What is a Profit Margin Test?

Every DCAA (Defense Contract Audit Agency) audit, whether requested or self-initiated, begins with a risk assessment. A risk assessment is a set of tools auditors - all auditors - use to help decide where and what to focus on in an audit. So, for example, if only $100 of material costs have been charged against a $1 million contract, the auditor would probably conclude that his/her limited resources can be better spent on other than material costs.

For T&M (Time and Material) contracts, there are two inherent risks to the Government. First, did the Government really receive the services that it paid for and second, were those services rendered by personnel with the right qualifications? There have been some well-publicized criminal cases were contractors reaped windfall profits by not providing the requisite skill level that the Government paid for. For example, the Government contracted for Senior Engineers but the contractor performed the work with Junior Technicians.

One test the auditor might perform to determine whether there might be a risk for that happening is what DCAA refers to as the "profit margin test". The profit margin test compares booked cost (i.e. actual costs) to billed cost. If variances are significant, it might mean that the contractor is not paying employees the amount that it proposed and negotiated with the Government. And one reason why that might happen is because the contractor is utilizing lesser skilled employees for work that the Government desires (and pays for) higher skilled individuals. That's not the only reason for variances however. Variances could be cause by differences between negotiated and actual overhead rates.

If there is a significant variance between actual costs and billed amounts, auditors will perform further analysis to determine the reason for those variances. If it is caused by labor rate variances, Auditors will then assess the risk that the contractor is substituting less qualified employees. If substitution is occurring, auditors will most likely identify those personnel for detailed employee interviews.

Sometimes it becomes necessary to utilize different skills than what is contemplated on a T&M contract. The proper way to handle this is to notify the contracting office of the necessity and negotiate a contract rate adjustment. Don't wait for an auditor to find or a whistleblower to call the hotline.