Understanding the Life Cycle of Forward Pricing Rates and Their Impact on Contract Negotiations

Transcription

1 Understanding the Life Cycle of Forward Pricing Rates and Their Impact on Contract Negotiations By allie stanzione Abstract In the past, the most desirable way of negotiation with the U.S. government that usually resulted in quick awards was through the use of existing forward pricing rate agreements (FPRAs), which were negotiated between the administrative contracting officer (ACO) and federal contractors at the segment level. This approach allowed Department of Defense (DOD) agencies and industry negotiators to focus on the management and technical proposals and on the fee differences of a particular contract at hand. One of the main realignment actions addressed in the Under Secretary of Defense (Acquisition, Technology, and Logistics) Ashton B. Carter s September 2010 memo 1 was the alignment of Defense Contract Management Agency (DCMA) and Defense Contract Audit Agency (DCAA) processes to ensure work is complementary. Further guidance came from Director of Defense Procurement and Acquisition Policy Shay D. Assad in his January 2011 memo 2 to the top agency procurement officials outlined further actions of realignment, including reevaluation of DCAA responsibilities and shifting most FPRAs and forward pricing rate recommendations (FPRRs), cost-type proposals under $100 million, and fixed-price proposals under $10 million to DCMA for review and negotiation. This new policy proposed to increase the use of FPRRs to reduce administrative costs, while at the same time allowing the contracting agencies to negotiate their own rates during individual negotiations with contractors. This article explains the process of development, evaluation, and acceptance of forward pricing rates, explores how the recent change in policy affects negotiations at the agency level, and About the Author ALLIE STANZIONE, CPCM, CFCM, Fellow, is the operational contracts team lead at the MIT Lincoln Laboratory. Through her career, she has served in numerous contracting positions in federal, commercial, international, state, and local government fields. She has also authored several articles appearing in Contract Management Magazine and the Journal of Contract Management. She is a graduate of NCMA s Contract Management Leadership Development Program and holds an MBA from NYIT. She has served as the co-vp of membership for the Boston Chapter of NCMA since She is a co-recipient of NCMA s James E. Cravens Membership Award for 2011 and received honorable mention in the Sixth Annual Macfarlan Excellence in Contract Management Research and Writing Program. The author would like to thank Lynne Ziter and Scott Downer of Raytheon, Andy Habina of Draper Labs, and Matthew Grzyb and Tom Moschetto of DCMA for their assistance in making this article possible. The views, findings, and opinions expressed in this article are those of the author alone and do not necessarily reflect the views of present and former employers or any entity with which the author is affiliated. The information contained in this article is provided to you from the industry s perspective. Journal of Contract Management / Summer

2 company rates and drive them up or down? Rate drivers could include: Figure 1. discusses approaches that contracting officers and industry negotiators should utilize in order to reach a win-win situation. Introduction to Rates Government contracts mandate compliance with the Federal Acquisition Regulation (FAR) cost principles, the Cost Accounting Standards (CAS), and the Truth in Negotiations Act (TINA) requirements that call for the development of very complex, government contract unique accounting and data collection systems prior to entering into the contract. FAR establishes guidelines for the reasonableness and allocability of costs. The CAS explains how each contractor should account for certain types of costs. The TINA, per FAR , dictates submission of cost or pricing data that must be accurate, current, and complete. The government has the right to audit rates, proposal volumes, and related data as a means to monitor and enforce the contractor s obligations under FAR, CAS, and TINA regulations. Federal contractors establish forward pricing rates, which include projections of indirect costs and the bases on which these costs are allocated as well as direct labor rates. Established rates are then used for proposals to the government, as well as for DCMA/DCAA auditing purposes. This article traces through the forward pricing rate types, what they consist of, and their drivers, establishment, and negotiation. (See FIGURE 1 above.) Rate Drivers Rates could fluctuate, and thus prompt an update to the rate memo already submitted or approved. What could impact Corporate organizational structure changes; Recent changes in the business volume or in the production methods; Medical cost escalation and expenses; Pension fund performance; Corporate business decisions such as major replacements of aging business systems (accounting, enterprise resource planning, work population replacement of retiring employees and recruitment, relocation, and training of new employees); Development of new products and services for specific business areas; Maintenance and expansion of a company s legacy product lines; and/or Win or loss of significant contracts. Rate updates are usually submitted at the same time each year, and are resubmitted with every rate update. However, significant changes e.g., the win or loss of major contracts or change of direction in the company business decisions should be reported as soon as the impact can be determined in order to comply with the FAR and CAS rules and regulations. Forward Pricing Rates Categories Rates commonly include overhead for both onsite and offsite employees, fringe benefits, direct labor, general and administrative (G&A), and facilities capital cost of money (FCCM), which are audited by DCAA on an annual basis or more often for forming an FPRA/FPRR opinion. Defining what is accounted for as a direct/indirect cost involves balancing the accuracy of the cost accounting and the administrative burden/cost and is outlined at FAR Indirect Cost An indirect cost forward pricing rate is a rate that is used in prospective contract pricing, as defined at FAR (c), (a), and (d). Indirect costs include fringe; fixed (utilities, leases, insurance, depreciation costs); and variable expenses (indirect labor, shipping costs, training, IT, material and supplies costs, travel). The FAR defines indirect costs as any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or with at least one intermediate cost objective. 3 Indirect cost rates are expressed in terms such as dollars per hour or percentage of cost. Indirect costs are grouped into common pools and charged to benefiting objectives through an allocation or an 96 Summer 2012 / Journal of Contract Management

3 indirect cost rate. The allocation base allocates indirect costs to the product or project based on the relative benefit received. 4 The fringe rate (which could be a separate rate or included as part of overhead) includes company paid benefits for employees such as medical, dental plans, vacation, holidays, and retirement benefits and is calculated by dividing the total fringe expenses by the total labor dollars. When indirect cost goes up, the overhead rate usually jumps up as well, and vice versa. Figure 2. Total Labor $ Total Hours = Direct Labor Rate Overhead Overhead expenses comprise all costs not including or related to direct labor, materials, or administration costs. 5 These are indirect costs related to support of specific operations, for example: material, manufacturing, engineering, field service, and site overheads. 6 G&A Costs G&A costs represent the overall cost to manage and grow the business and include marketing costs, patents and intellectual property costs, business development costs, executive staff costs, process improvement costs (such as Six Sigma), etc., and can be further broken down into several G&A category structures (e.g., foreign military sales G&A rates, study rates, DOD rates, non-dod rates). FCCM FCCM is a rate designed to recover the cost of borrowing capital in lieu of making interest an allowable cost. As contractor management considers investment opportunities, they must consider the cost of capital required to make each investment and the potential return from that investment. To attract investment, the prospective return on investment generally must be higher than the cost of capital required to make the investment. 7 It is generally an allowable expense, provided that it is measured, assigned, and allocated to contracts or measured and added to the cost of capital assets. The FCCM is based on interest rates specified by the secretary of the treasury 8 and must be identified in all proposals. The FCCM is not fee-bearing FAR requires contracting officers to use the pre-negotiation cost objective as the basis for calculating the objective for profit or fee and advises to exclude any facilities cost of capital included in cost objectives before applying profit or fee factors. Direct Costs Direct costs include material expenses (e.g., manufacturing and engineering material, major subcontractors, inter- organizational transfers) and direct labor expenses. The FAR defines direct costs as any cost that is identified specifically with a particular final cost objective. 9 The direct labor rate includes the annual average hourly cost of a particular group of direct labor employees (e.g., engineers, manufacturing, etc.) and is calculated by dividing the total labor dollars by the total labor hours. When direct cost base decreases, overhead rate tends to increase. (See FIGURE 2 above.) Types of Forward Pricing Rates The federal environment establishes several types of forward pricing rates, such as forward pricing rate proposals (FPRPs), FPRRs, and FPRAs. FPRP The FPRP is the direct and indirect rate proposed by the contractor. Usually, the contractor develops and submits an FPRP to the DCMA divisional ACO (DACO) at least on an annual basis. The FPRP can also be used for submission of a proposal to the government in the absence of, or with an outdated, FPRA and is used as a starting point for direct and indirect cost rate analysis and contract pricing. An FPRP write up includes all primary indirect pools for which indirect cost rates are calculated. The FPRP is always consistent with the firm s current CAS disclosure statement, compliant with the FAR, and the strategic plans, goals, and objectives of the company. The FPRP covers the most current accounting period and several subsequent periods, depending on the structure of the federal contractor. Rates documentation depends on the structure of a particular business and includes, but is not limited to, overhead, G&A, fringe, FCCM, direct and indirect labor rates, breakdown of the cost elements in each pool, calculations of the indirect cost rates, and the allocation base for each period quoted. Based on the changes in the marketplace and its impact on the company, the FPRP is usually updated several times throughout the year. Use of the FPRP in a proposal is the least-desired approach for the government as it generally requires a rate audit, slowing the award process. If the Journal of Contract Management / Summer

4 proposal is submitted and negotiated using a recent FPRP (which will change with the next rate change), it will be invoiced at the actual cost or negotiated billing rates. FPRA According to the FAR: [An FPRA is] a written agreement negotiated between a contractor and the government to make certain rates available during a specified period for use in pricing contracts or modifications. These rates represent reasonable projections of specific rates that are not easily estimated for, identified with, or generated by a specific contract, contract end item, or task. These projections may include rates for such things as labor, indirect costs, material obsolescence and usage, spare parts provisioning, and material handling. 10 Usually, the FPRA provides specific terms and conditions that cover expiration, application, and data requirements for systematic monitoring by DCMA to ensure validity of the agreed rates. Large federal contractors used to benefit from having an FPRA in place as it eased negotiations with the agencies and kept the proposal cycle and negotiations short and focused on other important aspects of a contract. No matter what type of contract, [firm-fixed-price] or cost-type (target cost establishment) FPRAs can facilitate the negotiation process. In those instances, only the change would need to be audited by DCAA. FPRAs can be beneficial to those contractors that are large enough to have a stable business base, sophisticated enough to accurately forecast indirect costs relative to forecasted volumes, and able to monitor their performance. However, if the contractor does not monitor its rates and trends on a continuing basis, it can be stuck with an agreement that does not reflect reality, and they may find themselves in a position of defective pricing exposure. 11 FPRR According to the FAR: [The FPRR is] a rate set unilaterally by the administrative contracting officer for use by the government in negotiations or other contract actions when forward pricing rate agreement negotiations have not been completed or when the contractor will not agree to a forward pricing rate agreement. 12 Recommended rates are developed by the government audit personnel, usually DCAA, as a result of their review of the Figure 3. contractor s indirect and direct cost rate proposal. The recommendation may result from the audit of the current contract proposal, a recent (within the last 12 months) contract proposal, or a separate indirect/direct cost rate proposal. During the audit, the auditor discusses only the factual matter related to the audit findings with the contractor. The contractor is expected to provide feedback on these findings on a timely basis. The DCAA audit objective is to examine contractor cost representations to determine whether costs are reasonable, allocable to the contract(s), in accordance with generally accepted accounting principles and Cost Accounting Standards (CAS), and not prohibited by the contract, government statute, or regulation. 13 Development and Evaluation of Forward Pricing Rates To better understand how FPRPs are evaluated and how FPRRs and FPRAs are developed, we must first understand what policy governs the implementation of the auditing standards. FAR and outline the basic functions of the DCAA and DCMA contract auditor. In the development of FPRAs and FPRRs, DCAA is responsible for recommendations to the ACO regarding whether: A contractor s disclosure statement adequately describes the actual or proposed cost accounting practices, A contractor s described practices comply with the applicable requirements of the FAR and the CAS, A contractor s changed cost accounting practice is adequately described and compliant with the applicable requirements of the FAR and the CAS, and A contractor s cost impact proposal is adequate and reflects the proper amount of contract price adjustments. 14 In evaluating rates, an auditor is trained to evaluate all aspects of contractor-proposed expenses. For example: [C]ompensation analysis is a complex task that requires 98 Summer 2012 / Journal of Contract Management

5 in-depth understanding of the firm s compensation package and accounting procedures. In most cases, the government auditor and the [ACO] are the two government acquisition team members who have the most in-depth knowledge of a firm s compensation package and accounting procedures. 15 (See FIGURE 3 on page 100.) Auditors are the only members of the government acquisition team that have general access to the contractor s accounting records. Auditors can only provide recommendations to the agencies, leaving contracting officers with the responsibility for evaluating contract price reasonableness, negotiating contract rates, and finalizing a contract. New Policy and the Outcomes Carter s and Assad s Memos shifted price analysis of lowdollar proposals from DCAA to DCMA. To deal with the increased workload, the DCMA has hired 215 new cost/price analysts and plans to hire 85 more by the end of Facing overwhelming transition and changes in the organization, DCMA and procurement contracting officers (PCOs) are collaborating with each other more than usual. Relying on the FAR Part 15.4 contract pricing principles, contracting officers and specialists are becoming more involved in pricing analysis and the evaluation of rates in preparation of the pre-negotiation position on rates at the agency level. The contracting officer has the ultimate responsibility for determining price reasonableness, but no one expects the contracting officer to be an expert in all the accounting and technical issues associated with direct labor cost analysis. However, one is expected to know who to ask for assistance and when. 17 Furthermore, FAR (c), , and (b) and Defense FAR Supplement (DFARS) (b) guidance recommend contracting officers to consult with the ACO, but make final decisions based on the situation at hand. If the ACO has issued a written [FPRR], do not deviate from the ACO-recommended rates without first contacting the ACO. The ACO should be able to provide detailed support for the current recommendation. After that contact, if you feel that the recommended rate is not reasonable and you can document why an alternative rate is more reasonable, you may use the alternative rate as a basis in developing your position on contract price. If the offeror and the ACO have negotiated a [FPRA], the offeror is obligated to use FPRA rates in proposal preparation and government contracting officers are obligated to use them as a basis for contract pricing. If you have information indicating that the FPRA rates are not reasonable, inform the ACO and request the ACO to negotiate an adjustment or terminate the FPRA. However, unless the FPRA is terminated or you are authorized under agency procedures to develop your own rate position, use the current FPRA as a basis for contract pricing. 18 Given more options and freedom to negotiate rates, are PCOs ready for this change? As contracting officers spend more time researching rates in order to establish agency position, one could only wonder: Do they have adequate time and proper training for such activities? Rather than digging through piles of fringe, overhead, and other rate categories all by themselves, shouldn t they be focusing on doing what they were given the warrant for and finalizing contractual issues on a contract? Between leading source selections, issuing requests for proposals, answering industry questions, settling protests, negotiating contracts, and issuing proper modifications, can PCOs find enough time to actually sit down and go through all proposed rates for the contract? Are they closely familiar with the structure of a contractor in order to make changes to major labor and overhead categories and negotiate proper rates that would benefit the government? Could a rate be overlooked or cut because of the unfamiliarity of a negotiating party with a particular contractor? Could a PCO s precious time spent on rates research delay negotiations and lead to delay in services the federal contractors provide to DOD? As proposals expire, some contractors are forced to re-bid and re-propose with newer FPRPs, when others might face even larger hurdles such as reassignment of expert personnel to different pursuits due to the delay in awards. Expiring funds, dissatisfied end users, and expired proposals that need to be re-priced could actually hurt government efficiency. The million-dollar question is: Is it really worth it? Should the rate negotiations be left alone to the pricing experts at the DCAA/DCMA? In cost contracts, all time spent on rate negotiations might not pay off at the end, as the rates will only be used for establishment of a contract ceiling at hand. When it comes to the invoicing, billing rates approved by the DACO will be used. Negotiating Rates In developing a plan for negotiation of rates, contracting officers should consider the risk to the government in terms of dollars involved and the probability that the rates developed Journal of Contract Management / Summer

6 by the contractor are reasonable estimates of actual indirect cost rates. In order to get an accurate picture of the risk, PCOs should focus on the following questions: Is there an existing valid and current FPRR/FRPA? If the FPRA/FPRR is not available, could a recent indirect cost rate audit report approved within the last 12 months be obtained? If the report is inadequate and there s no up-to-date FPRR/FPRA, should a new audit be requested? Would the audit delay the award? Contracting officers have several methods to choose from when developing a negotiation strategy during proposal evaluations: Contracting agencies could use the existing FPRA or FPRR and settle on already established recommendations given by DCMA/DCAA. If using this approach, to defend reasonableness of approved rates, contracting officers should consider inviting the ACO that issued the FPRR and as well as a cognizant auditor to attend negotiations concerning forward pricing rates. Contracting agencies could split the difference between contractor-proposed FPRPs and DCAA-established FPRR/FPRAs to make rates acceptable to both the government and the contractor. Contracting agencies could evaluate both the FPRP and FPRR and pick rates that benefit the government the most. It is vital to remember that if a contracting officer decides to use FPRP during negotiations, as part of the cost analysis, he or she must assure that all forward pricing rates used in contract pricing are reasonable. Indirect cost rates for each accounting period are estimates until actual costs are determined after the end of the period. However, the rates should be updated as more information becomes available. Contractor personnel should be monitoring the indirect rates and the underlying budget throughout the period. Typically, the contractor will document this monitoring process which can be a valuable source in evaluating whether the rates continue to be reasonable as events and conditions become known. 19 PCOs should know: [If PCOs intend to negotiate rates rather than adopt the DCMA position] in the proposals valued at $10 million or more, and the contracting officer does not intend to sustain at least 75 percent of the costs questioned by DCAA, the contracting officer is required to justify his [or] her departure from DCAA s recommendations. Additionally, the contracting officer is required to submit the request for deviation for review by a review board at a higher level of management within the contracting officer s component (agency or buying command). 20 Even so, if a contracting officer believes that such action is necessary for the greater good and benefit of the government and the agency, it is a significant step toward reaching agreement in the negotiation. Establishing Rate Characteristics Prior to Negotiation Current FPRAs are considered a luxury these days. Negotiating indirect rates tends to be time-consuming and contentious. Since the FPRA is a formal bilateral agreement that binds the contractor to propose the negotiated rates and the government to accept them in pricing individual contracts, it could take years to come to a mutual understanding. Overwhelmed DACOs and DCAA price analysts, along with large federal contractors, are known to still be negotiating some rates that date back to the early 2000s. It should be noted that each negotiated FPRA includes a way out: provisions for canceling all or a portion of the agreement if circumstances in the company change and the rate(s) are no longer valid representations of future costs. In the past, the FPRA rates were used for both forward pricing and provisional billing purposes; they also prevented a need for frequent DCAA audits of rate proposals. A key consideration in obtaining an FPRA agreement is you need to be able to monitor performance against these rates on a continuing basis to prove that they are still adequate. 21 If a recent FPRA exists (usually negotiated within the same year), it is the preferred output for all contractors, federal agencies, and DCMA. With the volume of audits DCAA faced in previous years, large FPRA negotiations were falling behind. However, contractors were still left with the duty to keep the cost or pricing data regarding the FPRA updated by constant disclosure to the ACO. In recent years, federal contractors rely more on the FPRPs because they believe proposed rates resemble business changes closer than FPRAs, as they are considered the most updated and competitive rates for proposal submission from the industry perspective. If no formal agreement is reached, federal contractors usually utilize the FPRPs in order to stay competitive and up to date with organizational changes. Proposed rates are submitted identifying the rates a business will use for 100 Summer 2012 / Journal of Contract Management

7 proposal purposes and for requesting new provisional billing rates. In the event of an FPRP, the DACO may recommend alternative rates (FPRR) to the contracting agencies that, in their turn, can accept the FPRR position for negotiation or try to come out with their own approaches to negotiating. The FAR and DFARS policies, as well as Assad s memo, strongly suggest collaboration between the contracting officers at the agencies, their counterparts, ACOs, the DCMA regional offices, and DCAA auditors. ACOs are now responsible for negotiating FPRAs, including labor-rate agreements. The policy recommends that if DCAA has completed an audit of a particular contractor s rates, DCMA shall adopt the DCAA recommended rates as the department s FPRR position. 22 How would this affect the contractor? Capital Edge Consulting Inc., in their June 2011 article, Where have Forward Pricing Rates Gone? insists that the abovementioned policy regarding recommended rates puts DCAA squarely in charge of determining forward pricing rates which the contractor has to accept without the opportunity to negotiate. 23 In support of this position, Capital Edge Consulting Inc. argues: When DCMA adopts and publishes the FPRRs as their own (without negotiation), the contracting officer treats them as though the contractor had agreed to the rates. The total of the factors in play sets up the circumstance where DCAArecommended rates will be rubber stamped by DCMA without negotiation, and passed to the contracting officer who will use them without considering input from the contractor. 24 If their supposition is true, the reality for federal contractors looks grim: Not many contractors have the leverage to stand firm and force a contracting officer with whom they are negotiating a contract, to reconsider what DCAA has reported, and DCMA has stamped as an FPRR. 25 What would be a solution under such a circumstance? If federal contractors could influence the recommended rate, FPRA, or FPRR early enough, they will not face the difficulties previously described. However, with DCAA following their Contract Audit Manual, they are not allowed to discuss specific recommendations with the contractor; only factual aspects of the proposed rates. After submitting a rate memo change, or prior to a rate negotiation or audit, federal contractors could walk through their proposed changes and ensure that the auditor understands how rates were established. Contractors should also monitor the auditor s responses and present detailed explanations regarding each questioned cost, whatever it might be. Industry cooperation with the auditors at DCMA and DCAA pays off, as any engaged contributor who honestly presents his or her position and supports his or her costs as accurate, complete, and current can help bring any miscommunication to a positive resolution. Shrinking DOD budgets should draw agencies and industry closer together, eliminating waste and bureaucracy. DCMA, DCAA, and agencies are aligning to bring the best value and cost savings to the government. Federal contractors are polishing basis of estimates; providing cost or pricing data that is accurate, complete, and current as of the date of the proposal submission; and closely monitoring costs at the corporate level. Conclusion Forward-pricing rates are all part of a continuing indirect cost allocation cycle. They will affect budget decisions and the rates used in contract billing. 26 All parties involved in forward pricing rate establishment, evaluation, and negotiation should be focusing on achieving a higher level of efficiency in the acquisition cycle as specified in the Carter and Assad guidelines in order to guarantee the best value to the government and fair compensation for industry. Rapidly changing technology impacts both the federal and industry workforce. More skilled workers and smarter, more technically savvy engineers are also more expensive. Hiring new graduates and retiring the aging workforce could definitely impact the rates of the company, making it more competitive, but it could also hurt the technical approach and the knowledge base. When a company s workforce is modified on a quarterly basis, can the government really afford to demand an FPRA? The time to achieve an FPRA has not kept pace with the technical growth and commensurate compensation demands on industry. Given that fact, should FRPAs even exist? With the recent changes in policy, will FPRRs eventually replace FPRAs as more current and up-to-date rates that both government and industry can rely on? The answers to these questions will impact negotiations between DOD and industry for the next generation. JCM Journal of Contract Management / Summer

8 Endnotes 1. Office of the Under Secretary of Defense, Memorandum for Acquisition Professionals, Better Buying Power: Guidance for Obtaining Greater Efficiency and Productivity in Defense Spending (September 14, 2010). 2. Office of the Under Secretary of Defense, Memorandum for Commander, U.S. Special Operations Command, Better Buying Power: Guidance for Obtaining Greater Efficiency and Productivity in Defense Spending (January 4, 2011). 3. FAR See FAR See overhead.asp#ixzz1hqzmq2kr. 6. See DAU ACC Contract Pricing Reference Guide, Chapter 9 (June 23, 2010), available at 7. Ibid., at Chapter Under Public Law 92-41, FAR FAR Ibid. 11. Sam Davidson, Pros and Cons of Forward Pricing Rate Agreements, GovCon E-News (Fall 2007), available at FAR DCAA Pamphlet No , Information for Contractors, Chapter 6 (January 2005), available at Ibid., at Chapter DAU ACC Contract Pricing Reference Guide, see note 6, at Chapter Anthony Critelli, DCMA Eases DCAA Logjam by Taking on More Work (January 2011), available at Ibid., at Chapter Ibid., at Chapter Ibid., at Chapter Director of DPAP Policy Memo to all Major Acquisition Commands and Agencies, The Protocol for Elevating and Resolving Disagreements Between Contracting Officers and DCAA over DCAA Audit Recommendations (December 2009). 21. Davidson, see note See note Capital Edge Consulting, Inc., Where Have Forward Pricing Rates Gone? (June 2011), available at Ibid. 25. Ibid. 26. DAU ACC Contract Pricing Reference Guide, see note 6, at Chapter Summer 2012 / Journal of Contract Management