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GOVERNMENT CONTRACTOR ECONOMICS 101
Guest Article by Doug
Allston, President, Advantage Consulting. Article Used by
Permission, © 2007 Advantage Consulting, Inc. http://www.acibiz.com/
Over the years we have witnessed a lot of
misinformed acquisition decisions because many Federal personnel do not
understand the basic economics of government contractors. A better
understanding of the government contractor’s perspective—and economic
reality—can benefit the entire acquisition community, and that is the
point of my guest article here.
Direct
Labor. First
consider the contractor employee’s salary. The fact is that salaries
for people with comparable credentials are very similar. You are
not going to hire a computer scientist with a master’s degree and 10
years of experience for significantly less then a competitor in the
same geographical location, and if you somehow do they will probably
not stay long. The only employees that a contractor can pay less for
are what I call “captured employees”. They have very narrow functional
expertise, such as the techie who knows everything about the XYZ-47B
torpedo. That is a skill that is not transferable.
Fringe
Benefits.
Employees have fringe benefits just like the government. These are
holidays, vacation, retirement and health benefits. In addition to
a competitive salary, the contractor is not going to attract and keep
employees without providing comparable benefits. If you
want the headaches of turnover on a contract, let your contractor start
playing around with salaries and benefits. About the only way a
contractor can play around with fringe and undercut a competitor is to
hire retired government and military personnel who already have health
plans. However, that strategy generally raises the cost of health plans
for those employees who do not have one from their former career.
Overhead. There
are other expenses in addition to the compensation that the contractor
employee receives directly or indirectly. These are infrastructure
costs —overhead— directly
supporting the people and work performance on the contract: typically
rent, heat and air-conditioning, electricity, desks, computers, etc.
Most of these are fairly fixed based on location and type of work.
Often the government likes to have their contractors located close. So
contractors often may not have an option about whether to consider
lower-cost geographic areas.
Sometimes the government provides the space and
office infrastructure for the contract employees, lowering the
contractor’s overhead while raising the government’s cost of overhead.
However, the contractor almost always needs to have some sort of local
office to provide offsite company services such as accounting and other
administrative support. The local office also supports business
development activities like proposal writing, because the contractor’s
employees cannot use government furnished equipment or space to write
proposals. Office space for writing proposals is a benefit to the
government: public policy assumes competitive acquisitions, and
government organizations would be highly displeased (and impaired) if
they do not receive responses to their Requests for Proposals. In
general, the contractor has minimum control over basic overhead if they
are to be competitive.
General &
Administrative. From the government’s
perspective, the most sensitive expense of the contractor is General
and Administrative (G&A) cost. This is sometimes viewed as
“corporate fat” by the government. It is the expense of running a
company. Back in the days when companies routinely had 15% to 20%
G&A, it was mostly made up of accounting and HR salaries—costs that
most companies have moved to overhead. G&A does pay for the
salaries and overhead of senior managers and support staff, and it is
where Bid and Proposal money is budgeted. My experience is that, if a
company is going to attract and keep good corporate leadership and
senior staff, they must pay the going rates. The President, CFO or VP
of HR of a small to midsize contractor who is not an owner is someone
in demand. If they are any good, they normally can command a
competitive compensation package.
Fee and Profit. Last, we have the fee
or profit. No, fee is not profit because the profit is fee minus
unallowable costs. Typically the single largest unallowable cost is the
cost of money. The government does not allow the contractor, except on
projects involving large capital expenses, to recover the bank charges
for borrowing money. The government wants the contractor to hire an
employee, and the employee expects to get paid a couple weeks after
starting to work. But the government does not pay the contractor for
several months. Where does that money come from? From the banks, and
they charge interest!
Multiplier. When we bring
together the fringe, overhead, G&A, and fee we can create a
multiplier. This is a number starting with a 1 for the salary and a
decimal for all of the other costs. So a typical IT contractor might
have a multiplier of 1.88. This is the number used to multiply the
salary that gives the contractor what they have to charge the
government. So we have a contract employee who gets paid $80K so the
contractor charges the government $150,400. That seems to be a big
number, especially if the government employee working under this
contract is only getting paid $90K. The fact is that the contract
employee is not taking home $150K and the comparable government
employee costs more than $90K also. The government has all the same
cost categories: fringe, overhead, and G&A. The only cost the
government does not have is fee or profit, and a lot has been made
about that in the news media.
The profit motive does not necessarily inflate
costs: My firm, Advantage Consulting, has worked with non-profits, and
we have competed against non-profits. A for-profit company will almost
always beat a non-profit company on price. Non-profit contractors tend
to be much more generous with their fringe and overhead and it usually
more then wipes out any cost competitive advantage they may have.
The long and short of it is that companies in a
specific type market of similar size tend to have cost structures that
are within plus or minus 3%. Therefore, there are only a few ways one
company is going to price their work significantly lower than their
competitors. The first way, and probably what happens most often, is
that they do not offer the same solution because they do not understand
the government’s requirement; they miss-measure the requirement. This
can result in a lower price or sometimes a higher price. Second, they
offer an alternative solution to the government that is less expensive
because it involves fewer people, or lower overhead because of the
location of the workforce or they plan to pay the employees of the
previous contractor less salary because they are a captured workforce.
Of course, the government then may have to deal with the low morale of
the contractor’s employees. Third, the contractor with a lower price is
not applying all their actual costs to this specific project. They may
not be allocating all of their normal G&A costs. Although this
means a lower price for this project those costs have to be recovered
somewhere else, such as by charging another project higher G&A.
There are no free lunches. I believe the best
way for the government to improve its acquisition strategy is to tell
all the competitors what the price has to be. Then the contractors can,
with reduced risk, optimize their solution.
GOVERNMENT COST ACCOUNTING
Government contractor economics are affected by
the requirements and constraints of various Federal laws and
regulations. You may view and download key documents from the Defense
Contract Audit Agency (DCAA) at http://www.dcaa.mil/, including:
FAR Cost Principles Guide
Information for Contractors
DCAA Contract Audit Manual (CAM)
- Cost Accounting Standards (CAM Chapter 8)
- Audit of Cost Estimates and Price Proposals (CAM
Chapter 9)
- Audit of Contractor Compliance with Contract
Financial Management Requirements (CAM Chapter 11)
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