Original Date: 10/18/1999
Revision Date: 01/18/2007
Information : Firm Pricing Model for Engineering Support Services
Orenda Turbines provides Technical Investigations and Engineering Support (TIES) services as part of its engine repair and overhaul services to the Canadian Forces (CF). In the past, the company negotiated this type of multi-year contract on a cost-plus basis the actual number of hours incurred (up to a maximum) times the negotiated hourly labor rate for each task. With this approach, there was no incentive for Orenda Turbines to become more efficient nor to reduce the number of hours required. In fact, the opposite was true more hours meant more revenue. The cost-plus approach had limited profit potential for Orenda Turbines and did not contribute to increasing the company’s competitiveness. From the customer’s standpoint, there was little potential for cost reduction. To improve this situation, Orenda Turbines implemented a Firm Pricing Model for Engineering Support Services. This system enables the company to negotiate the contract using a fixed-price model, whereby gains resulting from efficiency improvements are shared by Orenda Turbines and the customer.
Under the Firm Pricing Model (Figure 2-3), Orenda Turbines and the Canadian government negotiate in advance a fixed number of hours to perform an agreed Engineering Support package for each one-year period of the contract. They also determine a labor rate separately and apply it to the number of hours to calculate the yearly price, which is paid in 12-equal monthly installments. If Orenda Turbines incurs more time to perform the contract tasks than has been negotiated, the company absorbs the extra costs. If it takes less time, Orenda Turbines’ profit margin will be higher. The company reports the actual hours worked to the customer for each contract period. Using an agreed upon formula, Orenda Turbines and the customer will reduce the specified hours in the next contract period by a portion of the difference between actual and contracted hours in the previous period. In the early years of a contract, the government retains the larger share of the difference because the initial improvements are easier for Orenda Turbines to achieve. In the later years of a contract, Orenda Turbines retains the larger share because these improvements are now more difficult to accomplish.
The Engineering Support aspects of TIES lend themselves to the Firm Pricing Model because they are well defined, continuous, and stable. However, Orenda Turbines continues to price Technical Investigations on a cost-plus basis since their number and scope cannot be accurately estimated in advance. A key factor in the successful implementation of the Firm Pricing Model is mutual trust. The approach would fail if either party abused it (e.g., the supplier cut corners on some activities to increase profit; the customer tried to include additional activities to the workscope without adjusting the contracted hours). To ensure that the work performed under the system meets customer requirements, Orenda Turbines asked the CF to implement a feedback system in which it rates the performance of each Engineering Support task performed by the company on a monthly basis. This feedback system has helped validate the effectiveness of the Firm Pricing Model.
The Firm Pricing Model enables Orenda Turbines to make more profit than it would using the cost-plus approach while allowing the customer to benefit from consistently decreasing costs. Between 1993 and 1999, the Engineering Support contract hours for one engine program were reduced by 43%. Orenda Turbines and the CF are currently increasing the workscope to include the provision of two technical service representatives at the operating bases.
Figure 2-3. Firm Pricing of Engineering Support
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