SI’s Director of Operations, Alayne Dunn, sits down with Founder, Richard L. Dunn, to discuss milestone payments. What are OT milestone payments and how do they differ from FAR performance-based payments?
AD: Rick, let’s talk about milestone payments. Can you tell me the difference between other transactions milestone payments and FAR performance-based payments?
RD: The first thing to note, at DARPA, we pioneered milestone payments in other transactions and a few years later performance-based payments showed up in the FAR as a way to finance procurement contracts. The idea behind milestone payments relates to the basic flexibility of other transactions. In the Federal Acquisition Regulation, you have basically cost reimbursement contracting and fixed price contracting. Now there are variations on those themes, but it’s basically that dichotomy. Most of the idea behind milestone payments was that they are not just one thing, they’re not just a method of financing the effort, they are that and they are also a key management tool in the project.
AD: So, there’s an additional benefit there?
RD: Yeah, it’s getting away from this either-or mentality that you end up with in a highly regulated system and they can be used in a variety of ways. So, the idea is that you can break up the project into segments where you have defined technical goals, and those technical goals are associated with payments, and the payment does not necessarily have to be related to the estimated cost of accomplishing the goal. In fact, a related issue, not part of your question, but nonetheless a related issue, is that in other transactions advanced payments are authorized. Now we have seldom used advanced payments, but what we often have are what we call soft milestones. On the front end of the project, there is an event that occurs for which a payment is made, and the payment may have very little connection with the cost of the event, but it provides that financing for initial labor and for long lead-time items. That might be a very valuable thing if you have a poorly capitalized company or perhaps if you’re dealing with an academic institution.
AD: So, it’s kind of a kickstart?
RD: It’s absolutely a kickstart to the project. Once you do that however, you want your milestones to be relatively disciplined, and not disciplined in the sense that key things actually have to occur. The mindset that you bring to laying out the milestones is “I’m at this point and my project goal is over there, and I want to get there. What key points should I get to, to go there?” So, I might use a critical path methodology and put milestone payments at critical nodes on that critical path. And I might take a systems engineering approach and say “you know, what accumulation of efforts do I have to have in order to accomplish my goals?” and again, associate the milestone payments with those. The idea being that if you fail to…and we call these milestones really talking about defined observable achievements, typically technical achievements, but I’ll get to that a point where that’s not always the case, and if we fail to accomplish them, and they’re typically also associated with a schedule to get to this particular event, if we fail to accomplish them, that forces us then to ask the question, “why didn’t we accomplish that?” The answer to that question then relates to a management decision: the performer was inadequate, it doesn’t look like he’s going to be able to accomplish this project at all; we got the milestone wrong; there was a an intervening cause that we didn’t expect and it interfered with performing. The answer might be varied, but by asking the question, understanding the answer, we then determine what comes next…Do we just continue? Do we just skip that milestone and continue with the project? Do we terminate the project now? Do we realign the project? Rather than in cost reimbursement contracting, where we just keep trudging on trying to get to the end and an incurring costs all the way, we have a dot that a failing is okay and if we’re going to fail, fail early. It’s sort of a different approach and a different philosophy.
Now how is that distinguished from performance-based payments under FAR? First of all, we pioneered milestone payments at DARPA, and a few years later the FAR incorporated performance-based payments. Typically, OT milestone payments don’t look at incurred costs at all. The level of fidelity that you want, the level of discipline that you put it into relating estimated cost to milestone, depends on the project. It depends whether or not there’s resource sharing involved, it depends on who the performer is. However, under FAR you must track incurred cost even though you’re doing milestones, even though you’re doing performance based payment, and you’re looking at technical achievements along the way, and you can’t pay more than 90 percent of the payments without validating that incurred costs have been incurred. Again, it’s a fundamentally different approach, where we’re looking at price and value rather than cost. And some people are so wedded with getting the cost issues right that they really miss out trying to understand “what’s the value to the government of this project succeeding or even the project failing?” Because failure of the project may teach us a great deal.
I said these milestones are typically technical milestones, observable technical accomplishments, but not always. One of the examples of that is not a DoD example, but it’s actually a NASA example with the Commercial Orbital Transportation System (COTS), which resulted in the development by Space Exploration Corporation of the Falcon 9 launch vehicle. That was laid out with a series of payable milestones, most of which were technical in nature, but some of which were financial in nature…namely that in addition to government money coming into the project, the company put money into the project and the company was required also to bring in third-party financing into the project. And some of the milestones were X amount of third-party money coming in and a government payment was premise on this third-party money. So, the flexibility on structuring OTs is almost limitless. They can be firm fixed price, they can be cost reimbursement, but payable milestones serve the dual purpose of financing the project as well as a key role in managing the project. The literature on performance-based payments in FAR contracting are actually seldom used and the workforce has very little background in using milestone payments. For OTS, they are the preferred or the recommended method of structuring the agreement, so they are really fundamentally different.
AD: Great. Well, thank you for answering that question and if you would like to learn more about milestone payments, please visit our website at strategicinstitute.org.