Shared-Risk Incentive Contract
Align buyer and supplier rewards around a realistic target cost
- Difficulty
- Advanced
- Time to result
- ~months to results
- Steps
- 6
- Confidence
- 99%
The Shared-Risk Incentive Contract replaces open-ended cost reimbursement with an agreed target cost, reasonable supplier profit, and explicit sharing rules. Carter describes a Joint Strike Fighter arrangement in which the government and contractor would split moderate overruns, while the contractor would absorb all costs beyond a defined ceiling. Savings below the target would also be shared, allowing the supplier to benefit from efficiency rather than merely increasing reimbursable spending. The mechanism aligns economic behavior with program performance while recognizing that early experimental work may still require flexible reimbursement. Its effectiveness depends on a realistic baseline, transparent measurement, a meaningful overrun ceiling, and the supplier's actual ability to control the relevant costs.
Origin
Extracted from Masters in Business through Ash Carter's account of restructuring Joint Strike Fighter production contracts to halt escalating costs.
Core principles
- 01Match contract structure to the maturity of the work
- 02Set a credible target rather than reimbursing every expense
- 03Share moderate overruns and savings
- 04Shift extreme overruns to the party able to control them
- 05Protect reasonable supplier profit for successful delivery
How to run it
- 1
Assess cost maturity
Determine whether the supplier has enough production experience and technical certainty to estimate the work responsibly.
Pro tip Use historical units, process stability, and unresolved technical risks to judge maturity.
Watch out Imposing a fixed target on genuine research uncertainty can produce inflated bids or hidden compromises.
- 2
Set the target cost
Negotiate a credible estimate of efficient delivery based on evidence available to both parties.
Pro tip Separate known production costs from exceptional risks.
Watch out An unrealistic target destroys trust and may encourage gaming.
- 3
Protect reasonable profit
Include a fair profit at target performance so successful delivery remains commercially attractive.
Pro tip Link the profit opportunity to outcomes the supplier can influence.
Watch out Treating all profit as waste can reduce competition and supplier commitment.
- 4
Share ordinary variance
Specify how the buyer and supplier divide moderate overruns and underruns around the target.
Pro tip Use a simple formula that operational teams can understand and forecast.
Watch out Complex formulas can obscure the actual incentive.
- 5
Create an overrun ceiling
Define the point after which the supplier bears all additional cost, limiting the buyer's exposure.
Pro tip Place the ceiling far enough from the target to accommodate normal variance but close enough to change behavior.
Watch out A ceiling is ineffective if later negotiations routinely waive it.
- 6
Measure and enforce
Track actual cost against the target, investigate variance, and apply the agreed sharing rules consistently.
Pro tip Review leading production indicators before financial overruns become irreversible.
Watch out Changing rules after performance is known undermines future contracts.
In the wild
After repeated delays, cost growth, and reputational damage, Carter moved early aircraft production from reimbursement of whatever the contractor spent to an incentive structure. The parties set a target, shared ordinary overruns and savings, and made the contractor responsible for costs beyond a ceiling.
→ Joint Strike Fighter costs stopped rising and eventually declined.
A buyer commissioning the fifth rollout of a stable software platform uses prior deployments to establish a target cost. Moderate savings or overruns are shared, but the supplier bears excessive overruns caused by inefficient delivery.
→ Both parties gain from realistic planning and efficient implementation while the buyer's downside is capped.
Common mistakes
Using cost reimbursement forever
Continuing to reimburse every expense after production becomes predictable removes pressure to improve efficiency.
Setting an arbitrary target
A politically attractive but technically unrealistic target encourages defensive pricing and disputes rather than efficiency.
Socializing every overrun
If the buyer always absorbs excess cost, the supplier lacks a meaningful downside for poor cost control.
Is it for you?
Best for
It is best for repeat production or sufficiently mature work where both parties can estimate a defensible target cost.
Not ideal for
It is not ideal for early experimental research whose scope and technical path remain too uncertain for responsible pricing.
From the transcript
“will agree on a target price seems like and that you think and I think, is about what it will cost to build that plane.”
“every dollar you overrun of that, I'm gonna make you pay fifty cents and the tax barrel bay fifty cents”
“if you if you deliver it cheaper then the target you get to keep fifty cents. I get fifty cents back.”
From the episode
Ash Carter Discusses the Business of Defense
Ash Carter