FAR 16.402-1—Cost incentives.
Plain-English Summary
FAR 16.402-1 explains the basic structure and purpose of cost incentive contracts. It covers what a cost incentive is, how it is usually expressed as a profit or fee adjustment formula, and why the government uses it to motivate the contractor to manage costs effectively. The section also states a key limitation: if a contract includes any incentive other than a cost incentive, it must also include a cost incentive or a cost constraint. For most incentive contracts, the rule requires a target cost, a target profit or fee, and a formula that adjusts profit or fee based on actual cost performance, subject to any price ceiling or minimum/maximum fee limits. The section also identifies the special case of award-fee contracts, which are treated differently under FAR 16.404 and 16.401(e). In practice, this provision is the foundation for structuring incentive arrangements so that both parties understand how cost performance affects contractor compensation and how the contract will reward savings or penalize overruns.
Key Rules
Cost incentives are the norm
Most incentive contracts use only cost incentives. These incentives are usually built into a profit or fee adjustment formula designed to encourage the contractor to control costs efficiently.
Other incentives need cost protection
A contract may not include incentives other than cost incentives unless it also includes a cost incentive or a cost constraint. This prevents a contract from rewarding non-cost goals without also tying compensation to cost performance.
Target cost is required
Except for award-fee contracts, incentive contracts must include a target cost. The target cost serves as the baseline against which actual cost performance is measured.
Target profit or fee is required
The contract must also include a target profit or target fee. This is the amount the contractor earns if actual cost equals the target cost, before any adjustment for performance.
Formula must adjust compensation
The profit or fee adjustment formula must increase compensation when actual cost is below target and decrease compensation when actual cost is above target, subject to any ceiling or fee limits in the contract.
Award-fee contracts are different
Award-fee contracts are excluded from this specific structure and are governed by FAR 16.404 and 16.401(e). They do not follow the same target-cost/adjustment-formula model described here.
Responsibilities
Contracting Officer
Structure the incentive arrangement so it complies with FAR requirements, including using a target cost and target profit or fee for applicable incentive contracts. Ensure any non-cost incentive is paired with a cost incentive or cost constraint, and confirm the adjustment formula is clear and consistent with any ceiling or fee limits.
Agency
Use incentive contract structures that support cost control and align with acquisition objectives. For award-fee or other special incentive approaches, apply the correct FAR authority and ensure the contract type is appropriate for the work and risk.
Contractor
Manage performance to control actual costs because compensation will rise or fall based on cost results. Understand the target cost, target profit or fee, and adjustment formula so the contractor can forecast financial outcomes and avoid surprises.
Contracting Activity/Acquisition Team
Develop incentive terms that are measurable, understandable, and enforceable. Make sure the contract’s incentive structure matches the work, the risk allocation, and the intended behavior the government wants to encourage.
Practical Implications
This section matters because it ties contractor profit or fee directly to cost performance, so both sides need a clear, mathematically workable formula.
A common pitfall is drafting an incentive that rewards schedule, technical, or other performance goals without also including the required cost incentive or constraint.
Another risk is failing to define the target cost or adjustment formula precisely enough, which can lead to disputes over how much profit or fee is earned.
Contracting officers should check that any ceiling, minimum fee, or maximum fee limits are consistent with the incentive formula and do not create contradictions.
Contractors should model best-case and worst-case outcomes before award so they understand how overruns or underruns will affect compensation.
Official Regulatory Text
(a) Most incentive contracts include only cost incentives, which take the form of a profit or fee adjustment formula and are intended to motivate the contractor to effectively manage costs. No incentive contract may provide for other incentives without also providing a cost incentive (or constraint). (b) Except for award-fee contracts (see 16.404 and 16.401 (e)), incentive contracts include a target cost, a target profit or fee, and a profit or fee adjustment formula that (within the constraints of a price ceiling or minimum and maximum fee) provides that- (1) Actual cost that meets the target will result in the target profit or fee; (2) Actual cost that exceeds the target will result in downward adjustment of target profit or fee; and (3) Actual cost that is below the target will result in upward adjustment of target profit or fee.