GRANT THORTON SURVEY ON PROFESSIONAL FIRMS
(Editor’s Note. As we have been doing the last several years now, we are happy to present a summary of Grant Thorton’s Annual Government Contractor Industry Survey that benchmarks primarily professional services firms. The 18th Annual GT survey for 2012 provides a variety of very useful information. You can contact the firm at 703-847-7515 to purchase a copy of the survey.)
Company Profile
53% of the surveyed companies are classified as large and 47% as small where 18% had sales less than $10M, 10% between $10M-20M, 17% between $20M-50M, 13% between $50M-100M and 42% over $100M. The vast majority of surveyed companies sell professional services – consulting, IT, research, engineering, general business services, science and technology, training and education, other services – while less than 5% sell products. 84% said their primary customer is the federal government. 47% of their revenue came from the Defense Department, 37% from other federal agencies, 7% came from state and local government and 9% was commercial. The survey shows government business trends are lower where 36% of respondents had increased revenue over the prior year (50% in 2011), 26% had no significant change while 38% had reductions (compared to 29% in 2011). We are seeing a shift from federal to state and local and commercial business where over the next 18 months 49% of surveyed company said they expect to see increases coming from federal prime contracts and 34% say they are expecting increases in federal government subcontract work (substantially lower than 2011) while 19% expect increases from state and local government and 32% from the commercial sector (both significantly higher than 2011).
Indirect Headcount Breakdown
12.5% of total headcount is represented by management and support functions. There is an overall downward trend over the last several years which is attributed to more outsourcing of support services such as HR, legal, internal audit, contract compliance as well as some larger contracts allow for direct billing of normal indirect support costs. The breakdown of certain functions are finance and accounting (2.9%), contract and procurement administration (1.7%), sales and marketing (2.1%) and other indirect (5.8%). Though not reported this year, facilities costs as a percentage of revenue last year was reported by 80% of respondents as less than 5%, 14% reported 6-10% and 6% said it was greater than 10%.
Government Contracts
Breakdown of Revenue by Contract Type. 40% of revenue from federal contracts came from cost type contracts compared to 45% last year, 20% are fixed price (equal to last year) and 40% are time and material (compared to 35% last year) indicating a decrease in cost type and a corresponding increase in T&M.
Fees. Though fees were not tracked this year, the results for last year which is pretty consistent from year to year were average negotiated fees for cost type contracts was 6-7%, T&M contracts had an average of 8-9% while firm fixed contracts had 9-10%. It should be noted that these negotiated profit rates are computed after deducting unallowable costs and before income taxes so actual profit rates are lower than negotiated rates.
Proposal Win Rates. Surveyed companies stated their win rate on non-sole source proposals was 30% and 50% when they were the incumbent. Win rates when either a special business unit or joint ventures were created was 50%, higher than 43% last year.
Bid and Proposal costs as a Percent of Revenue. 14% reported less than 1%, 41% 1-2% while 44% reported greater amounts.
Contractor Business Systems. The survey notes recent changes to contractors either fully or modified CAS covered are now subject to audits of six business systems (cost accounting, EVMS, estimating, purchasing, material management and accounting and property management) where future surveys will focus on results of these audits. For now, the survey found that 33% of respondents had already undergone at least one of these audits and that 29% said they had made improvements to their business systems in order to comply with these new rules.
Financial and Cost Statistics
Profit. Contrary to common public perceptions, government contracting does not generate abnormally high profits where the survey defines it as profit before interest and taxes as a percent of revenue. Profit rates appear to be plunging compared with prior years where 56% of survey companies had profit rates between 15%, 31% between 6-10%, 5% between 11-15% and 4% above 15%. 4% of respondents reported no profit. These figures would be even lower after deducting interest and taxes. Compared to last year, there has been a substantial decrease in profit where this year 60% of surveyed companies either did not make a profit, experienced a loss or posted a 1-5% profit rate compared to 37% last year.
Fringe Benefit Rates. Fringe benefit pools consist of payroll taxes, paid time off, health benefits and retirement benefits (some include bonuses while others do not). Fringe benefit rates as a percentage of total labor averaged 36.4% when bonuses were included and 34% when excluded which is an increase from last year.
Medical Expenses. Despite widespread concerns about health care costs increases, most contractors have apparently not made any changes to health coverage. In response to questions asking what percent of health benefits are paid by the company the survey results were: 5% reported the company pays for less than half, 12% pays 51-60%, 20% pay 61-70%. 36% pay 71-80%, 9% pay 81-90% and 18% pay 91-100%. With respect to health costs as a percentage of labor costs, 6% of respondents incurred health costs less than 4% of labor costs (14% last year), 5% between 4.1-5%, 11% between 5.1-6%, 13% between 6.1-7%, 9 between 7.18%, 5% between 8.1-9%, 12% between 9.1-10% and 39% over 10% of labor costs.
Wage Increases. They ranged from 0-7% where the median was 3%.
Overhead Rates. These costs are considered to be in support of direct staff working directly on contracts and hence are normally allocated as a percentage of direct labor costs. Some companies include fringe benefits associated with direct labor in the direct labor base while others do not – the result when they do is to lower overhead rates. Average overhead rates are as follows: (a) on-site direct labor (on-site means performed at company sites) – 84% compared to 80% last year (b) on site direct labor and fringes – 43% compared to 48% last year (c) off-site direct labor – 38% as opposed to 48% last year (off-site is lower because facility related costs are normally borne by the customer at their facilities) (d) off-site direct labor and fringes – 21% compared to 23% last year. When companies used multiple overhead rates logic used for them were location (52%), labor function (13%), customer (28%) and products versus services (7%).
G&A Rates. The survey states that general and administrative rates are typically those incurred at the headquarters and include executives, accounting and finance, legal, contract administration, human resources and sales and marketing as well as IR&D and bid and proposal costs. G&A costs are most often allocated to contracts on total cost input (direct operating costs, overhead, material, subcontracts) or a value added base that generally includes all the above costs except material and/or subcontracts. Average G&A rates under a total cost input base was 12% (13.5% last year) while those using a value added cost input was 15% (15.4% last year).
Material handling and subcontract administration costs. 24% of surveyed companies used a material handling and or subcontract administration rate as a burden chargeable on direct material and subcontract costs (higher than last year’s 22% and 19% the previous year). The survey notes that in service industries a handling rate is established in conjunction with use of a value added G&A base to reduce burden applied to pass-through subcontract and material costs. Average material handling rate was 3.0 and subcontract handling rate of 3.4% (2.7 and 2.5% last year).
Labor multipliers. Multipliers, a term commonly found in the commercial world, are fully loaded labor multipliers used to price out work and are derived by dividing total burdened labor cost by base labor cost. The average labor multiplier was 2.2 for on-site work and 1.9 for off-site work. Almost all respondents expressed a belief their labor multipliers were competitive with their industry. It should be pointed out that the labor multipliers are overall averages where many companies commonly use different multipliers for different markets.
Uncompensated overtime. (Editor’s Note. Uncompensated overtime refers to hours worked exceeding the normal 40 hour work week by those salaried employees exempt from the Fair Labor Standards Act.) 60% of respondents said their employees work uncompensated overtime (UOT) while 40% said no. 80% of the companies working UOT use total time reporting while the other 20% report only 40 hours per week. 78% use a rate compression method of accounting (e.g. computing an effective hourly rate dividing salary by hours worked) while 22% use a “standard/ variance method” that charges an hourly standard rate and then credits an indirect cost pool for the difference between labor costs charged to projects.
EVMS. Earned Value Management System, elaborate project management systems, have increasingly become a focus of the Defense Department where now dedicated teams evaluate those systems. 31% of the respondents state they have contracts that are subject to EVMS in spite of the fact that 59% do not believe these systems are cost effective to be in place (41% do believe they are).
Charging Subcontractor hours on T&M contracts. We have frequently reported on new regulations that provide that subcontract labor can be charged at fixed rates provided in the prime contract as opposed to the older way of simply billing subcontractor costs plus applicable prime indirect rates. 80% of surveyed companies bill the cost of subcontract hours at the fixed rates in the contract or subcontract while 20% bill on a cost reimbursable basis (i.e. as an ODC). This change has led to a different audit focus from merely auditing hours charged to ensuring labor skills being billed meet contract requirements where 77% of respondents state their procedures for properly assigning employees to labor categories are effective while 23% state they are either somewhat effective or not at all.
Dealing with the Government
The Defense Contract Audit Agency, because of their Defense Department contracts or contracts with other agencies that use the audit agency, audits most of the contractors in the survey. Regarding the respondents opinions of DCAA audits, 47% say auditors’ opinions are substantiated with appropriate references and 53% are arbitrary and not substantiated while 40% of auditors are open-minded and receptive to contractor rebuttals and 60% say auditors are inflexible and are rarely receptive. Contracting officers receive higher ratings where 60% of their opinions are considered substantiated with references and 56% are considered open-minded and receptive. When asked if their relationship with DCAA has changed, 71% said it had stayed the same, 19% reported the relationship had worsened (compared to 2% last year) while 10% said it had improved. In an effort to measure the quality of relationships with ACOs and DCAA, the survey found 18% of respondents resolve issues efficiently where the remaining 82% say the government was inefficient where 56% say they believe DCAA is the primary cause for delays of resolving issues while 26% believe it is the ACO. The most frequent types of costs questioned by DCAA are executive compensation (23%), consultant costs (7%), incentive compensation (17%), labor charging (11%), indirect cost allocations (12%), legal expenses (9%) and employee morale (5%). Most frequently cited violations of cost accounting standards were CAS 401, consistency (2%, compared to 16% last year), CAS 403, home office expenses (3%) and CAS 405, Unallowable costs (9%, compared to 4% last year). Costs questioned as a percent of revenue were less than 1% of revenue (61%), 1% of revenue (11%), 2% of revenue (6%), 3% of revenue (3%), 4% of revenue (0%) and 5% or more of revenue (19% compared with 4% last year). Of those companies experiencing audit issues, 18% were very satisfied with the resolution of the issues, 61% were somewhat satisfied and 21% were not satisfied.
Executive Compensation
(Editor’s Note. Care should be used if our readers consider substituting the following results for a bona fide compensation survey where sometimes hundreds of firms are surveyed. However, the results shown below are interesting.) Surveyed companies provided information on the four highest paid executives in the company and the results are presented by company size measured by revenue for 25th, median and 75th percentiles. The following is a summary of the results.
Highest Position (in thousands)
Revenue 25% Med. 75% $0-10 M 250 320 447 $11-50M 260 349 500 $51-150M 275 407 585 >$150M 300 410 708 Seccnd Highest Position $0-10 M 170 262 432 $11-50M 225 294 444 $51-150M 250 339 479 $>$150M 280 372 646
Third Highest Position $0-10 M 160 242 300 $11-50M 180 269 379 $51-150M 225 279 450 >$150M 260 357 565
Fourth Highest Position $0-10 M 144 189 267 $11-50M 157 228 310 $51-150M 208 241 344 >$150M 218 322 395
Companies whose executive compensation was challenged by DCAA and provided rebuttals and/or additional information state 30% of their positions were sustained, 30% stated a reasonable compromise was achieved and 40% stated either DCAA’s position was sustained by the ACO or an unreasonable compromise was put forth.
REDUCED GOVERNMENT SPENDING REQUIRES FAMILIARITY WITH LIKELY GOVERNMENT CONTRACTING ACTIONS
(Editor’s Note. Daily news reports on sequestration or at least a high probability of austerity means the government will likely attempt to generate savings on existing contracts and subcontracts. The most likely contract vehicles they will use include terminations for either default or convenience or deductive changes. It may also use a combination of partial termination with deductive changes. Though we have examined T of Cs and deductive changes in prior articles we thought it would be a sound idea to provide a basic understanding of these vehicles now since there is a good chance you will be faced with one of them under the current environment. We have used a recent article in the November issue of the CP&A Report written by Mary Wills and J. Andrew Stowe as well as our extensive experience helping clients manage these occurrences.)
The US government has the unique ability to terminate or reduce the scope of a government contract. In exchange for these unique rights, it has the obligation to allow a number of remedies to make the contractor whole. You should have a basic familiarity with (1) which termination or contract change is appropriate under the circumstances (2) which processes are followed under them and (3) what remedies are available under each action to maximize cost recovery.
Terminations for Default
FAR Part 49 generally address all forms of terminations. A termination for default (T for D) may be either full or partial where it requires the government to show in a written notice of default to the contractor (1) it has failed to deliver products or services on time or failed to perform work specified in the contract within time specified (2) the contractor is making progress in performing the work at a rate that endangers performance or (3) other provisions of the contract are failing to be performed. If the contract is to be terminated before delivery, then a cure notice is required. If not enough time remains on the contract (less than 10 days) then a cure notice will not be used but a show cause notice will be substituted which requires the contractor to provide a realistic reason as to why it is not in default by showing it can meet the deadline, is able to make sufficient progress as to not endanger performance to provide quality products or services or is following other contract terms and conditions.
In its rush to meet budget cutting goals or to limit a contractor’s cost recovery opportunities, the government may issue a T for D. Because a T for D leaves a black mark, makes the contractor liable for the costs of completing the contract and limits the cost recoveries a contractor is entitled to it always benefits the contractor to attempt to convert the T for D into a termination for convenience (T for C). It is appropriate to use a T for D only if there are material contract delinquency circumstances that cannot be cured e.g. significant delivery delays, project progress or contractors’ unwillingness to follow contract provisions. The contractor should be prepared to document its version of key issues (e.g. schedule slippage, subcontractor defaults) to either withdraw the T for D or have it converted into a T for C. Though contractors are often quite successful in obtaining this T for C conversion, an appeal through the Disputes clause may be necessary but still be worth it to avoid a black mark or allow for greater cost recovery.
Termination for Convenience
As history has taught us, an environment of budget cuts or sequestration will guarantee a proliferation of terminations for convenience. A T for C can either be a full or partial termination. A long list of cases have established the government’s right to terminate a government contract when it is in their interest to do so. The first step is the government issues a notice of termination to the contractor specifying the extent of it and the effective date. Immediately upon receiving the notice the contractor must (1) stop work as specified in the notice (2) place no further subcontract orders except as necessary to complete the continued portion of the contract under a partial termination (3) terminate all subcontracts that relate to the work being terminated (4) at the direction of the CO or TCO (termination contracting officer) assign all rights, title and interest of the contractor under subcontracts terminated which gives the government the right to settle or pay any termination settlement proposals (5) with approval from the CO settle all outstanding liabilities and settlement proposals of subcontractors (6) as directed by the CO transfer and deliver to the government fabricated or unfabricated parts, work in process, completed work, supplies and materials acquired for the terminated work, completed or partially completed plans, drawings, information and property and other property that would have been required to be furnished by the government(7)
complete performance of the work not terminated(8)take all action needed, or that the CO may direct, to protect the property related to the contract and (9) use its best efforts to sell any property identified in No. above if the contractor is not required to extend credit to any purchaser or if it wants to acquire the property at prices approved by the CO. The CO usually issues the termination notice and then a TCO is identified to settle the termination.
In exchange for its right to terminate the contract the government has the obligation to make the contractor whole through the termination settlement process. A settlement can be made by a negotiated agreement, a determination by the TCO, costing-out vouchers or a combination of these. Settlement proposals under a T for C can be a no-cost settlement or a cost proposal based on the inventory or the total cost method. A no-cost basis is obviously preferable to the government though it may be valid if no contractor costs have been incurred but the government commonly seeks such a settlement under most circumstances. It is advisable for contractors to reject this first offer where if a no-cost settlement is not executed, then the other two methods – inventory or total cost – may be used. Of these two, the government usually prefers the inventory method.
The difference between the inventory basis and total costs basis is that the inventory basis itemizes only those costs incurred for the terminated portion of the contract while the total cost basis itemizes the entire cost of the contract. Generally under the total cost method the contractor can recover its allowable incurred costs up to the total contract price minus the amount paid on the contract. If an equitable price adjustment is approved then that can be added to the total contract price to determine the maximum allowable.
We have written in detail (use our key word search function at our website) how to maximize cost recovery on a T for C and we highly recommend a careful review of these articles before preparing a settlement proposal. Basically the FAR cost principles together with a separate termination cost principle at FAR 31.205-49 address what costs are allowable. In summary, the allowable costs include (1) allowable pre-contract costs (2) initial “ramp up” costs which are abnormally high at the beginning of a contract (3) completed products or services which have been accepted but not delivered (4) facilities cost of capital (5) termination inventory (6) loss of useful value of special tooling, machinery and equipment (7) rental under unexpired leases (8) restorations of leased property even if they would not be allowable under a non-terminated contract (9) post termination costs (10) subcontractor claims (11) settlement costs that include in-house or outside consulting, accounting, legal or clerical costs, reasonable storage and transportation costs (12) idle capacity related costs (13) indirect costs applicable to relevant costs in the proposal and (14) profit on all costs except for the settlement expenses. It should be noted that profit is not allowed if the contract was in a loss position where if so, a “loss ratio” is computed and is used to reduce not only profit but also the amount of costs you are entitled to. (However, see our articles on how to reduce the perception of a loss position.) In addition, anticipatory profit on the work not performed on the terminated portion of the contract is not allowed.
Under a partial termination a contractor may request an equitable adjustment (REA) in the price of the continuing work of a fixed price contract. For example, if the contractor has incurred costs for expendable tools, dies, fixture for the terminated portion of the contract then if there are no other uses for these items it would be entitled to an equitable adjustment in the price of the contract for these items.
The contractor has one year from the effective date of the termination to submit a final settlement proposal to the TCO. If the Truth and Negotiations Act threshold is exceeded (currently $850,000) the contractor must certify the submittal is accurate, current and complete. Once submitted, the TCO is required to have an audit performed on any prime or subcontract settlement proposal exceeding $100,000. Once the audits are performed and the parties agree upon a settlement proposal, a negotiation memo is prepared by the TCO where it is recommended the contractor prepare their own memo. Rather than wait for government audits, the prime may select to conduct its own audits of subcontractor costs where such costs are allowable settlement costs.
Deductive Changes
Work scope or delivery may be eliminated from a contract using a deductive change process. Under such a method, the government changes the specification for a portion of the work. The contractor is supposed to be left “unharmed” because of the deleted work and associated profit being removed from the contract. The process for a deductive change is the same for any contract change. There are specific clauses in the contract that are applicable to fixed price, cost reimbursable and time-and-material or labor hour contracts. The different clauses in each contract defines what can be charged by the government so it behooves contractors to become aware of these clauses in the contracts.
We have addressed the significant cost and pricing issues related to deductive changes in our prior articles of the GCA DIGEST so we will not recount those here. In summary, contractors have the normal remedies available under the Changes clauses including REAs which if applicable must be submitted within 30 days of the written notice of the change. Be aware that under a deductive change, the contractor may be entitled to less settlement costs than what would be available under a T for C.
Partial T for C versus Deductive Changes
Whether a contractor characterizes an event as a termination or a change often significantly affects the dollar recovery it may be entitled to where there is often considerable flexibility in how to characterize the event. Several cases have addressed the uncertainty of “termination” versus “change” where for example, major versus minor variations, elimination of identifiable work or the government’s continuing need for work will affect how an event is characterized. For example, a termination may exist when the government no longer has a need for the article or service a major variation in the plan exists while a deductive change may exist if there is a minor variation in the plan, elimination of non-identifiable work or the government has a continuing need for the products or services. Though too detailed to recount here, differences in characterizing the event can affect both profit and allowable settlement expenses. Obtaining expert help in all the areas discussed here is highly recommended where such costs are normally reimbursable as allowable settlement expenses.
APPLYING COMMERCIAL PRICING TECHNIQUES FOR GOVERNMENT CONTRACTS
(Editor’s Note. The following is the first of many future articles we plan on addressing practical pricing issues. We would like to apply our extensive experience helping clients price their proposals to provide some insights into pricing strategies and techniques. In this article we address possible approaches found in the commercial world that contractors and the government can agree to use that differ from a cost build up approach. Whether it is to increase revenue or offer lower prices than a full cost approach would require, pricing found in the commercial world often offers better alternatives. The transfer of audit responsibilities from DCAA to buying commands where price analysis over cost analysis dominates as well as emphasis on replacing cost based pricing with commercial practices in the last 10 years provides some opportunities that contractors and the government may agree to use. The source of the following article comes from Darrell Oyer’s text Cost Based Pricing as well as our own experience.)
The FAR recognizes commercial, catalog and market based pricing. Many of our clients are simply used to pricing their products and services using cost based estimates for fixed price and time-and-material contracts and actual costing for cost reimbursable contracting. However, pricing based on commercial pricing rather than cost can either generate more revenue or less to meet lower price objectives. The following addresses certain commercial pricing concepts and contrasts them from normal cost based pricing.
Cost based pricing is detailed in many FAR provisions but commercial, catalog and market based pricing is also prevalent. For example, Part 38, Federal Supply Service (FSS) establishes market based pricing on schedules where agencies purchase items without the burden of issuing solicitations and price reasonableness is assumed to exist by comparing prices of other vendors. FAR Part 12 is dedicated to commercial item pricing. Commercial pricing can apply even to new products where various techniques are useful for pricing the items and evaluating the price for reasonableness. These techniques include value based pricing, incremental pricing, activity based costing and design-to-cost techniques.
Commercial and Market Pricing
T&M and Labor-Hour Contracts
Commercial time-and-materials contractors do not require cost or pricing data but rather a market rate for the labor being priced where pricing based on cost data is a foreign concept. These techniques are highly relevant in the government world where under similar conditions, the prices are evaluated by comparing them to other vendors and upon evidence of sales at these prices for commercial situations.
Until 2007, the FAR did not permit a prime contractor to invoice the government for subcontract labor obtained in the prime contract unless there was specific authorization in the contract. Subcontract costs had to be invoiced at cost plus any additives such as G&A or subcontract administration. However, in early 2007, the FAR was revised to allow for commercial and noncommercial T&M contracts. For commercial items and non-commercial items that were competitively awarded, the rule permitted payment based on the prime contract labor-hour rate for all labor hours that meet the qualifications in the contract whether those hours were supplied by the prime contractor or subcontractor.
Though DOD limited noncommercial contracts, all other government departments do allow T&M commercial and noncommercial contracts that are awarded with adequate price competition to invoice subcontractors at prime contract labor rates.
Commercial Pricing Additives
In the commercial market it is quite common and desirable to be able to add items and price them accordingly. For example, expedited delivery or freight charges are common examples. Such pricing is difficult when FAR required costing practices exist. Under FAR-covered negotiated contracts, a contractor must establish direct and indirect costs in its accounting structure for purposes of pricing cost-based government contracts. A contractor may have clients who pay market prices for goods or services where some costs are invoiced to the client but are not classified as direct costs in the contractor’s accounting system. For example, under cost based government contracts, if a contractor wants to charge more for the expedited delivery or freight charges, these costs must be specifically identified as direct costs in its accounting system. This is not true for market-based prices. If the prices are not cost-based, no segregation of such cost additives in the cost accounting system are needed to substantiate a price. If a contractor records these costs (e.g. delivery, freight) as indirect they may nonetheless negotiate a market based higher price for the expedited delivery or freight charges though the costs accumulated on the government contract does not reflect these costs. In this case, the government benefits by receiving additional value and the contractor is able to realize added revenues without violating the FAR or cost accounting standards. Some caution may be called for because there may be the assumption that negotiating added revenue is based on such costs being separately identified so there should be an explicit understanding that a negotiated price was made.
Price Analysis
Price analysis is the process of evaluating a proposed price without evaluating separate cost elements and proposed profit. When commercial items are priced, no cost data are required and the buyer must rely on price analysis to ensure price reasonableness exists. Price analysis is the cornerstone of ensuring prices are reasonable, both in the commercial and government world. There are many accepted techniques that government buyers find acceptable for ensuring price is fair and reasonable such as comparing proposed prices, comparing proposed with historical prices (significant time lapses and different terms of conditions should be considered), parametric estimating or rough yardsticks (e.g. dollars per pound), comparison with published price lists, market research or value analysis of the worth of a product or service.
Value Based Pricing For New Items
Imagine pricing a new product or service the government wants on cost incurred in the current year. In such cases it is certainly desirable to avoid pricing a new product on a cost basis. As an extreme example, consider a government purchase of Microsoft Office where the price must be based solely on the cost of the one dollar disc containing the software. Though the government’s first choice may be to seek cost data for the item since no market price exists but an alternative basis may be desirable. Even if the development costs were partially recovered in prior years as IR&D costs that were accumulated over several years the current year’s costs are probably negligible. Under such circumstances it is almost futile to establish a fair and reasonable price for the contractor based on costs incurred. In such circumstances, the fair and reasonable price must be based on an evaluation of output (i.e. what value the item provides to the buyer) not the input (e.g. costs). Here, the seller and buyer should compare the price of the item to similar-functioning items in the market. Alternatively, most new items like software and hardware are valuable because they reduce the buyers costs, save lives, improve processes so a valid technique would be to calculate the savings the buyer will derive from purchasing the item.
Incremental Pricing
Sometimes it is desirable for contractors to keep prices low. Under these circumstances prices based on incremental costs may be desirable. Such incremental costing is contrary to the government concept of full-absorption costing where all direct and indirect costs are taken into account but charging for incremental or marginal costs is quite common in the commercial world.
Incremental costing includes all direct costs but only a small amount or even no indirect costs caused, say, by the production line or office staying open for a little extra time. As a general rule, about 80 percent of overhead is variable (varies with direct labor dollars) and 20 percent is fixed while about 90 percent of G&A costs are fixed. So a new item may cause some additional overhead to be incurred but not much G&A so full rates as applied using FAR based full-absorption costing would not reflect actual costs incurred. Though a detailed variable versus fixed cost analysis could be performed a shortcut method might be to apply overhead but no G&A to the new or additional items.
Other Means
In the 1990s a new costing and pricing concept was emphasized both by commercial and government contractors, activity based costing, which was used to supplant or replace incremental costing described above. Like incremental costing, ABC spurns the full-absorption costing and pricing concepts and refines cost allocations in novel ways where, for example, one element allocation bases like direct labor is replaced by several cost drivers like machine setups or number of times material is moved. In addition, Mr. Oyer refers to a new concept gaining popularity in government circles called design to-cost where contrary to cost-based pricing, the first step of design-to-cost is to determine, through market research, what a realistic price would be for the item in the commercial marketplace where the contractor designs the item to stay within the price that market research establishes. If a realistic cost cannot be achieved then the item is not produced. If costs can be reduced to a level that provides a profit and produces a marketable item, then the product is put into production.
Case Study…
CHANGING TO A TOTAL COST INPUT BASE FOR INTERMEDIATE HOME OFFICE AND SEGMENT G&A
(Editor’s Note. The following represents an edited response from us to a client that was considering changing its indirect rate structure for both home office allocations and G&A allocations within its segments. We believe it is instructive to our readers because it addresses many issues that need to be considered when evaluating both your current structure as well as making changes.)
Background
Contractor is primarily a manufacturing company. Its business has changed where one of its business units (we will call it BU1) is going after large contracts that are highly price sensitive where it must find ways to reduce cost allocations and hence reduce its offered price. Its other business unit (BU2) has more of a mix of contracts where some are somewhat price sensitive while others are not – its unique position in industry provides it considerable pricing flexibility. Each segment has an identical indirect rate structure – overhead allocated on direct labor and general and administrative (G&A) costs allocated on a value added base of direct labor and overhead. In addition there are also shared services such as accounting, HR, IT and corporate services which are allocated to each segment based on those segment’s percentage of sales. These shared services often go by the name of “home office” costs.
The company is considering switching its G&A base to total cost input which would apply to both segments. It expects this would lower its G&A rate which in turn would lessen the burden costs on direct labor making prices lower and more competitive. The company is also considering switching from a total sales base to a TCI base for allocating the shared services or home office costs. There are also questions related to the timing of this change and how to communicate the change to the government or prime contractor but it will not be addressed here.
Thoughts on the Indirect Rate Structure
First, I agree totally with your approach to the issue – you are considering, first and foremost, your pricing objectives (e.g. lower prices on some contracts) and then considering the best indirect rate structure that will achieve that. Many contractors attempt to design their indirect rate structure on abstract accounting concepts rather than on what structure will best achieve their pricing objectives so I agree with your approach.
Several thoughts have occurred to me when considering your idea to establish a TCI base at each segment as well as the allocation of shared services:
What is the level of price sensitivity for BU1 and BU2 contracts? In an email to me you stated that BU1’s contracts were highly price sensitive and needed to definitely be lowered while for BU2’s products there was room to allocate even more costs. Is the desire for lower cost allocations equal for each segments’ contracts?
Do you have any market intelligence on what are the indirect rates and total burdened costs as a percentage of direct costs for competitors? This way we could possibly determine competitors’ indirect cost rates on different contrcts and hence know what, at least, the high range would be for us.
Using a TCI base may or may not be a good idea. It is true that the use of the TCI base will have the effect of lowering the allocation of indirect costs on direct labor but that change will now create an allocation of costs to direct material, subcontracts and ODCs. Will your customers now accept burdened costs on these direct costs when there were not such costs in the past? If not, then you wind up not recovering all of your costs in your price. For example, for BU2, the G&A rate applied to direct labor goes from 35% to 25% but will your customer accept 25% add-ons to direct material, direct subcontracts and ODCs when no such add-ons were made in the past? If not, then you are stuck not recovering all your costs.
If some customers will accept it and others not, then you may want to consider a material/subcontract handling rate at one or even both segments where some G&A and/or overhead costs are removed from their respective pools and placed in a material/subcontract handling pool where the base is direct material and subcontract costs. The G&A base stays as value added. Use of a material handling rate generally results in a burden rate of 3-5% on material and/or subcontract costs.
Based on our discussions, there seems to be many types of costs included in the G&A pool that can legitimately be moved to the overhead pool (e.g. IT related costs). This flexibility can significantly affect the indirect costs rates within each segment. As for the shared services, there are several potential methods of allocating them to the two segments (e.g. total costs, three-factor formula). Also, once assigned to the segments, the allocated costs can all be considered part of the G&A pool costs of that segment or can be split up between G&A and overhead. The sales base should be discontinued because it is generally considered not be to equivalent to total cost activity..
I believe the decisions on what the new indirect rate structure will be should be discussed and decided by senior management (e.g. CFO, CEO) and not relegated to the controller. The controller – you – can and should suggest alternatives and even make recommendations but the decision should be squarely put on senior management.
Knowing Your Cost Principles… SELECTED ELEMENTS OF COMPENSATION
(Editor’s Note. Following our article on bonus expenses in the last issue we have received requests to address other elements of compensation found in FAR 31.205-6 so here it is. Our sources for this article are pretty much the same as those used for bonus costs: (1) one of our favorite texts – Accounting for Government Contracts, Federal Acquisition Regulation edited by Lane Anderson (2) an article by Karen Manos in the Dec. 2007 issue of Briefing Papers (3) the Defense Contract Audit Manual (DCAM) and (4) our own experience helping clients either challenge questioned costs or helping them develop policies that would be acceptable by auditors.)
Background
FAR 31.205-6 defines the term compensation as “all remuneration paid currently or accrued in whatever form and whether paid immediately or deferred, for services rendered by employees to the contractor.” Compensation includes payment made or to be made in the future in the form of cash, corporate securities such as stocks, bonds and other instruments or other assets, products or services.
FAR 31.205-6(a)(1) sets forth five general criteria that must be met if costs of personal compensation are to be allowable. First, with limited exceptions such as severance pay, deferred compensation, pensions or other post retirement benefits, the compensation is for work performed in the current year and may not be a retroactive payment for work in prior years. Second, the compensation in total must be reasonable for work performed as well as individual components where “reasonableness” is defined in FAR 31.201-3. Essentially it is what is normal for a comparable business, what is consistent with an established plan of the business, restraints imposed by business circumstances (e.g. highly competitive environment, absence of all cost reimbursable contracts) and what the IRS allows as a deduction. “Reasonableness” criteria usually translates into results of compensation surveys used by auditors. Third, the compensation must have been paid in accordance with an “established compensation plan or practices followed so consistently as to imply, in effect, an agreement to make the payment.” Despite recent DCAA assertions to the contrary, the plan or practice in existence need not be in writing (Systemetrics Engineering Corp, NASA 1270-20, Boeing Aerospace Operations Inc., ASBCA 46274). Fourth, there is no presumption of allowability where the contractor has made a major revision to its compensation plan or practice without notifying the ACO (the opposite is also true where there is a presumption of allowability where the contractor has notified the ACO and provided an opportunity to review the change). Fifth, costs considered unallowable under other cost principles are not considered allowable simply by being called compensation (e.g. cost of country clubs, “entertainment”).
We have addressed salaries and wages in numerous other articles as well as bonuses in the last issue. Here we address other selected areas of compensation.
Income Tax Differential Pay
The cost principle explicitly permits the cost of differential allowances such as housing expense allowances, higher living costs, transportation, bonuses and additional federal, state, local or foreign taxes. The cost of tax “gross ups” to compensate an employee for additional federal, state or local income taxes from domestic assignments are not allowable. However, tax “gross ups” for increased income cause by reimbursement of relocation costs are now allowable.
Severance Pay
Severance pay is compensation in addition to regular salary and wages for being involuntarily terminated. It is allowable if it is reasonable and is required by law, employee-employer agreement, an established policy that in effect constitutes an agreement or the circumstances of the particular employment. However, if the employee is employed by a replacement contractor or employed by the contractor or an affiliate under equal conditions as the replaced employee and with credit for prior service their severance pay is unallowable. “Normal” severance pay must be allocated to all of the work performed (i.e. charged indirectly). Accruals for “abnormal” or mass severance are unallowable but the cost principle states the government is liable for “its fair share” of any such payment. Nonetheless, contractors are not entitled to severance payments under fixed price contracts.
Retirement Incentives and Employee Release Arrangements
As opposed to involuntary severance pay, the cost principles explicitly allow costs for retirement incentives limited to the employee’s annual salary the year before their retirement. Earlier versions of the FAR disallowed both severance and retirement incentive payments but later versions were changed to allow both.
Employee release arrangements, where an employee receives more severance pay than normal in exchange for releasing the employer from liability for wrongful termination, used to be disallowed by DCAA on the grounds it was backpay for services not rendered. In the mid-90’s DOD rejected their position where DCAA published guidance prohibiting the disallowance and recommended auditors evaluate the reasonableness of such payments on a case-by-case basis.
Backpay
Before changes to the FAR in August 2003, the cost of backpay was allowable unless it (1) resulted from a violation of federal laws or the Civil Rights Act and (2) did not represent additional compensation for worked performed. After 2003, FAR revisions made all backpay unallowable unless it was for work performed but was underpaid.
Corporate Securities
Corporate securities such as stock options and stock appreciation rights are one of the most common forms of long term incentive compensation for executives. Certain restrictions apply such as (1) the securities must be valued at their fair market value on the measurement date which is defined as the first date the number of shares is known and (2) any accruals for the cost of securities before issuance to the employees must take into account the possibility the employees’ interest in the securities may be forfeited. Any compensation that is calculated based on changes in the price of the securities (or represented by or calculated based on dividend payments) is unallowable. This is true even if the payment otherwise meet the criteria for incentive compensation. Prior to 1996, cases focused narrowly on specific types of securities (e.g. phantom rights, stock appreciation rights) that were deemed unallowable after which a general cost principle for all stock based securities was put forth that is not tied to any particular security. Now any compensation that is calculated or valued on the basis of a change in the price of the contractor’s securities is unallowable. Similarly, compensation paid in the form or calculated based on dividend payments is unallowable. Also, compensation paid in lieu of receiving a right, option or benefit that is unallowable is also unallowable.
Pensions
The cost principles recognize two types of pension plans
– defined benefit and defined contribution. The “funded pension cost”, the amount paid to a funding agency for the accumulation of the contributions of either plan, are generally allowable as long as they are measured, allocated and accounted for in accordance with CAS 412 and 413. Ms. Manos details several changes made in the recent past but they are too involved to recount here.
Employee Stock Ownership Plans (ESOPs)
ESOPs are employee bonus plans intended to invest in the stock of the employees’ company where the contractor makes annual contributions to an employee stock ownership trust (ESOT). ESOPs may be leveraged or non-leveraged where under a leveraged ESOP the ESOT borrows money, buys the stock which is held by the lender, the company pays down principle and interest (which is allowable) where the stock is gradually released, assigned to individual employees and when they retire, they receive their share of stock or cash equivalent. Following a long history of FAR and CAS proposals, FAR 31.205(q) was passed that provided ESOPs meeting the definition of a pension plan would be covered by CAS 412 and not meeting the definition would be covered by CAS 415. All ESOP payments would be allowable if made by the federal tax filing date. Conditions of allowability include (1) they don’t exceed the tax deductibility limits (2) when contribution to an ESOT consists of stock, the amount allowable is limited to its fair market value measured on the date the stock is effectively transferred and (3) when the contribution is in cash, stock purchases that exceed the fair market value of the stock is unallowable.
Deferred Compensation
Though we discussed this form of compensation in the past, we will summarize it by saying deferred compensation consists of payments made to an employee in a future period for work performed in an earlier period. It is covered by provisions of CAS 415, whether or not a contract is CAS covered which generally requires the amount of future payments recognized in the current period will be measured by the net present value of these future payments using the discount rate established semi-annually by the Sec. of Treasury. There are several conditions required for the deferred compensation to be allowable in the current period: (1) the contractor may not unilaterally void the requirement to make future payments (2) the compensation award must be satisfied by payment in cash, stock of the contractor or other means (3) the amount of the future award must be determinable with reasonable accuracy (4) the recipient of the award must be known (group plans can avoid this requirement for identifying individuals) (5) if receipt of the award is based on occurrence of future events there must be a reasonable probability those events will occur and (6) for stock options, there must be a reasonable possibility they will be exercised. If any of these conditions are not met, the cost must be assigned to the period the payment is made.
Fringe Benefits
The term “compensation” is often linked with “fringe benefits” which are defined as allowances and services provided to employees in addition to their regular wages and salary. Similar to other types of compensation, they must be reasonable and required by law, employee-employer agreement or an established policy of the company. Some fringe benefit costs, whether or not they are considered to be taxable income and even reasonable, are unallowable such as rebate and purchase discount plans, personal use of a company car and costs of social, dining or country club fees. When determining whether levels of compensation are reasonable, whether using annual salary caps established by the government or surveys used by DCAA, fringe benefits which can constitute 40 percent or even more of salary and wages, are not to be included as benchmarked compensation but is rather to be evaluated for reasonableness separately.
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