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.

Negotiated Profit or Fee Percentages Should Be Applied to Total Negotiated Cost

The Government wants its contractors to be profitable and it is the Government's policy to negotiate a fair profit on each contract. We have written several articles on profit over the years to help contractors understand how the Government develops its negotiation objectives for profit. Consider the following.

• Factors that the Government Considers in Considering Profit/Fee
• Government Approach to Profit/Fee Analysis
• DOD Weighted Guidelines for Determining Profit and Fee

To summarize some of the key points in those articles, it is in the Government's interest to offer contractors 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 (FAR 15.404-4(a)(2)).

Both the Government and contractors should be concerned with profit as a motivator of efficient and effective contract performance. Negotiations aimed merely at reducing prices by reducing profit, without proper recognition of the function of profit, are not in the Government's interest. Negotiation of extremely low profits, use of historical averages, or automatic application of predetermined percentages to total estimated costs do not provide proper motivation for optimum contract performance (FAR 15.404-4(a)(3)).

FAR requires a "structured approach" for determining profit or fee. A structured approach provides discipline for ensuring that all relevant factors are considered. FAR leaves the development of structured approaches up to individual agencies. For DOD, the structured approach is commonly referred to as the "Weighted Guidelines Method". Agencies are allowed to use another agency's structured approach (see FAR 15.404-4(b)(2)) and as a result, many agencies have adopted the DOD model or slight variations thereof. The DOD weighted guidelines model is described in DFARS (DOD FAR Supplement) 215.404-4.

We recently became aware of a situation where a Government negotiator refused to apply profit to a contractor's negotiated G&A (General and Administrative Costs) because he had "learned" that to do so was inappropriate. We don't know where he "learned" this but his learning does show a lack of understanding of applicable FAR considerations.

For example, one of several common factors that require consideration in determining a profit percentage is "General Management" (see FAR 15.404-4(d)(1)(i)(D)). General Management ... measures the prospective contractor's other indirect costs and general and administrative (G&A) expense, their composition, and how much they contribute to contract performance. There it is, G&A specifically called out in the procurement regulations.

We always recommend that contractors perform their own structured approach to determining reasonable profit rates prior to negotiation and to ask the Government for their analysis as well. There is a lot of subjective elements to developing a profit objective but reviewing the Government's "weighted guidelines" analysis or another agency's structure approach could lend some clarity on what the Government considers important. Perhaps its not the same as what the prospective contractor believes to be important and resolving these differences could facilitate negotiations and result in a profit percentage that is more "reasonable".

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.

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.

Excessive Pass-Through Costs

Last month, the FAR councils published an interim rule that limits excessive pass-through costs charged to Government contracts. The limit on excessive pass-through costs has applied to DoD contracts since 2007. The new interim rule covers all Government contracts.

 We will discuss how the new rule works, but first, some definitions.

• Pass-through costs are defined as indirect costs and profit or fee.
• Excessive pass-through costs arise when a contractor (or a higher-tier subcontractor) subcontracts out all or a substantial portion of the work and adds no or negligible value to contract performance. Excessive pass-through indirect costs are unallowable.
• No or negligible value means that the contractor cannot demonstrate to the contracting officer that its effort added value to the contract in accomplishing the work performed under the contract.
• Added value means that the contractor performs subcontract management functions that the contracting officer determines are a benefit to the Government (e.g. processing orders of parts or services, maintaining inventory, reducing delivery lead times, managing multiple sources for contract requirements, coordinating deliveries, and performing quality assurance functions.

For DoD contracts, this regulation applies to negotiated cost-type and fixed price contracts greater than $650 thousand (cost or pricing data threshold). For civilian agencies, it apples to cost-type contracts over $100 thousand (simplified acquisition threshold).

The interim rule includes requirements for both offerors/contractors and Government contracting officers.

Proposal preparation phase:

1. Offerors must identify the total cost of the work to be performed by the offer and the total cost of the work to be performed by each subcontractor.
2. If the offeror intends to subcontract more than 70 percent of the total cost of work to be performed under the contract, the offeror shall identify
• the amount of indirect costs and profit/fee applicable to the work to be performed by subcontractors
• a description of the added value provided by the offeror as related to the work to be performed by the subcontractors

Negotiation and award phase:

• If the offeror intends to subcontract more than 70 percent of the cost of work to be performed, the contracting officer must make an affirmative determination that pass-through costs are not excessive.

After contract award phase:

1. Contractor must notify the contracting officer (in writing) if it changes the amount of subcontract effort after award such that it exceeds 70 percent of the total cost of work to be performed.
• must identify the revised cost of the subcontract effort.
• must include verification that the contractor will provide added value
2. If the contracting officer determines that excessive pass-through charges, the Government can recover.
• for cost-type contracts - unallowable for reimbursement
• for fixed price contracts - contract price reduction
3. Contracting officer or authorized representative (e.g. DCAA) has right to examine and audit contractor records necessary to determine whether the contractor proposed, billed, or claimed excessive pass-through charges.

PNWC observations.

1. A contractor's G&A base will influence whether indirect pass-through costs are excessive. The three most common G&A allocation bases are total cost input (TCI), modified TCI (excludes subcontract costs) and single-element (usually direct labor costs). Modified TCI and single-element allocation bases already exclude subcontract costs which means that subcontract costs are not burdened with G&A and therefore could not have excessive pass-through indirect costs.
2. Profit/Fee percentages might already reflect the anticipated level of subcontracting. When the Government uses the weighted guidelines method to establish negotiation targets for profit or fee (most of the time), it assigns weights to various risk factors. One of those factors is the degree of management effort necessary to ensure that contract requirements are met. Many contracting officers weight this element lower when the offeror has proposed significant subcontract costs.
3. Subjectivity of the contracting officer determination: The determination of whether contractor activities benefit the Government include an assessment of such things as processing orders of parts or services, maintaining inventory, reducing delivery lead times, managing multiple sources for contract requirements, coordinating deliveries, performing quality assurance functions. This is a very subjective assessment and contractors should not underestimate the benefit of "good writing" when describing the value it intends to add to the subcontracted effort. 
4. GAO Review: The GAO reviewed DoD implementation of the earlier interim regulation (see GAO-08-269, Contract Risk a Key Factor in Assessing Excessive Pass-Through Charges). The GAO stated that contracting officers needed guidance in how to assess whether proposed pass-through costs are reasonable for the work performed. Additionally, they should obtain DCMA and DCAA input. DoD responded that it willl issue guidance once the regulation becomes final.

AIA "Jumps the Shark"

The Aerospace Industries Association (AIA) issued a response last week to the Pentagon’s call for ideas to restore affordability and productivity in defense spending. Culled from among a larger listing of 97 initiatives that AIA published last July are three ideas that AIA believes can be accomplished within current DoD authorities, hence the title “Ways to Reduce Costs Immediately”.


These are not new ideas – we’ve seen them all before. The first of AIA’s three proposals is to employ better contracting methods by using more multi-year procurements, increasing the use of long term performance and outcome based product support contracts and expanding the definition of commercial products. The second idea is to cut down on the amount of cost or pricing data the contracting officer needs or requires in order to justify a fair and reasonable price, use pre-established direct and indirect forward pricing rates, eliminate serial reviews of contractor proposals prior to negotiation and reinvigorate the use of weighted guidelines to develop profit objectives.

The third idea is not new either but resonates with us because of frustrations we experienced when we were Government auditors. The oversight process makes multiple, sometimes contradictory, demands on contractors that drive up overhead costs. Agencies in the DoD are providing different interpretations of policy that cause contractors who have common systems, to make agency-specific adjustments. The lack of consistent policy interpretations result in determinations of inadequate proposals due to immaterial fact finding questions and adverse audit reports for contractor failure to supply unavailable information. Sometimes paper records are stored at a central storage facility and retrieval of the paper record cannot be made within the time frame demanded by the auditor. It is not clear to the contractor, or often to the government officials, where responsibility, accountability, and authority lie when conflicts take place. Such conflicts can delay contract award and drive up costs. DCAA has wrestled with this problem for many years – trying to apply consistent positions form a geographically dispersed work force.

AIA’s solution to this problem is for DoD to combine multi-agency compliance reviews, establish a single point DCMA/DCAA authority at major prime contractors to drive commonality and consistency, and base audits on materiality and risk. Its probably not realistic to believe that these ideas will save taxpayer dollars. The single point DCMA/DCAA authority will never fly as long as those Agencies remain separate. DCAA must remain independent to comply with GAGAS (Generally Accepted Government Auditing Standards). The idea that audits be based on materiality and risk is already integral to DCAA policy and Governmental auditing standards. The criticism of DCAA lately has hinged on the Agency taking too much risk. Finally, FAR and DFARS already specify lead agency status for multi-agency compliance reviews. For example, DCMA is lead agency for EVMS (earned value management) and CIPR (insurance/pension) reviews while DCAA is lead agency for ESS (estimating system) and CAS (cost accounting standards) reviews.