See Article Excerpt below regarding Cost Based Pricing as it relates to government contracting. Paraphrase the author's description and elaborate with the aid of two library articles.

COST-BASED PRICING

Cost-based pricing differs from other pricing techniques in several ways. Cost-based pricing uses actual or estimated costs to determine the price of a government contract. Price is established by adding a profit or fee to these actual or estimated costs. Compared with market-based pricing, cost-based pricing is much more difficult to perform and subject to many more regulations. For example, the cost principles in FAR Part 31 apply when using cost-based pricing. Profit or fee is not significantly subject to regulation but is more prominently influenced by federal agency guidelines on negotiating profit or fee. Some legislated fee limits exist for cost-plus-fixed-fee contracts and for architect-and-engineering contracts; existing regulations do not address what fee a contractor may request but do provide guidelines to the government contracting officers. In market-based pricing, cost allowability and profit levels are irrelevant in that the price is assessed by the potential customer in terms of value received by purchasing the goods or services rather than by the cost (or estimated cost) to the seller.

By contrast, market-based pricing consists of a single figure for the price, which the buyer evaluates based on the perceived benefit or value received. The estimated cost and the amount of profit are irrelevant to the buyer's decision; the value of the goods is simply assessed and compared to the price by the buyer. Prices of competitors' products and services might be also compared in this decision process. In addition, completely different alternative solutions can be compared to one another.

Need for Cost-Based Pricing Cost-based government contract pricing has its origins in World War I. Before that time, the federal government purchased goods and services mostly available to the general publichorses, guns, wagons, foodstuffs, and so on. The need to design and build advanced, technological, and highly specialized war machinerysuch as tanks and airplanesnot sold to the general public caused a shift to cost-based pricing, for good reason. If a company had had to accept a firm-fixed-price contract to design and build the first United States government-purchased tank, the price would have been exceptionally high due to the uncertainties of production cost, technological feasibility, production quantity, and price stability of materials. Sellers would have had to include substantial contingencies to be assured of a profitable contract. Setting the price at allowable cost plus a fixed fee removed enough risk from the seller that the total price was much less than that for a fixed-price contract.

Note the use of the word allowable to describe reimbursed costs in the previous paragraph. Clearly, the government did not want to give any contractor a blank check. Certain costs were considered to be not reimbursable due to public policy. Thus, FAR Part 31 now provides detailed guidance on what costs are unallowable. For example, entertainment costs are unallowable because "entertaining" government officials is not allowed; thus, taxpayer money should not be paid to contractors to cover costs of entertainment.

Often cost-reimbursement contracts are rightly criticized as not providing an incentive for a contractor to reduce costs, because cost reductions result in a lower price for the next sale and less profit. This is a valid criticism, but this contract type still has value for certain procurements where the risk under a fixed-price contract is so great that the resulting prices would be extremely high.