Who bears overruns | Government | Contractor |
| Incentive to control cost | Weak | Strong |
| Suits | Novel development | Well understood production |
| Oversight required | Extensive | Limited |
| Contractor risk | Low | Potentially severe |
The Cost Plus Problem
The weakness is immediate. If costs are reimbursed, spending more does not harm the contractor, and under structures where the fee is a percentage of cost, spending more actively increases the fee. That specific form is now generally prohibited for exactly this reason.
Even with a fixed fee, the incentive to economise is weak. The contractor is not rewarded for efficiency, so the discipline has to come from outside, through government audit of allowable costs, oversight of accounting systems and detailed rules on what may be charged.
This oversight is itself expensive, for both parties, and it creates a compliance burden that deters commercial companies from bidding on government work at all. The result is a specialised contractor base that is expert at operating within these rules, which reduces competition.
The Fixed Price Problem
Fixed price contracting appears to solve everything. The contractor has every incentive to control cost, oversight requirements fall, and the government knows its exposure.
It works well where the work is understood. Applied to development programmes with genuine technical uncertainty, it has repeatedly produced large losses.
The mechanism is straightforward. Contractors competing for an award bid aggressively, sometimes below realistic cost, because winning the development phase positions them for decades of production and sustainment revenue. When the technical difficulties prove greater than assumed, the losses fall entirely on the contractor, and there are well documented cases of charges running into billions on individual fixed price development programmes.
The consequence is not only financial. A contractor losing money on a programme has an incentive to minimise further investment in it, which can affect schedule and capability.
The Middle Ground
Most contracts sit between the poles. Incentive fee structures share overruns and underruns between the parties according to an agreed formula, so the contractor bears part of any excess and keeps part of any saving. Award fee arrangements pay based on subjective assessment of performance against criteria.
A common approach uses cost reimbursement during development, when uncertainty is highest, and transitions to fixed price for production once the design is stable and costs are understood. This matches the structure to the actual risk at each stage, which is what the choice is supposed to do.
Why Programmes Overrun Anyway
Contract structure is only part of the explanation. Requirements change during long programmes as threats and technology evolve, and each change is renegotiated. Optimistic initial estimates help programmes secure approval, a bias well documented across large public projects. Production quantities are frequently cut after development, which spreads fixed development cost across fewer units and raises the price per unit, which prompts further cuts.
That last dynamic is particularly damaging, because it is self reinforcing and originates in budget decisions rather than in contractor performance.
The Bottom Line
Defence contracting is an extended exercise in allocating uncertainty that nobody can eliminate. Cost reimbursement protects contractors and weakens cost discipline, requiring expensive oversight to compensate. Fixed price restores the incentive and has produced severe losses when applied to work whose difficulty was genuinely unknown at bid. The structures that work best match the contract type to the stage of technical maturity, and the failures usually come from applying fixed price certainty to a problem that had not yet been solved.