Material acquisition, Conversion to direct labor, Conversion-related indirect costs, and. General management.

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1 26 Contract Management July 2009

2 Contract Management July

3 Profit is a motivator of efficient and effective contract performance. In price negotiations based on cost analysis, profit is one of the elements addressed during negotiations. In preparing for and conducting contract negotiations, both government and contractor negotiators find working with the cost elements of labor, material, other direct costs, and indirect costs to be relatively straightforward. Negotiating profit is a different matter, however, but it does not need to be difficult. Profit negotiation is often viewed less as science and more as art with an associated potential for significant pitfalls. However, armed with the right knowledge and a structured, analytical perspective, negotiators can reach mutual agreement on profit with the same confidence as when working through the more quantitative parts of a negotiation. In principal, profit can be viewed in a number of different ways. An economist sees profit as the expense associated with attracting industry into committing its resources and assuming risk. From a financial perspective, profit is the incentive that entices business entities to apply capital, given a measure of unknown factors in order to accomplish a return on an investment. An accountant identifies profit as residual revenue above and beyond costs. To the IRS, profit is a tax target. The Federal Acquisition Regulation (FAR) offers the federal contracts view of profit at FAR (a)(2): It is in the government s interest to offer contractors opportunities for financial rewards sufficient to stimulate efficient contract performance, attract the best capabilities of qualified large and small business concerns to government contracts, and maintain a viable industrial base. In a competitive environment, profit, like other costs, is assumed to converge at a fair level through normal market forces. Therefore, from a buyer s perspective, profit need only be analyzed in situations when cost analysis is performed. Price analysis, of course, does include a review of profit, but unsegregated and as a part of the overall determination of price reasonableness. What may make negotiating profit so daunting for many people is the abstract nature of profit itself. Taken at the macro level, profit is admittedly difficult to analyze. Approaching profit from a structured, analytical perspective will help lessen the hesitation usually associated with negotiating profit. To highlight the importance of a systematic approach for profits analysis in federal contracts, FAR (a)(3) states, Negotiation of extremely low profits, use of historical averages, or automatic application of predetermined percentages to total estimated costs do not provide proper motivation for optimum contract performance. To illustrate how using one of the above practices can negatively impact both parties, let s consider the application of predetermined percentages that occurred in one large Department of Defense development and production program. The government and the contractor had an understanding that all negotiated changes and additional work would carry the same rate of profit. The assumption was that over the long haul, profit would balance out to a consistent equilibrium and both sides would save administrative costs by avoiding repeated negotiation of the profit factor. In reality, profit negotiations utilizing a structured approach would not have been that onerous or costly. The government lost out on the opportunity to influence contractor performance by avoiding profit discussions during negotiations. Conversely, the contractor lost in instances where unique aspects of the negotiated work would have warranted an increased rate of profit. The FAR describes a structured approach to analyzing profit in terms of common factors and other factors. Common factors are those that the FAR requires to be considered when profit is up for negotiation. Others factors are those that may be unique to a particular agency, acquisition, or specific procurement approach. Figure 1 on page 30 shows the breakdown of common factors into six major categories. Contractor Effort Contractor effort is the factor that goes to the heart of actual performance in accomplishing the work required. A higher profit would be given a greater degree in complexity and a higher level of effort, which would correspondingly increase risk. Contractor effort is subdivided into four elements: Material acquisition, Conversion to direct labor, Conversion-related indirect costs, and General management. Material Acquisition As a sub-element, material acquisition measures contractor input and management of the acquisition of the necessary physical contributions to contract output. If more complex or difficult to obtain items are required in contract performance, consideration for higher profit may be in order. Certainly, the complexity of managing a large number of suppliers and subcontractors adds directly to overall risk. Conversely, less profit consideration for material acquisition would be appropriate, for example, if the work required was all in-house contractor labor in performance of a service contract. Conversion to Direct Labor A second sub-element of contractor effort is what the FAR calls conversion of direct labor. Additional profit consideration should be given if the labor required is more diverse, more skilled, or requires more supervision and coordination. At the high end of the profit spectrum are contract projects that pull together tight schedules of engineers, scientists, or high-end manufacturing trades. These would be candidates for a closer look at increasing profit due to direct labor conversion factors. At the lower end of the profit spectrum might be contracts for staff augmentation, where much of the day-to-day tasking is provided by the acquiring activity. However, in instances where recruitment and retention are substantial concerns, these augmentation type 28 Contract Management July 2009

4 contracts may warrant consideration of the higher end of the profit spectrum for labor that is in high demand. Conversion-Related Indirect Costs and General Management Indirect costs and general management expenses relate to profit in terms of the significance that indirect activities contribute to contract performance. Indirect cost activities that are routine in nature provide no support for negotiating increased profit. Conversely, activities such as specialized continuing education or the need to maintain highly technical IT systems suggest higher profit. Even though they may not be direct costs, they do have a direct impact on the quality of contract performance outcomes. Contract Cost Risk A second element in analyzing profit is contract cost risk. Decisions about contract type generally attempt to take into account the performance risk that a contractor will assume and balance this with the contract cost risk that directly results from the various contract types. The standard onedimensional illustration of contract types casts risk assumption by a contractor from low to high as contract types vary from cost-plus-fixed-fee to firm-fixed-price. From a cost perspective, firm-fixed-price is traditionally viewed as the most risky for contractors. (See Figure 2 on page 32.) Beyond contract type, other factors can significantly bear on the nature of cost risk as well. Work that is routine, has plenty of cost history, and is predictably steady carries much less cost risk to a contractor, even when performed under a firm-fixed-price contract. Timing of the profit negotiation is also a consideration (e.g., undefinitized contracts). Even though the final cost settlement for undefinitized contract actions may concern work that, by its nature, carries high cost risk, these negotiations often primarily involve discussions of actual costs. In these cases, the contractor would bear virtually no cost risk and should expect lower profit consideration. Taken in total, the greater amount of cost risk a contractor should expect to assume should correspondingly trigger consideration of a higher profit. Federal Socioeconomic Programs The FAR provides the government a way to incentivize federal socioeconomic programs through profit analysis and positive profit consideration. FAR (d)(iii) states, Greater profit opportunity should be provided contractors that have displayed unusual initiative in these [socioeconomic] programs. The broader goal of a more diverse industrial base is supported and encouraged by the implementation of this aspect of profit policy. It is not often that contractors take the opportunity to highlight socioeconomic effort in respect to higher profit expectations. Capital Investments Contractors who make capital investments that will provide for efficiency and economical performance can also be encouraged through profit considerations. Contract Management July

5 Figure 1. Profit Analysis 30 Contract Management July 2009

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7 Figure 2. contractor cost risk By including the potential for increased profit for appropriate non-government investment during the profit analysis process, the government encourages contractors to plan beyond the short term toward longer-lasting benefits to the government. Contractors should remember to include discussions of current and planned capital investments when negotiations with the government turn to profit. Cost Control and Other Past Performance While additional profit is in order when cost risk on a contract is high, FAR profit guidelines can be used to motivate contractors to lessen potential cost variability. By taking the opportunity to reward past successful efforts at cost control by profit consideration on current and future work, the government s intention is to counter any potential incentives contractors may have by continuing high levels of cost risk into follow-on contracts. Independent Development Contracting officers are encouraged to reward contractors who contribute independent development that directly benefits contract outcomes or performance with additional profit consideration. The FAR emphasizes the need to verify the independence of the development costs, as opposed to government-funded work. Further, agencies are required to have a structured approach to analyze and negotiate profit. Some, like the Department of Defense, have a required form entitled, Weighted Guidelines, DD Form 1547 used to document negotiation objectives. However, profit analysis involves more than assigning values in a form. Negotiators should understand the rationale behind the suggested ranges and weights for each factor so that the buildup to the overall objective results in a reasonable profit target. Since there is purposefully subjectivity in assigning the weighted values, understanding the theory behind the numbers is essential for a structured process to be genuinely valid. 32 Contract Management July 2009

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9 Conclusion One final caution: government contracting officials should realize that the profit, as negotiated, does not necessarily equate to the ultimate financial gain realized by a contractor. Factors such as efficiencies gained in fixed-price contracts or non-allowable costs that contribute to the success of a cost type effort all calculate into a company s final rate of profit. Concrete information about actual profit rates is typically proprietary to the contractor and perhaps beyond the bounds of government contract audit. Conversely, a contractor might negotiate profit rates for an overall return in the context of the overall portfolio of business. No matter what the profit is that is eventually negotiated, negotiations aimed merely at reducing prices by reducing profit, without proper recognition of the function of profit, are not in the government s interest. CM About the Authors WILLIAM BUD ALMAS is a retired U.S. Army officer. He is a certified contracts and purchasing professional and is the CEO and founder of B3 Solutions LLC, an 8(a) service-disabled veteran-owned small business providing both program management and acquisition management expertise to government and industry. FRED SCHLICH, CPCM, is a retired U.S. Air Force officer. He has over 25 years of federal contracting and program management experience in which he has provided consulting expertise to a number of government acquisition organizations. He is currently manager of contracts and subcontracts for Cahaba Government Benefit Administrators, LLC. Send comments about this article to cm@ncmahq.org. Discuss this article with your peers online! Just go to Almas and click on Join Discussion. AudioSeminarS Learning Made Easy navigant consulting SEMiNArS contract accounting These seminars provide participants with brief introductions to the accounting for costs at each step of contract performance, from bidding to closeout. Because of the complexity of government and commercial business cost accounting rules, all professionals involved with contracts in these forums need a basic understanding of the cost accounting requirements that affect these contracts. The Foreign Corrupt Practices Act (FCPA) and the International Traffic in Arms (ITAR) Law July 21, 2009 Contractor Purchasing System Reviews August 18, 2009 Optimizing Government Contractor Supply Chains September 22, 2009 Cost Realism october 20, 2009 Earned Value Management Systems November 17, 2009 Incentive and Award Fee Contract Pricing Best Practices all classes run from noon to 1:30 p.m. (est). December 15, 2009 What is an audio Seminar? NCMA s audio seminars are live, 90-minute events, much like talk radio programs. The typical format of the program is a 60-minute presentation, followed by a 30-minute Q&A period (both live over the phone and responding to questions sent in through the internet during the program). Earn.15 CEus or 1.5 CLPs with each seminar. What is the cost? For one low fee of $189 per seminar, there is no limit to the number of people who can listen and participate at each site. For those who cannot participate live, we have professionally recorded audio Cds (with all seminar materials included as PdF documents) available for purchase. For more information, visit us online at or call Contract Management July 2009