Thursday, June 04, 2020

PMP Prep: Range of Incentive Effectiveness in Procurement Management




Recently, I wrote an article on Point of Total Assumption (PTA), which is used in Fixed Price with Incentive Fee (FPI/FPIF) contracts. 

One of the biggest misconceptions I’ve seen – PTA can surely be used in Cost Plus Incentive Fee (CPIF) – has been dispelled in the article. I’ve mentioned the reason for it. I’ve also mentioned that Range of Incentive Effectiveness (RIE) is used in Cost Plus Incentive Fee (CPIF) contracts.

Article: Point of Total Assumption in Procurement Management


Questions on PTA have been coming in the PMP exam. In a recent success story, a successful PMP mentioned questions are there on PTA in the exam. In other success stories also, PMPs have mentioned on PTA questions. Another candidate recently asked on the Range of Effectiveness (RIE). As questions on PTA (at most one or two) come, I believe it’s good to know on the RIE concept as well. If you understand PTA well, you can easily understand RIE.

Hence, this post. In this article, we will know more about RIE.


RIE Definition 
The range of incentive effectiveness in a CPIF contract can be defined as follows:

“Range of incentive effectiveness is simply the range of costs in which the incentive is effective. Below this range or above this range, the contract behaves like a Cost Plus Fixed Fee (CPFF) contract.”

In other words, below this range of incentive effectiveness (RIE), after paying a fixed fee to the seller, the buyer share is 100% and sellers share is 0%, i.e., the sharing ratio between buyer and seller is 100%:0%. Similarly, above RIE, after paying a fixed fee to the seller, the sharing ratio between buyer and seller is 100%:0%.

The fee is paid to the seller, because the contract behaves as a CPFF contract, as the previous definition informs. Also, when the CPIF contract becomes a CPFF contract, the fee for the seller becomes fixed.

If there is profit below the RIE, then this profit is taken up by the buyer, after paying the fixed fee to the seller. Similarly, if there is a loss above the RIE, then the loss is also taken by the buyer, after paying the fixed fee to the seller. This concept of RIE is displayed in the below figure.


RIE - Simplified Image, One-Dimentional (Cost)

As shown above, the RIE is basically the cost range – from a minimum RIE cost point to a maximum RIE cost point. You see, in the name itself we have the term “range”!

In case of cost underrun, the buyer takes all the share after the fixed fee of the seller is given. Similarly, during cost overrun, a fixed fee is given to the seller and the buyer has to take all the share. Remember outside RIE zone, the CPIF contract behaves as a CPFF contract!

Hence, beyond RIE, incentive has no effectiveness.

We will understand more of it with an example shortly, but first let’s understand the terms related to RIE in CPIF contracts.

I’ll also strongly recommend that you read the concepts of cost, profit, fee and incentive in the article earlier mentioned. It’s under section: “Price, Cost, Profit, Incentives”.


Terms Related to RIE
When I say terms related to RIE, I mean terms related to CPIF contracts. As noted earlier, RIE is usually the case in CPIF contracts. The terms are:
  • Target Cost (TC): The amount taken by a seller to create or develop an item.
  • Target Fee (TF): It is the profit taken by the seller on top of cost. It is also known as margin or fee.
  • Target Price (TP): Target Price is a combination Target Cost and Target Fee. The formula for TP is Target Price (TP) = Target Cost (TC) + Target Fee (TF).
  • Share Ratio (SR): This is the sharing ratio between buyer and seller, e.g., 80:20. The first percentage is for the buyer, and the second is for the seller. It means for every $1 cost overrun; 80 cents will be paid by the buyer and 20 cents by the seller.
  • Buyer Share Ratio (BSR): This is the share ratio for the buyer. In the above case, the buyer share is 80%. It means for every $1 cost overrun; 80 cents will be paid by buyer. Also, for every $1 cost underrun; 80 cents will be taken by the buyer.
  • Seller Share Ratio (SSR): This is obviously the difference from 100%. In the above case of 80:20, the seller share ratio is 20%. It means for every $1 cost overrun; 20 cents will be paid by seller. Also, for every $1 cost underrun; 20 cents will be taken by the seller.

As you would have noticed the terms are very similar to the ones used in Fixed Price with Incentive Fee (FPIF) contracts. Now, I’ll introduce four more related terms to understand RIE. These are particularly applicable to CPIF contracts.
  • Maximum Fee or Fee (max): In CPIF contract, the fee is incentivized and the maximum fee informs the maximum amount that can be taken as a profit or fee. It is typically be +3% or +4% above the target fee (TF).
  • Minimum Fee or Fee (min): The minimum fee informs the minimum amount that can be taken as a profit or fee. It is typically be -3% or -4% below the target fee (TF).

Both maximum and minimum fee limit is set by the buyer for the seller.
  • RIE (max): This is the cost at minimum fee or Fee (min). In the range of incentive effectiveness, the cost is at its maximum point; hence simply named as RIE (max). This cost point is reached in the cost-profit curve, when the profit or fee is minimum.
  • RIE (min): This is the cost at maximum fee or Fee (max). In the range of incentive effectiveness, the cost is at its minimum point; hence simply named as RIE (min). This cost point is reached in the cost-profit curve, when the profit or fee is maximum.
Do note again: in the profit-cost curve, we have the following key points.
  • When cost is at RIE (min), we have Fee (max).
  • When cost is at RIE (max), we have Fee (min).

With this understanding, I’ve expanded the previous figure, and showing only the cost part, in one-dimensional (1D) format.


RIE - Explanatory Image, One-Dimentional (Cost)

As shown in the above figure:
  • At RIE (min), the fee is maximum. In other words, when the Fee is maximum, in the range of effectiveness, we are at RIE (minimum) cost point.
  • At RIE (max), the fee is minimum. In other words, when the Fee is minimum, in the range of effectiveness, we are at RIE (maximum) cost point.

Also, the figure informs that the target cost (TC) is somewhere between the RIE (min) and RIE (max) cost points.


RIE Formulas
Now we have two RIE points – RIE (min) and RIE (max). And at RIE (min), the fee is maximum and at RIE (max), the fee is minimum.

It’s obvious that when the fee/profit is maximum, then there is cost underrun, whereas when the fee/profit is minimum, there is cost overrun.

Hence, there will be two formulas for RIE.

RIE (min) Formula – Cost Underrun
RIE (min) will be during cost underrun. The formula for RIE (min) is depicted below.



RIE (max) Formula – Cost Overrun
RIE (max) will be during cost overrun. The formula for RIE (max) is noted in the below figure.



RIE Formula
As the Range of Incentive Effectiveness (RIE) is the cost range between RIE (min) and RIE (max), obviously, the formula for RIE will be the one shown below.



Example
Let’s take an example to understand. I’ll reuse the same example given in PTA for FPIF contracts. This will make your understanding easier and also easy to solve.
An Example of RIE

Question: In a CPIF contract, the buyer and seller agreed to a cost of $300,000 and a fee (or profit) of $30,000, which is 10% of the cost. Because it’s a CPIF contract, the maximum fee is set at 13% and the minimum fee is set at 7% of the cost. The share ratio between the buyer and seller will be 60%:40%. Determine the RIE (max) and RIE (min) values, along with the range of incentive effectiveness (RIE).

Solution:
From this example, let’s find out the values.
  • Target Cost (TC): $300,000
  • Target Fee (TF): $30,000
  • Target Price (TP): $300,000 + $30,000 = $330,000
  • Sharing Ratio (SR): 60:40
  • Buyer Sharer Ratio (BSR): 60% or 0.6
  • Seller Sharer Ratio (SSR): 40% or 0.4
  • Maximum fee or Fee (max): 13% of TC, i.e., 13% of $300,000
    Fee (max): $39,000
  • Minimum fee or Fee (min): 7% of TC, i.e., 7% of $300,000
    Fee (min): $21,000

We will first calculate the case for RIE (min), which is for cost underrun.

Calculation for RIE (min)
RIE (min) = TC - [ Fee (max) – TF ] / SSR
=> RIE (min) = $300,000 – [($39,000 - $30,000)] / 0.4           40% is 0.4
= $300,000 – [$9,000]/0.4
= $300,000 – $22,500
= $277,500

Next, let’s calculate the case for RIE (max), which is for cost overrun.

Calculation for RIE (max)
RIE (max) = TC + [ (TF - Fee (min)] / SSR ]
=> RIE (max) = $300,000 + [($30,000 - $21,000)] / 0.4           40% is 0.4
= $300,000 + [$9,000]/0.4
= $300,000 + $22,500
= $322,500

Calculation for Final RIE
Hence RIE = RIE (max) – RIE (min) = $322,500 - $277,500
RIE = $45,000


Conclusion
In this range of incentive effectiveness, i.e., $45,000, the CPIF contract is effective. Beyond this range – above RIE (max) of $322,500 or below RIE (min) of $277,500 – the CPIF contract no longer behaves like an incentivized contract. Rather, it behaves like a CPFF contract.

For the PMP exam, you need to know these basics to answer questions. The questions are most likely to be direct in nature for RIE and for that you need to just remember the formulas. Sometimes the questions can be a bit tricky, e.g., it might give you just the Fee (max) and Fee (min) values and you will be asked to calculate RIE.

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