(Editor’s Note. Proper treatment of independent research and development (IR&D) and bid and proposal (B&P) costs are oftena source of confusion. Last year we reported extensively on the results of a new case, Newport News, that effectively forcedcontractors to charge costs that had ordinarily been considered IR&D to specific contracts where such costs were usually not recoverable.Whereas there was a long history of distinguishing between “explicit” requirements of a specific contract, where R&D (and byextension bid and proposal costs) costs would be charged directly to a contract and “implicit” requirements where costs would becharged as IR&D and allocated to all contracts, the Newport News case, in effect, discontinued the distinction, significantlybroadening the times that R&D had to be charged direct to a contract. The following case changes the impact of that case and clarifies how both IR&D and B&P costs should be treated. There have been several articles commenting on this important casewhere the most interesting one we have relied on was written by Tom Lemmer and Philip Seckman of McKenna Long and AldridgeLLP, the lawyers representing ATK Thiokol, in the April 6 issue of Federal Contract Report.)
The United States Court of Appeals for the FederalCircuit affirmed the Nov 30, 2005 United States Court of Federal Claims (COFC) decision in ATK Thiokol v United States, 68. The two decisions should end the debate that has existed for four decades regarding theproper interpretation of the phrase “required in theperformance of a contract.” The Federal Circuit held the phrase means that research and development(R&D) efforts are independent and associated costsqualify as IR&D costs, unless the R&D effort isspecifically required by the terms of a contract. The standard applies to all IR&D, including developmentof commercial products and permits “parallel” IR&Dand the use of “branch technology” so long ascontracts are negotiated and drafted properly and theproper cost accounting practices are in place andfollowed consistently. The Fed. Circuit decision also provides contractors extra confidence that theiradherence to their written disclosed practices will guidewhether R&D costs properly are classified as indirectcosts under CAS 420 (which is largely incorporated inthe FAR hence affecting non-CAS covered contractsequally) and are allowable under FAR 31.205-18. TheCourt affirmed contractors are free, within the broad parameters of CAS, to establish their own accountingpractices that make sense for them and that onceestablished bind the contractor and government.
Background
The basic issue was the proper standard fordetermining whether R&D costs are indirect IR&Dcosts and when they are direct costs of a contract.Two regulations define the types of costs that qualifyas IR&D.
1. CAS 420, which governs the allocation of IR&Dand B&P costs, provides the term IR&D does “notinclude the costs of effort sponsored by a grant orrequired in the performance of a contract.” Under CAS 402, R&D costs that are “independent” have abroad benefit which are indirect costs to be allocated to all contracts while when R&D costs are “requiredin the performance of a contract” they must be treatedas direct costs because only one contract benefits.
2. FAR 31.205-18, which covers allowability ofIR&D and B&P costs, contains the same limited phrase “required in the performance of a contract”to define the types of costs that do not quality as IR&Dor B&P. As we see later, the fact this phrase appliesto both IR&D and B&P is key to the court’s decision.
Some History
The government has long recognized that IR&Dbenefits and is critical to the contractors’ financial health and technological growth and thus its abilityto supply the goods and services the governmentneeds. However, beginning in the late 80’s and intothe 90’s the government began to question contractors’treatment of R&D effort as IR&D. During this periodthere was a decline in defense spending whichprompted a government push for defense contractorsto expand their business into commercial markets.These moves were considered to be a means of increasing the contractors’ base and thus decreasingits indirect costs. This shift was accompanied by anincrease in IR&D effort which prompted a numberof aggressive auditors to question IR&D costsviewing them as related to “commercial development” where now they were considered“required in performance” of commercial contracts.Since the 1990s several cases reinforced the government position that the phrase should beinterpreted broadly (e.g. Mayman V Martin Marietta,US vs Newport News Shipbuilding, TRW Inc). These casesemboldened auditors to increasingly question IR&Dcosts and created uncertainty and even risk of fraudallegations for contractors.
The outcome was these cases issued decisions that were inconsistent with the settled distinctions between direct and indirect costs as well as the interpretationof B&P costs which are defined using the samedefinitions. The Newport News case went the furthest going so far as to interpret the “required in theperformance” to mean an effort “implicitly” requiredto perform a contract. This position was oftenadopted by the government and formed much of thegovernment’s basis in ATK Thiokol.
ATK Thiokol Dispute
In the early 90s, in response to shifting marketconditions and increases in the commercial launch market, ATK’s predecessor, Thiokol Corp. concludedthat with certain technical upgrades, a variant of itsCastor IV rocket motor could increase sells to both the commercial and government buyers. As part ofits sales strategy, ATK began to market the upgradedCastor motor to various potential customers such asMcDonnell Douglas, Lockheed Martin and the US AirForce. In Feb 1996, Misubishi began to express aninterest in purchasing the upgraded Castor motor butrefused to pay for general development effort requiredto upgrade the motor. ATK’s proposals andsubsequent contracts with Misubishi, therefore statedit would sell it ready-to-launch motors where thecontract price did not include any of the upgrade effort.
The Court was influenced not only by the Mitubishicontract that prohibited charges directly to thecontract but also because (1) multiple contractsbenefited and (2) charges to IR&D was consistent withits disclosed practices. As for multiple contracts, thetwo parties reasonably concluded there was alikelihood of multiple sales to numerous customerswhere the records of ATK management approval ofexpenditure of company R&D funds made this clear.As for consistency with its disclosed practices andprior accounting practices, ATK’s disclosure statement said R&D costs would be indirect unless (1) the particular contract in question specifically required ATK to incur the cost (2) the contract paidfor the cost and (3) the cost had no reasonablyforeseeable benefit to more than one cost objective.
After making its accounting decision, ATK proposedan advance agreement to the government to establishthe costs would be properly allocable and allowableIR&D costs. The contracting officer disallowed thecosts on the basis that they were “required in theperformance” of the Mitsubishi contract and thereforehad to be charged direct to that contract.
The COFC Decision
The Court of Federal Contracts held that resolution of the issue should depend on interpretation of thecontract and relevant FAR and CAS requirements. A detailed discussion of relevant regulations (CAS 402,CAS 402 Original Interpretation NO. 1, and FAR31.205-18) led it to the conclusion that the phrase“required in the performance” determines whetherthe costs are properly IR&D costs and the contractand disclosed practices should determine whether therequirement has been met. Here it found that ATK and Mitsubishi did not intend for Mitsubishi to payfor the upgrade costs under the contract because theparties believed there was a commercial market forthem and it appeared likely there would be multiplepurchases for the motors. The Court also found that ATK accounted for the effort consistently with itsdisclosed practices and hence it properly charged thecosts to IR&D.
The Government and ATK’s Positions on Appeal
In its appeal, the government contended the correctinterpretation of “required in the performance of acontract” precluded all costs whether they werespecifically or implicitly required by the contract.Relying on the Newport News case, the governmentargued it could not meet its contractual commitmentto sell Mitsubishi the motors without putting in theupgrade effort, arguing the effort was “necessary” or“implicitly required”. The government argued theCOFC decision should be reversed stating the decisionwould allow contractors to routinely “game thesystem” by improperly shifting commercial contractcosts to the government.
ATK said the COFC decision should be affirmed for two reasons. First, it argued the decision “achieved harmony” between the definition of IR&D and B&P – that is should be interpreted similarly – since the two costs were defined in the regulations using the same limiting phrase. Second, the decision was consistent with Boeing Co v US where there the issue was whether different circumstances allowed certain B&P costs could properly be charged direct andindirect where the government concluded that aspecific requirement in an existing contract is a differingcircumstance that triggers charging normally indirectB&P costs as direct. As for its reliance on the NewportNews decision ATK argued it was wrong because itignored relevant regulations and Federal Circuitprecedent. As to the government’s gaming the systemargument, ATK countered that the cost shifting fearedby the government was precluded by CAS 402 as wellas its stated practices that identified the times costswould be charged direct or indirect. Finally, ATKargued the government’s position would create a “firstin-line” problem that would harm the government.That is, if the government’s interpretation of any“implicit” cost being included in “required by acontract” that would mean the first purchaser of anyproduct would have to pay all R&D costs associatedwith that product. Since the government is often thefirst purchaser of products, the government wouldpay for all the R&D effort rather than benefit fromspreading R&D costs across the contractor’s entirebusiness base.
The Federal Circuit’s Decision
The Federal Circuit ruled that R&D effort is IR&D unless the effort is “specifically required by the termsof an existing contract.” Its reasons were as follows:
1. In considering whether the phrase “required in theperformance of a contract” has clear meaning, it statedthat “standing alone the language of the regulation isambiguous.” By recognizing the ambiguity, the Circuitrejected the claimed “plain language” advanced tosupport the Newport News case that claimed both specifically and implicit costs are part of the contract.
2. It next looked to see whether the regulatory historyprovided a clear meaning and the Circuit concludedthat was “inconclusive.”
After concluding both the clear language underlyingthe Newport News case and regulatory history was nothelpful, it then turned to relevant regulations,specifically CAS Interpretation No. 1 and settledinterpretations of B&P costs.
3. CAS Interpretation No. 1. The Circuit concluded IR&D costs must be treated the same as B&P costs. Interpretation No. 1 clearly distinguished betweenB&P costs being a specific requirement of an existingcontract and different circumstances when normal B&P costs relate to all work of a contractor. It stated circumstances are different because preparing aproposal specifically required by the provisions ofan existing contract relate only to that one contractwhile all other proposal costs relate to all work of a contractor. The Circuit then held thoughInterpretation No. 1 does not address IR&D costs,IR&D must be interpreted the same as B&P costssince otherwise IR&D and B&P costs would require a “different construction” which is impossible whenthere is identical regulations and language for both types of costs.
4. The Circuit rejected the gaming the systemargument of the government concluding there wasno risk contractors would routinely manipulatecontract terms in order to charge the government forcosts that do not properly qualify as IR&D.
5. The Circuit agreed with ATK’s position on theadverse effects cause by the “first-in-line” position.It explained that the government’s approach wouldeither disproportionately burden the contract thathappened to be first in line or ensure the first contractwould loose money if the R&D costs were notrecoverable. To allocate research costs that is expected to benefit multiple contracts, bothcommercial and government, to only the first contract“is not sensible as a policy matter.” It added since the purpose of IR&D costs is to encourage innovationthose costs benefit government contracts since theyare associated with effort to invigorate and improvethe products sold to the government.
Clarifying the IR&D Test
The authors state the Circuit’s decision should provideclarity to contractors and the government regardingwhat R&D effort is not independent and hence direct.It also addresses other cost accounting issues.
1. The decision establishes that like B&P costs, R&D effort is independent unless the effort is specificallyrequired by the terms of an existing contract. Absent such a specific requirement, contractors canconfidently classify R&D costs as IR&D and chargethem as indirect.
2. Contractors still must ensure their disclosed practices are consistent and compliant with CAS 402.Specifically, contractors should ensure that R&D costsincurred in like circumstances for the same purposeare classified consistently and the disclosed practicesidentify these circumstances. (We would argue disclosedpractices need not be limited to a formal CAS disclosure statement and since FAR Part 31 closely mirrors CAS 402requirement, it applies to non-CAS covered contractors as well.)
3. Now it is safe to clearly state that R&D costs not“specifically required by a contract” is an IR&D cost.To further clarify the authors recommend the phrasebe defined in its disclosed practices to mean (a) theeffort is not specifically required by the contract’sStatement of Work or specifically included in thecontract’s cost or cost build-up in support of a contract price and (b) there is reasonable expectationthe effort will benefit more than one contract.
4. Since the facts and circumstances of a particularcontract will continue to be relevant in anydetermination, contractors should carefully considerthe facts relating to any contract where it can be arguedthat R&D effort is not IR&D. Relevant facts mightinclude (a) parties’ intent as shown in proposals,negotiation documentation and other documentation (b) contract’s wording (c) contract’s cost estimatesand actual costs (d) why IR&D effort was taken and (e) explanation of why there was a reasonableexpectation of benefit for multiple contracts.
5. The long standing practice of “parallel” or“generic” IR&D effort along with funded direct R&Deffort remains in tack. Though the Newport News case had the effect of questioning such practices the resultof the Circuit decision permits contractors to engagein R&D effort to support ongoing contract work andclassify such costs as IR&D as long as the necessaryconditions expressed above are met.
6. The case affirmed that B&P costs are subject tothe same rules as IR&D costs. The decision on how to determine whether R&D costs are required undera contract or are properly IR&D should be the samefor B&P costs. To treat these two differently is torisk questioned costs.
7. The decision established the primacy of acontractor’s disclosure statement. ATK affirmed that contractors enjoy substantial discretion in selectingtheir disclosed accounting practices and onceestablished have a sound basis to dispute government,especially DCAA, attacks on contractors’ accountingpractice. The ATK case addresses specifically CAS402 which gives the contractor freedom to determinehow it will classify certain costs as long as it isconsistent where the disclosed practices are theprimary means for establishing these practices.Absent a CAS non-compliance, the contractor’spractices are considered acceptable and if thegovernment insists on a change, the contractor shouldbe compensated for it.
Finally the authors added a couple more conclusions.The ATK decision has provided much needed clarityregarding when R&D effort is IR&D costs.Contractors should examine their cost accountingpractices, disclosed practices and related policies andprocedures to ensure IR&D costs are maximized.They should ensure their contract pricing andnegotiation policies as well as standard terms andconditions and SOWs for both government andcommercial contracts establish a clear statement of intent regarding what R&D effort is specificallyrequired by the contract.
(Editor’s Note. We are often asked by our readers to providemore insight into what profit rates to propose and how tonegotiate “fair” profit rates. Though we have addressed theissue previously (“What’s a Fair Profit or Fee?” in the Nov-Dec 2001 issue of the GCA REPORT) we still need toaddress how to best defend a given level of profit against FARcriteria. We found an article in the July 2009 issue of ContractManagement written by Bud Almas and Fred Schlich of B3Solutions LLC that we found particularly interesting because (1) the auditors were both former Air Force officers presumably involved with negotiating profit rates for the government and (2) the list of considerations they put forth (we are usually notparticularly great fans of lists) is consistent with the types ofpoints we have helped clients put together to justify their proposedprofit rates.)
The concept of “profit” has a variety of meanings.To economists it is the expense needed to attractofferors to commit its resources, finance peopleconsider it as the incentive to risk capital in uncertainenvironments, accountants consider it as the difference between revenue and costs and the IRS as its tax target. To the government, as provided inFAR 15.404, a profit rate is that which is “sufficientto stimulate efficient contract performance, attractthe best capabilities of qualified large and smallbusinesses” to enter the government marketplace andto “maintain a viable industrial base.”
When price is based on competitive forces profit,like all other costs, are assumed to be at a fair level due to market forces. When a price analysis is made,a review of profit may be made but is not separablefrom other costs in reviewing an overalldetermination of price reasonableness. It is only whena cost analysis is made that profit becomes a factorto propose, analyze and negotiate. In negotiating profit the FAR 15.404(4) warns against such methodsas negotiating low profits, use of historical averagesor automatic applications of predetermined profitpercentages to cost estimates because they “do notprovide proper motivation for optimum contractperformance.” Rather the FAR prescribes a“structured approach” where “common factors” and“other factors” are required to be analyzed in arrivingat a fair profit. Whereas “other factors” are considered to be those that may be unique to a givenagency, acquisition or specific procurement approach,“common factors” are specified as contractor effort,contract cost risk, federal socioeconomic programs,capital investments and cost control and other past performances.
1. Contractor effort is broken into four elements:
b. Conversion of Direct Labor. Higher profitconsideration should be given if the labor required ismore diverse, more skilled or requires moresupervision and coordination. Higher profit wouldapply if a contract requires pulling together tightschedules of, for example, engineers, scientists or highend manufacturing skill levels. At the lower end of the profit spectrum are contracts with a high level ofstaff augmentation where much of the day-to-daytasking effort is made by the government. However, even in such circumstances, difficulty in recruiting orretaining employees may justify higher profit levels.
c. Conversion Related Indirect Costs and General Management. Indirect cost effort has a material impact on overall quality and cost of a contract.Indirect effort that is routine in nature provides littlesupport for high profit but activities that are specialized needing, for example, continuingeducation or highly technical IT systems suggest ahigher profit.
3. Federal Socioeconomic Programs. The FAR explicitly uses higher profit to incentivize contractorsto provide greater opportunities for socioeconomic programs. We and the authors find that generousprograms are not sufficiently highlighted when itcomes to negotiating higher profits.
4. Capital Investments. Making “capital investments”that will provide for efficiency and betterperformance are of great interest to the governmentare to be considerations for higher profit. Like federal socioeconomic programs, contractors need to identifytheir current and planned capital investments whennegotiating their profit levels.
5. Cost Control and Other Past Performance. FAR profit guidelines put emphasis on using profit levelsto reward past successful efforts at cost control aswell a future, planned efforts. These should be putforward during profit negotiations.
6. Independent Development. Contracting officersare encouraged to reward contractors with higherprofit levels who contribute to independentdevelopment, as opposed to government fundedwork, that directly benefits or will benefit contractperformance.
In addition, agencies are required to have their ownstructured approach to analyze and negotiate profit.The DOD Weighted Guidelines, DD Form 1547 isthe most well known. The authors state such guidelineshave limitations where profit analysis should be morethan simply putting in values on a form and tend tobe excessively subjective. (Editor’s Note. That mayhelp explain why we do not see these guidelines used exceptmaybe at the prime contract level for major systems acquisitions.)
Of course profit rates negotiated on a contract do notequate to actual financial gain on a contract. Efficiencies gained on fixed price contracts can increase the gain,for example, and incurrence of unallowable costs oncost type contracts can decrease it. This information is not and should not be privy to government auditors.The authors end their article by stating no matter whatthe negotiated profit is, negotiations aimed merely atreducing prices by reducing profit without recognizingthe proper role of profit is not in the government’sinterest – a thought that often needs to be repeatedduring negotiations.
Case Study…
(Editor’s Note. Our client has a history of burdening itssubcontract costs as well as certain direct material and equipmentcosts in various ways, sometimes using a special burden rate(SBR) and sometimes using a full G&A rate. They askedus to help them establish criteria for using either the SBR orfull G&A rate and recommend any changes we thoughtappropriate. The following is a highly edited version of our report. We have used the term “Contractor” rather than divulgethe name of our client and changed the numbers used.)
The intention of this memo is to recommend what I consider to be the best way to provide add-on chargesto such direct costs as subcontractors, materials and purchased parts to meet its twin goals of providingpricing flexibility and compliant accounting practices.
Background
2005 Proposal. Prior to 2005, all subcontract, material and purchased parts were burdened with a SBR thatvaried from .5 to 3 percent over the years. In 2005, the company established an accounting change wherethe SBR would apply to some subcontract costs whilethe full G&A rate would apply to others. Though amemo written at the time indicated the criteria for determining what rate would apply should be basedon dollar value of subcontracts (full G&A burdenapplied to subcontracts and purchased parts valuedat less than $50K and the SBR applied when the costexceeded $50K) it appears as if this suggestion wasnot consistently followed.
On-Going Discussions. Over the years, several alternativesways of when to apply the SBR were considered butno definitive decision was made. There appears to bea keen understanding that whatever criteria is used, the decision should be based on what will satisfyContractor’s clients and provide a competitive edgewhile making sure that Contractor does not give upexcessive dollars it would be allowed to receive. All people I spoke with as well as memos I read emphasizedthe need to come up with a way to be able to provideflexibility in pricing, using a lower rate when neededand a higher rate when it would be acceptable. Several criteria alternatives were put forth:
1. Large or small, similar to the criteria expressed inthe 2005 memo.
2. Purchases where Contractor does or does not “add value.”
3. Whether the purchase involves doing business witha “strategic partner” (use the SBR) or non-strategicpartner (use the full G&A). Examples of a strategicpartner might include subcontractors under SmallBusiness Innovative Research (SBIR) awards thatprovided essential technology breakthroughs.
4. Distinguishing between subcontracts and purchasedparts with some variation of consideration for largeversus small dollar purchases.
5. Some suggestions recommended a combinationof criteria such as a procurement exceeding $100Kwith no value added.
The internal memos I read had some thoughtfulinsights into the weaknesses of the above criteria. For example, one memo challenged the “added value”criteria due to the difficulties in determining whenvalue was and was not added while another memo challenged the large versus small dollar criteria,pointing out both some small but also some large,expensive items required a SBR.
What Options are Available. Early in the engagementContractor asked us to identify the types of indirectrate options they had. We provided a memoidentifying five general options for burdeningsubcontract/PPE costs – (1) Contractor’s currentSBR method adjusted for greater consistency (2) purevalue added G&A base (3) added value G&A baseand a special material and/or subcontract burden rate
(4) total cost input (TCI) G&A base and (5) a modifiedTCI base where only a portion of subcontract costsbased on dollar criteria would be included in the base. We indicated all five options were potentiallydefensible against FAR and CAS criteria (too detailedto recount here).
What Cost Elements Go Into the SBR and G&A Pools. There was also a history of difficulty in determiningwhat costs should go into the SBR cost pool used tocompute the rate. The current methods of using eithertimesheets or estimates of time spent on supporting subcontracts and purchases included in the base weresubject to significant imprecision and I was concernedthey would likely be challenged by auditors. As for the G&A pool, traditional pure G&A costs such as CEOand CFO as well as business development, IR&D/Bidand Proposal and board of director expenses areincluded. Other less strict G&A type costs are alsoincluded in the G&A pool such as senior operatingmanagers, senior VP support staff such as HR, IT andTechnology as well as all functions of accounting andfinance, contracts and legal.
Future Contract Work. In my mind, the key for understanding the issues lie in first determining thetype of work likely to be performed in the near futureand what was their clients’ attitudes about applyingfull G&A rates to selected ODCs. My interview with the heads of the company’s two business unitsidentified the following type of work:
1. Research and Development projects. This business represents the majority of Contractor’s current workwhich includes outputs of professional labor, prototypeitems and short production runs. Here, the managersindicated a full G&A rate would be acceptable to itsclients on most subcontract costs despite the fact mostsubcontract and material costs were currently burdenedwith the SBR. However, one particularly largesubcontract (representing close to 75% of the dollarvalue of subcontracts) that did receive the SBR couldnot be burdened with a full G&A rate because it would be strongly resisted by the customer.
2. SBIRs.. Though representing a small dollar valueof business, these contracts are strategically importantfor future business. The managers indicated theywould like to see no G&A or at most a small SBR applied, especially for Phase I SBIRs, since they arereluctant to have indirect costs take up highly limitedfunds of these contract vehicles.
3. Hardware. Currently this work does not require acost buildup to determine price so no add on isapplied to subcontract/parts costs. In the future, the company is going after a large, probably CAS coveredcontract, where the price will be based on a costbuildup estimate and half the costs will besubcontracted out. One of the managers said a fullG&A rate would likely be acceptable.
4. Production Items. In this work, much of the work is subcontracts with large prime companies whereContractor provides high end items where there islittle price sensitivity so Contractor can apply evenhigher G&A rates with no resistance from its clients.
Our Conclusions
2005 Proposal. The 2005 proposal seems to be anexcellent improvement over what went before. Rather than the “one size fits all” SBR approach, the distinctionsof high and low dollar subcontract costs provided away to burden similar costs differently for achievingthe goal of pricing flexibility. The weakness of the 2005proposal was that pricing strategies for different typesof contracts were not clearly defined and the detailswere left for the future – what are the costs in the SBR pool and what criteria for applying the rates.
Basis for Applying the SBR Versus Full G&A Rate. The confusing nature of the criteria to be used andweaknesses of them all is a source for significantpotential audit challenges to Contractor’s rates. The commonly acceptable rules are: – like costs must betreated consistently and the way to burden subcontractsis to either use a TCI G&A base or a value added base where subcontracts, material and/or equipment partsmay be burdened with a handling rate. A subcontract rate (excluding material and PPE) is commonlyaccepted for non-CAS covered contractors (thoughauditors will sometimes challenge this).
Any other choice is a tough sell. In our experience, wehave not seen any criteria where value added, strategicor non-strategic partner or combination with largeversus small costs has been accepted when reviewed.The only criteria we have seen accepted (we helped sellthis approach) is a large versus small basis (e.g. belowand above $50K) where the methodology foridentifying the pool is clear (e.g. specific individualsassigned to the pool, subcontract handling cost center).However, considerable “selling” must be involved togain acceptance including a convincing justificationnarrative, allusions to relevant regulations and case lawand a cost impact analysis ideally showing how thegovernment benefits (has less dollars allocated torelevant government contracts).
In addition, since the two types of subcontract costswhere the lower SBR rate most commonly apply –SBIRs and certain large R&D contracts where lowerdollar and high dollar subcontract costs apply,respectively -a low/high price threshold criteriaapplied to all subcontracts would not make much sense. Though it is true SBIR contracts and a limitednumber of other R&D contracts would benefit by alow SBR rate, other contracts where both low dollar and high dollar subcontract costs can be burdenedwith full G&A would result in excess dollars “left on the table” by applying an unnecessary low burden rate.
What Cost Elements Go Into the SBR Pool. If reviewed, the current method of assigning costs to the SBR poolwould be challenged. Estimates are normallyunacceptable except when used for forward pricing purposes. Costs based on timesheets have the potentialof being more acceptable but is vulnerable to havingan auditor conduct a floor check where if problems ofinaccurate timekeeping are found it would make theentire cost pool unsupported. One approach that wouldlikely be accepted entails including subcontract supportcosts into one or more cost centers and allocating aportion of those costs to the SBR pool based on someobjective measurement like number of invoices.Nonetheless, DCAA is notorious for carefullyevaluating the accuracy of the types of bases used toallocate these types of cost center expenses (e.g. numberof vendor invoices) where if inaccuracies are found inthe base all costs are disallowed including those costsallocated to overhead.
Future Contract Work. Both the types of businessopportunities Contractor is facing in the near futureand ways G&A can be charged to those contracts areunusually varied. Given that the criteria of what G&A rate to apply should depend on client desires andpricing competition concerns as well as minimizingdollars “left on Contractor’s table,” the result of mydiscussion with management indicates the key elementmust be flexibility in applying rates. The SBIRs and certain other contracts where there is both a high dollarsubcontract cost element and a client concern of minimizing add on costs, a zero to 3 percent add onis desirable. In other contracts, a higher rate may beacceptable but not one higher than other competitorsmay add, perhaps in the 8-13% range. In much of Contractor’s future work the current G&A rate is acceptable where even higher rates could be approved.In my opinion, the pricing scheme selected must beable to meet these varied pricing strategies as muchas possible.
Discussion of Current Rates. Contractor’s 2009 G&A rate of approximately 17% and its overhead rate of60% should be compared to other firms thatContractor does and will compete with in the future.There is no substitute for sound business intelligenceto determine what these benchmark rates are because we see widely divergent “bogey” rates in differenttypes of competitions. No general survey orconsultant’s impressions can substitute for suchspecific information.
Nonetheless there is some very limited benchmarkdata that can be used as a rough indicator. Grant Thorton’s 15th Annual Government Contractor Industry Survey (see our 1Q10 DIGEST for a fullerdiscussion) that compares primarily professionalservice firms indicates a 13% G&A rate is normal when total cost input is the allocation base and 15%when a value added base is used. Average overheadrates for on-site labor is 60% when the overhead base is direct labor and 48% when the base is direct labor plus fringe benefits, which is the case with Contractor.For those firms using a separate subcontract handlingor subcontract/material handling rate, the surveyresults are 4% and 3.5%, respectively compared toContractor’s 1.5%. Our experience provides a bitdifferent results – lower G&A rates than the surveyin the 8-11% range and higher overhead rates(sometimes up to 120% or more) are typical ofprofessional service firms in our experience. The bottom line of these statistics is that Contractor’s G&A rate is higher than most while its overhead rate,though higher than survey results, is still lower thanmost companies we encounter. Only its SBR handlingrate is lower.
Recommendations
Our intention is to provide recommendations to provide Contractor sufficient pricing flexibility to beable to offer a range of add-ons amounts to itssubcontract/material/PPE costs and still be inreasonable compliance with government contractaccounting regulations. We would offer the followingas recommended preferences.
1. Eliminate the SBR. Though it seeks the laudableobjective of providing a cost based justification toallow Contractor to charge both full G&A and asignificantly smaller add-on to its direct subcontract/PPE costs to meet its pricing goals, its shortcomingscan undermine the very goals it seeks to achieve. The criteria Contractor uses to distinguish what rate toapply are problematic and obtaining DCAA approvalis unlikely if they are reviewed unless the criteria is asimple dollar threshold. However, the simple dollarthreshold criterion will not accomplish the goal ofapplying an SBR to both low dollar SBIR subcontractcosts and high dollar subcontract and equipment costson selected R&D contracts. In addition, justifyingthe pool costs through unreliable timesheets orestimates is highly problematic where even a surrogatemeasurement, though more defensible, is also subjectto DCAA disallowances. As we see below, the company’s pricing flexibility objectives can beachieved in other ways.
2. Establish one full G&A rate applicable to all subcontract/material/PPE costs where the base would be total cost input. I believe establishing one add-on amount providesmaximum pricing flexibility and would not bechallenged by DCAA. Pricing flexibility stems fromusing a maximum add-on factor for those subcontractamounts Contractor wishes to apply a full G&A rateto without suffering objections of its client. Based on estimates of future business opportunities, this willbe the case in the vast majority of contracts. Since subcontract/PPE costs represent a low amount ofdirect costs, adding them to the current value basewould result in about a half a point decrease to thecurrent 17%. In those situations where it wants to lower its add-on or even eliminate it, the firm has that option as discussed below.
3. Consider lowering the full G&A rate by moving some G&Apool costs to overhead. The 17% G&A seems rather highwhile the overhead rate may be somewhat lowdepending on what survey or experience is used (again,I urge you to use your own business intelligence). This may be desirable if Contractor wishes to charge a fullG&A rate but wants to keep its burden rate low.Contractor can lower its G&A rate and increase its overhead rate to be more closely aligned withcompetitors by reassigning certain costs now includedin its G&A pool that can legitimately be placed in theoverhead pool. Examples of possible candidatesinclude such functions as contract and subcontract administration, HR, accounting, senior operatingmanagement and certain legal expenses. Of course, this may not be a desirable move if substantially moresubcontract costs are incurred in future years.
4. Two options come to mind when Contractor wantsto offer a less than full G&A rate on selected contracts:
b. Offer a special allocation. As an alternative to a management concession, a very limited number of contracts can offer a special allocation. The mechanics of computing a special allocation is to establish a baseand pool of costs where the base represents thesubcontract/PPE costs applicable to that specialcontract and the pool is the support expenses for thosebase costs. Both these pool costs, which presumablycome from either or both the G&A or overhead pools,and base costs are eliminated from their respective poolsand bases where the normal G&A rates are computednet of those costs. This has the advantage of offeringa low (or even zero rate if no costs are transferred tothe new pool) rate without diluting the G&A rate. In practice a special allocation should be used sparinglybecause approval before contract award by the ACOis required where often significant administrativeburdens need to be followed.
(Editor’s Note. The issue of Organizational Conflicts ofInterest (OCI) has become one of the hottest topics aroundlately. Much criticism by various government groups haveasserted not enough is being done to prevent contractors fromwinning awards when they may have unfair access to informationgiving them an unfair advantage over other bidders. In addition, many industry groups have been saying that several recent caseshave generated rulings that make current regulations governingconflicts of interest obsolete. The current proposed rule intendingto address these concerns has generated considerable commentary. We have relied on an article in the April 27issue of Government Contractor written by Marcia Madsen,David Dowd and Rodger Waldron of Mayer Brown LLP toaddress this new proposed rule.)
On April 22, 2010 the Defense Department issued aproposed rule to amend the Defense FederalAcquisition Supplement to implement the WeaponsSystem Acquisition Reform Act of 2009 (referred toas the Act). The proposed rule addresses changesfor treatment of organizational conflicts of interest,representing a significant change over currentregulations of OCI. It reflects a current government-wide focus on avoiding OCIs even if the goal ofexpanding competition suffers.
Background
Section 207 of the Act directs DOD to revise the DFARS to provide “uniform guidance” and “tightenup existing requirements” for OCIs by contractors involved in major acquisition programs. A Panel earlier recommended the FAR Council address OCIs stating that growth of services, industry consolidationand use of multiple award contracts had increasedthe likelihood of OCI and the need to address it. Keyaspects of the rule include:
1. Reorganization and Application. The current FAR addresses OCIs in FAR Subpart 9.5 while theproposed DFARS rule would relocate coverage ofOCI concerns in a new subpart 203.12 section in theDFARS. This relocation would group OCI withimproper practices and personal conflicts of interest.It is unclear whether DOD would exempt itselfcompletely from the FAR 9.5 section. The proposedrule covers three methods for resolving COIs –“avoidance, limitation on future contracting(neutralization) and mitigation.”
2. Reflection of Case Law Developments. The Rule acknowledges that the FAR provisions are outdatedand do not reflect more current principles developedthrough many protest cases issued in the last 15 years.For example, in Aetna Gov. Health Plans (B-254397)the GAO recognized there are three types of OCI:
(i) unfair access to non-public information (ii) “biasedground rules” and (iii) “impaired objectivity.” The proposed rule mirrors these three types of OCI andgoes much further by introducing new approachesand significant obligations on the part of offerors,contractors and agency personnel.
The Rule expresses a policy preference for mitigationof OCI rather than other techniques for addressingOCIs. It recognizes some OCIs are not alwayssusceptible to mitigation in which case the CO is toeither select another offeror or request a waiver. The Rule does not provide guidance on when mitigationshould not be used. Authority to grant a waiver isallowed where resolution of an OCI is either not feasible or it is in the “interests of the government.”Before granting a waiver, however, agencies mustresolve conflicts “to the extent feasible” and the waiver should be applied only for “residual conflicts”after all techniques have been used to lessen theconflict.
3. Task and Delivery Contracts. The Rule providesthat OCIs are to be addressed at both the contract and order level. If a COI can be identified at the time of award of the basic contract, COs are to include a resolution plan – mitigation or limitation on futurecontracting – in the basic contract. The Rule also directs COs to consider OCI at the time of issuing atask or delivery order. If there is a resolution plan in the basic contract, COs are to tailor the plan at theorder level.
4. New Tools and Techniques. Though some agencieshave their own OCI clauses, there is no current standard FAR OCI clause. The Rule would providestandard OCI clauses to be used by Defense agencies.If the DOD approach is adopted in the FAR rewritethen there would be standard OCI clauses for civilian and defense agencies that would address bothidentification and resolution of OCIs. The proposalputs forth clauses that would apply to major defenseprograms and others circumstances.
b. Resolution of OCI. This clause will be included in a contract when an OCI can be resolved through a mitigation plan. The clause will (i)incorporate the plan (ii) violations or changes to theplan (iii) require flowdown to subcontractors and (iv)when there is unfair access to non-public informationthe CO should consider whether a mitigation planincludes a limitation of reassignment of personnelwith such access.
c. Limitation of Future Contracting. This clause will be used when the CO decides to resolve a COI by limiting future contracting. Particular work the contractor is ineligible for will be identified with adefault period of three years which can be modified.
d. Disclosure of COI After Contract Award. This clause addresses COIs that may arise aftercontract award such as a novation of a contract or the acquisition of a business that may cause a COI.
6. Implementation of Section 207. The rule tracks the requirements of the act to tighten OCI rules. The Act provides that DOD will receive advice on systemsarchitecture and systems engineering (SETA) mattersfrom organizations independent of the primecontractor e.g. federally funded R&D centers. Thougha SETA contract prohibits contractors or an affiliatefrom participating as a prime contractor the ruleprovides for exceptions to ensure DOD has continuedaccess to SETA matters from highly qualified contractors. The rule would allow COs to accept amitigation plan to enable a contractor performing aSETA contract to participate as a prime or major contractor.
Comments on the Proposed Rule
The authors provide their opinion on several aspectsof the proposed rule.
1. The DFARS Subpart 203.12. The rule allows fora more “centralized and streamlined approach” thatis an improvement over the current approach ofallowing agencies to address their concerns in a widevariety of ways. It is interesting the new section isgrouped with other improper conduct e.g. gratuities,kickbacks, etc.. Though OCI can be detrimental tothe procurement process OCIs “do not turn” onimproper conduct and the fact that COs may waiveOCI is quite distinct from improper conduct wherethere is no concept of waiving requirements.
2. Definitions and Scope of Coverage. The rule is to apply to a contractor which includes the totalorganization including not only business units that signthe contract but subsidiaries and affiliates. The term “affiliate” is undefined so whether the entity needs tobe wholly-owned or whether even small interests issufficient for an OCI is unclear. Also, as mentioned before, there is no rationale why COTS is exempt butnot other types of commercial items. The only hint isthat COTS, which apply to supplies, is distinct fromcommercial services.
3. Identification of Resolution of OCIs – New Burdens
b. For agencies. COs must consider a broad range of information. Prior to issuance of an RFP, the CO must review the nature of the work to see if a potentialOCI exists. If no OCI is identified, the record must be documented while if one exists, the relevant clauses must be included. Next more information needs to be reviewed to see whether an actual OCI will exist upon award such as information put forth by offerorsand both governmental (e.g. files, knowledge of peopleat the contracting office) and non-governmentalsources (e.g. website, credit rating services). The shearvolume of information to consider can be quiteburdensome, especially for smaller procurements,where failure to consider some of the data may begrounds for a protest the CO failed to assess potentialOCI information.
5. Mitigation and Avoidance. The proposed rulegenerally states that of the three primary methods –avoidance, limit future contracting or mitigation –mitigation is the preferred method. The proposedrule states that if the CO is “unable to mitigate” anOCI, another approach shall be used but the proposedrule does not address a preference for any alternativeapproaches.
6.Waivers. In response to some cases, the new ruleprovides that a waiver may be granted after trying to“feasibly” resolve all conflicts. This rare act of granting a waiver will now be subject to challenge on the basisthe agency did not reasonably take all feasible stepsto resolve conflicts.
7. Impact on Discussions. Based on a case, the preamble to the proposed rule states thatcommunications with offerors regarding OCIs shouldnot be considered “discussions” because such exchanges do not result in changes to an awardee’sproposal. However, there may very well be instanceswhen exchanges regarding COI do result in changesto a proposal so it is unclear what would happen then.
8. Other comments.
b. The proposed rule requiring COs to considerthe award of a major subsystem by a prime to otherbusiness units or affiliates can have significant effectson a prime’s make or buy decisions. Nonetheless, the rule provides little guidance here e.g. what should a CO do.
c. The proposed rule prohibits contractors oraffiliates to participate in the development or“construction” of a weapons system if it was involvedin SETA contracts but this term “construction” is vague e.g. does it mean “production.”
d. The proposed rule does not address howexisting SETA contracts should be addressed. Is it to apply to contracts initiated after the effective dateor are the requirements intended to apply to existing contracts.
e. The proposed rule establishes “limited exceptions” to the SETA prohibition to ensure DODhas access to systems from highly qualified contractors.So a contractor may participate as a contractor ormajor subcontractor for development or constructionof a weapon system if it has a SETA contract butthere is no guidance for how a mitigation plan in suchcircumstances should be devised.
© 2024 Government Contract Associates. All Rights Reserved.