Determining Profit Rates

(Editor’s Note. We are often asked by our readers to provide more insight into what profit rates to propose and how to negotiate “fair” profit rates. Though we have addressed the issue previously (“What’s a Fair Profit or Fee?” in the Nov-Dec 2001 issue of the GCA REPORT) we still need to address how to best defend a given level of profit against FAR criteria. We found an article in the July 2009 issue of Contract Management 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 not particularly great fans of lists) is consistent with the types of points we have helped clients put together to justify their proposed profit rates.)

The concept of “profit” has a variety of meanings.To economists it is the expense needed to attract offerors to commit its resources, finance people consider it as the incentive to risk capital in uncertain environments, 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 “sufficient to stimulate efficient contract performance, attract the best capabilities of qualified large and small businesses” to enter the government marketplace and to “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 separable from other costs in reviewing an overall determination of price reasonableness. It is only whena cost analysis is made that profit becomes a factor to propose, analyze and negotiate. In negotiating profit the FAR 15.404(4) warns against such methods as negotiating low profits, use of historical averages or automatic applications of predetermined profit percentages to cost estimates because they “do not provide proper motivation for optimum contract performance.” Rather the FAR prescribes a “structured approach” where “common factors” and “other factors” are required to be analyzed in arriving at a fair profit. Whereas “other factors” are considered to be those that may be unique to a given agency, 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:

1. Material Acquisitions. This sub element seeks to measure contractor input and management of the acquisition necessary for the contract output. Higher profit is justified if the input is more complex, difficult to obtain or requires management of many supplier sand subcontractors. Conversely, less profit is appropriate if, for example, the work required was done by all-in house labor. b. Conversion of Direct Labor. Higher profit consideration should be given if the labor required is more diverse, more skilled or requires more supervision and coordination. Higher profit would apply if a contract requires pulling together tight schedules of, for example, engineers, scientists or high end manufacturing skill levels. At the lower end of the profit spectrum are contracts with a high level of staff augmentation where much of the day-to-day tasking effort is made by the government. However, even in such circumstances, difficulty in recruiting or retaining 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 little support for high profit but activities that are specialized needing, for example, continuing education or highly technical IT systems suggest ahigher profit.
2. Contractor Cost Risk. The type of contract awarded is considered to be a strong indicator of contract cost risk. The authors provide a continuum list of contracts from high to low risk where time and material/labor hour is at the bottom, next is cost plus and cost sharing arrangements followed finally by various fixed price arrangements. (The placement of T&M at the highest risk level is contrary to normal perception of cost type contracts being the highest risk.) The authors stress other factors than contract type also impact the nature of cost risk. Work that is routine ,has lots of cost history and is predictably steady carries much less risk than work that is not, even if both are based on fixed prices. Also contracts that are not definitized carry less risk than those that are because negotiating such contracts normally look to actual costs making them closer to cost type contracts. 3. Federal Socioeconomic Programs. The FAR explicitly uses higher profit to incentivize contractors to provide greater opportunities for socioeconomic programs. We and the authors find that generous programs are not sufficiently highlighted when itcomes to negotiating higher profits. 4. Capital Investments. Making “capital investments ”that will provide for efficiency and better performance are of great interest to the government tare to be considerations for higher profit. Like federal socioeconomic programs, contractors need to identify their current and planned capital investments when negotiating their profit levels. 5. Cost Control and Other Past Performance. FAR profit guidelines put emphasis on using profit levels to reward past successful efforts at cost control as well a future, planned efforts. These should be put forward during profit negotiations. 6. Independent Development. Contracting officers are encouraged to reward contractors with higher profit levels who contribute to independent development, as opposed to government funded work, that directly benefits or will benefit contract performance.

In addition, agencies are required to have their own structured approach to analyze and negotiate profit. The DOD Weighted Guidelines, DD Form 1547 is the most well known. The authors state such guidelines have limitations where profit analysis should be more than simply putting in values on a form and tend to be excessively subjective. (Editor’s Note. That may help explain why we do not see these guidelines used except maybe at the prime contract level for major systems acquisitions.)

Of course profit rates negotiated on a contract do not equate to actual financial gain on a contract. Efficiencies gained on fixed price contracts can increase the gain, for example, and incurrence of unallowable costs on cost 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 what the negotiated profit is, negotiations aimed merely at reducing prices by reducing profit without recognizing the proper role of profit is not in the government’s interest – a thought that often needs to be repeated during negotiations.