Reduced Profit Margins for Undefinitized Contract Actions

Sometimes, due to exigencies of Defense Department needs, the Government will authorize contractors to proceed with the work and submit the associated pricing proposal at a later date. These actions are typically referred to as "undefinitized contract actions" or UCAs.

As work progresses without a contract, a lot of the "risks" associated with performance evaporates. Ultimately, actual cost are rolled into the contract price while cost to complete remain the only uncertainty. The longer a contractor performs under a UCA, the less risk there is to that contractor.

Profit and Fees are based on risk perceptions. Fixed price contracts are awarded higher fees than cost-type contracts for obvious reasons. The Defense Department uses a tool called the "Weighted Guidelines Method" to calculate a reasonable fee range for each contract. See DoD Weighted Guidelines for Determining Profit or Fee. The concern has been, for some time, that contracting officers do not adjust the fee for UCA's where a substantial portion of the work has already been performed resulting in less risk for the contractor.

That's about to be corrected.

The Defense Department finalized a new rule last week to provide a more transparent means of documenting the impact of costs incurred during the undefinitized period of an UCA and to recognize when contractors demonstrate efficient management and internal cost control systems through the submittal of a timely, auditable proposal in furtherance of definitization.

According to the Defense Department, sometimes contracting personnel have not documented their consideration of the reduced risk to the contractor of costs incurred during the undefinitized period of a UCA. While such costs generally present very little risk to the contractor, the contracting officer should consider the reasons for any delays in definitization in making their determination of the appropriate assigned value for contract type risk.

Under the new rule, the weighted guidelines method adds two new factors; contract type risk based on incurred costs at the time of qualifying proposal submission and contract type risk based on government estimated cost to complete.

You can read more about the proposed rule here.

Be Prepared When You Go In To Negotiations With The Government

No one has a good count on the number of Government contractors. By one estimate, over 50,000 companies contract with the Department of Defense and there are many Governmental agencies besides DoD. Whatever the number, there are a lot of Government contractors but relatively few of them have had to go through the process of actually negotiating a contract price under FAR Part 15 procedures, Contracting by Negotiations.

Negotiating a fair and reasonable price is a complex process involving consideration of many factors including

• actual costs and completion estimates
• the amount of profit or fee in relation to the total cost, the complexity of the work, quality, efficiency, and ingenuity of the contractor's performance and the technical and financial risk assumed, and
• the competitiveness of the end price.

Costs constitute an important factor in the contract price negotiation and the discussion between the contractor and the contracting officer include the objective of arriving at a definitive agreement, to the maximum extent possible, on the amount of costs to be considered in the price.

Definitive agreement on each element of cost however may not always be possible because of honest differences of opinion or other considerations between the negotiating parties. As a result, negotiation involves a give and take proposition and the contracting officer usually cannot negotiate a price which includes cost considerations exactly in accordance with his/her "pre-negotiation objective" (PNO). Contracting officers develop their PNOs based on all available data and information including the contractor's certified cost proposal, the results of technical evaluations, and either audits or cost analyses performed by DCMA  (Defense Contract Management Agency) or DCAA (Defense Contract Audit Agency).

In some instances, a total end price may be negotiated without specific monetary resolution of all of the individual cost elements or other pricing factors involved. When this happens, the Government's "view" of negotiations can differ markedly from the contractor's "view".

Sometimes, the profit rate the Government is willing to pay is a hindrance to a speedy end to negotiating sessions. Cost or pricing data is typically based on factual matters. For example, a contractor solicits two quotes for a proposed material item and selects the lower of the two. But profit considerations largely rely on judgment. How does one measure "complexity of work", "ingenuity of contractor's performance", or "technical risk".

DoD Weighted Guidelines for Determining Profit and Fee

The Department of Defense issued guidance yesterday reminding its contracting officers to pay attention to the DFARS (DoD FAR Supplement) guidelines for determining profit or fee on negotiated contracts (see Guidance on Evaluation of Risk in Negotiating Contract Profit or Fee).

There is certainly nothing wrong with earning profit. In fact, the Government's official contracting policy is to pay companies a fair profit for the work performed. But what is a fair profit? DoD has developed a methodology called the Weighted Guidelines Method to developing a range of what is fair and reasonable. After developing the range, the final percentage is determined in negotiations.

The Weighted Guidelines Method (WGM) is, at its core, a risk based approach to determining profit or fee. Fixed price contracts are more risky than cost-type contracts so the profit percentage attributable to fixed price work will be higher than the fee percentage for cost type work.

Investments in property, plant, and equipment will also play a role in fee calculations. Manufacturers having invested considerable sums into equipment will earn a higher rate than say, a grass cutter on a military installation.

Progress payments (and interim billings on cost-type work) will also have a bearing on profit/fee calculations. Getting paid as you go reduces the overall risk of contract performance - it certainly reduces cash flow requirements.

The new guidance offered anew example. If a contractor, required to utilize DoD staffing in performing the work has a contract clause allowing it to submit an equitable adjustment in the event the DoD workforce is not performing up to par (i.e. a work stoppage), that clause reduces the risk to the contractor and should result in a lower profit rate.

The DoD issued the guidance because IG (Inspector General) audits have uncovered numerous cases where the profit paid to contractors were not based on a full understanding of the risks involved in the specific work being performed.

Contractors should familiarize themselves with DoD's weighted guidelines methodologies at DFARS 215.404-71. Although required for DoD contracts, we are aware that other Governmental agencies use the DoD methodologies for their own profit/fee negotiations.

Fixed Fee on Reduced Scope Contracts

We became aware of a situation recently where a CPFF (Cost Plus Fixed Fee) contract with a twelve month period of performance (POP) was modified to reduce the POP from twelve months to ten months. The question raised by both parties (the Government and the contractor) was whether under these circumstances, the contractor was entitled to keep the entire fixed fee. The contractor has been billing the fee on a pro-rata basis (one-twelfth of the negotiated fixed fee each month). The Government had a notion that the contractor should not be allowed the full negotiated fee.

Unfortunately for the Government, the question of the fee was the least of its worries. By modifying the contract using the "changes" clause, the contractor was entitled to file a claims proposal for increased costs resulting from the change. These increased costs included unemployment/layoff related costs, cost of finding new employment, equipment storage, and lease termination. Ultimately, the Government ended up paying more as a result of reducing the POP by two months than it would have paid had they allowed the contract to simply expire.

Oh yes, and the Government did determine that the contractor was entitled to the entire fixed fee.

Government Approach to Profit/Fee Analysis

We've discussed profit and fee several times in this blog but it is worth repeating because we continue to hear of situations where the Government attempts to coerce prospective contractors into accepting paltry profit and fee amounts during negotiations. This aggressiveness may well be contrary to Government policy.

The underlying assumption behind Government approaches to profit/fee analysis is the belief that contractors are motivated by profit/fee (see FAR 15.404-4(a)). The Government is required to use a structured approach (usually the weighted-guidelines method) which provides a disciplined approach for ensuring that all relevant factors are considered in developing Government profit/fee negotiation objectives.

It is in the Government's best interest to offer contractor's opportunities for financial rewards sufficient to

• Stimulate efficient contract performance;
• Attract the best capabilities of qualified large and small business concerns to Government contracts; and
• Maintain a viable industrial base to meet public needs.  

If the Government is to use profit/fee to motivate contractor performance and achieve the above goals, practices primarily intended to reduce profit/fee or diminish the impact of profit/fee analysis are not in the Government's best interest (see FAR 15.404-4(a)(3)).

• Negotiations aimed at reducing prices by reducing profit/fee without proper consideration of the profit function.
• Negotiation of extremely low profits/fees
• Use of historical average profit/fee rates without regard to the unique circumstances of the immediate negotiation
• Automatically applying predetermined profit/fee percentages without regard to the unique circumstances of the immediate negotiation.

While profit/fee calculations must consider the unique circumstances  of the immediate negotiation, contract fee cannot exceed statutory limits that apply to cost-plus-fixded-fee contracts;

• 15% for experimental, development, or research work
• 10% for all other cost-plus-fixed-fee contracts.