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Cost Plus Governmental Contracts

Billing Your Overhead Costs

By John Pruitt

Historically, engineering firms who contract with the government are less profitable than those that work in the private sector. It is usually more expensive to contract with governmental agencies due largely to the extra administrative overhead burden. By carefully controlling and properly classifying your direct and indirect costs you may make a fair profit on governmental cost plus contracts.

ContractsThe amount of profit or loss on a Cost Plus Contract will be influenced by your knowledge of what are allowable direct and overhead costs. The Federal Government publishes their regulations of allowable costs in the Federal Acquisition Regulations System (FARs). As you enter the realm of governmental contracts, you soon realize that local, state and federal governments use the FARs as a beginning basis for contract administration. The regulations and limitations added by local, state and federal governmental agencies turn the administration of Cost Plus Contracts into a challenging proposition.

WHAT ARE COST PLUS CONTRACTS & WHY DO WE HAVE THEM?

Cost Plus Contracts are agreements in which the client pays for the following three components of work performed on their behalf:

  1. Direct Costs: Costs that are directly associated with doing the contracted work. Examples include direct labor, consultants, materials, supplies and equipment rentals used on the job.
  2. Overhead Costs (or Indirect Costs): Costs that cannot be associated directly with any contract or project but are necessary business expenses. Overhead costs are typically stated as a percentage of direct labor costs associated with project work. Examples of overhead costs are office rent, depreciation and insurance.
  3. Fee (or Profit): Is usually either a fixed fee or a fee percentage based on labor costs associated with contracted work.

Cost Plus Contracts are typically used where the scope of a project cannot accurately be estimated. Therefore a fixed price contract is generally not a viable option. Many research and development projects sponsored by the federal government are on a Cost Plus contractual basis. Governmental agencies favor the Cost Plus method of contracting for engineering services for an additional reason. They prefer to conduct business with not necessarily the lowest dollar cost engineering firm but with a qualified firm.

HOW CAN YOU LOSE MONEY ON A COST PLUS CONTRACT?

There are two basic ways to lose money on a Cost Plus Contract:

  • Have Direct Costs associated with the project that are not billable to the client.
  • Have Overhead Costs that are disallowed by the client.

Typically, the amount of the disallowed overhead costs provide the most surprises for engineering firms.

DOES THIS HAVE MUCH OF AN EFFECT ON YOUR BOTTOM LINE?

Yes! One national engineering firm quit doing business in the State of Arizona because they could not bill enough of their overhead costs. They were unable to make any profit.

A medium-size engineering firm of about 120 employees discovered that the State of Washington disallowed over 10% of the firm’s overhead expense base. The impact for the firm was that the “Bottom Line” (Net Income) was reduced by over one half.

A smaller engineering firm discovered it was impossible for them to make a profit on inspection jobs in the State of Connecticut because of the limitations on field office overhead rates and caps on direct labor costs.

WHAT YOU CAN DO:

  • Know your client: Make sure you know the regulations under which the contract will be administered.
  • Negotiate up front, before the contract is signed, any modifications to the contract regulations.
  • Charge all of your Direct Costs to the job.
  • Document your costs: Make sure your records will withstand an audit.
  • Classify your costs honestly but to your advantage.
  • Consider ways to reduce overhead: Without constant attention overhead costs have a tendency to increase as a percentage of your Direct Labor costs.
  • Know your “hard” and “soft” costs.

KNOW YOUR CLIENT . . .

One of the primary axioms in the world of commerce is to know your customers and to tailor your services to fulfill their needs. Knowing a governmental client means a thorough understanding of the contract and also the regulations that will be used to administrate the contract. A Cost Plus Contract will have various limitations on allowable costs. You must be able to quantify the most likely profit that will be generated from a contract before it is executed.

Knowing the Contracting Officer and what information he/she needs is another necessary step in the process. With many governmental Cost Plus Contracts, the additional administrative burden placed on both the Contracting Officer and the engineering firm is a shared frustration. A clear understanding of what information and documentation the Contracting Officer needs to support his/her paper trail will save the engineering firm time and money. Additional information as to the Contracting Officer’s experience, reputation and track record will enable you to better anticipate potential problem areas with the contract administration.

Know the other governmental departments that will be involved in the contract. Information such as who disburses the contract payments and whether wire transfers of funds are available will probably not make or break the deal, but is part of the “do diligence” process in knowing your client.

NEGOTIATE UP FRONT . . .

Examples of successful negotiations of onerous contract limitations are the following:

The state government limited the mileage rate for an inspection vehicle to 20 ¢ a mile. The actual cost for the vehicle was approximately 40 ¢. When this was discussed during the negotiations of the contract, the Contracting Officer suggested that the engineering firm rent a vehicle and that the contract would allow payment in full for the rental cost of the inspection vehicle. This ended up costing the State government more than paying for a company inspection vehicle at 40 ¢ a mile, but the engineering firm did not lose money by providing an inspection vehicle!

Another case: The State government would not pay for computer time by the hour that was necessary to complete the contract. The engineering firm was able to negotiate with the State to pay for the rental of a computer from a third party.

Finally: The state would not pay for any “non-technical” direct labor costs. When the engineering firm demonstrated to the state that there would be a cost saving if a “non-technical” employee makes prints of the engineering drawings, the Direct Labor cost for “non-technical” employees was allowed.

The opportunity to negotiate the actual profit percentage or lump sum profit is usually available after the contract has been awarded but before the contract has been executed. The amount of the profit should depend on the complexity of the project, risk exposure, timing of the work and the competitive climate. Successful engineering firms often will spend many hours reviewing a proposed contract before meeting with the client for contract negotiations. Educating the client as to unforeseen risk factors regarding the engineering project is one of the functions of the negotiation process.

If you have a unique product or service, you may be able to negotiate conditions that are excluded to other engineering firms. Perhaps the opportunity to negotiate a Lump Sum Contract instead of a Cost Plus contract, or to negotiate a higher profit on a Cost Plus Fixed Fee Contract will be available. The key is: Negotiate the contract terms before the contract is signed.

As with any successful negotiations, you must know the terms you must have to make the minimal acceptable profit on the contract. Also knowing the contract terms that you would like to have and are willing to negotiate on will improve the outcome of your negotiating with all business entities. It is indeed difficult for professional engineers to walk away from work although sometimes that is the prudent action to take.

CHARGE ALL OF YOUR DIRECT COSTS . . .

This seems like an obvious statement to make, but many engineering companies are not charging all of their Direct Labor, sub-consultants, supplies, etc., to the job. A basic tenant of cost accounting for engineering firms is: If the expense was incurred as a result of the contract, then it should be recorded as part of the contract cost.

A few examples of Direct Costs that are sometimes not recorded are:

  • Labor for billing and collection services provided to the client
  • Monthly project reviews with Project Managers for the benefit of the client
  • Meetings with the client
  • Mobilization costs such as the preparation of inspection vehicles for a particular job
  • Rental of equipment such as theodolites, test equipment, etc. that are used
  • Telephone, copier, FAX, computers used for the benefit of the client
  • Transportation cost for both materials and manpower
  • Delivery cost for documents, etc.

There will be limitations imposed by the contract as to the recoverability of some of your Direct Costs. You can expect a delay in your contract payment if you disregard the contract limitations for cost recovery. If you have a cost that you feel is “borderline allowable”, a telephone call placed to either the Contracting Officer or the person responsible for reviewing the invoice, stating your position, may save you time and perhaps will give you the best opportunity to defend your position.

What if you are over budget and have exceeded the maximum amount of the Cost Plus Contract and there are no additional funds forthcoming? Should you continue to charge labor costs to the job? This is a “no win” situation. If you continue to charge labor costs when there is no possibility that the labor costs can be billed to the client, it will be a “Bad Debt”. The FARs do not allow bad debts to be counted as part of your overhead rate. If you choose to classify the labor overrun cost to overhead, such as “Tech. Unassignable”, you will not know the true costs of the job and you will probably be violating the government contract regulations. Bottom line: You should never have a cost overrun on a Cost Plus Contract.

DOCUMENT YOUR COSTS . . .

The contract with the client will specify the cost documentation required for contract payments. Most Cost Plus work requires that documents to support all charges be included with any contract payment request or invoice. This includes labor charged to the job, invoices for consultants, supplies, rentals, expense reports, etc.

With employee time sheets, a clear indication as to job number along with the project name is usually encouraged by the Contracting Officer. The reasoning is that having the job number and the project name is a double check that the time is charged to the correct job. Employee time sheets must be signed. Most governmental agencies prefer that time sheets be completed in ink instead of pencil but will not insist on ink.

Consultants hired by the “prime” engineering firm to perform work can have the same documentation requirement as the prime engineering firm who submits the contract request for payments. Many contracts between consultants and the prime engineering firm include a copy of the contract between the governmental entity and the prime engineering firm. There is usually a phrase in the contract stating that the consultant is required to fulfill the same administrative and professional requirements as specified in the “prime” contract.

Expense reports tend to cause many of the slow payment problems with contracts. Most governmental agencies will pay for lodging and meals if the federal guidelines for federal employees are followed. Besides the typical documentation for expenses, the federal employees must indicate what time of day the travel was started, the distance in miles, the return time, etc. This does tend to complicate the Expense Report Form, but a well-designed Expense Report Form will alleviate much of the problem.

CLASSIFY YOUR COSTS HONESTLY BUT TO YOUR ADVANTAGE . . .

The basic guidelines provided in the FARs used to determining the allowability of a cost are:

  • The cost should be reasonable, associated with the contract and included in the terms of the contract
  • The cost limitations as stated in the FARs will be followed.
    • (Federal Acquisition Requirements, Title 48, Chapter 31.201-2)
  • Costs that are not allowed under the FARs include:
    • Product advertising · Alcoholic beverages
    • Bad Debts
    • Contributions and donations
    • Federal income & excess profit tax
    • Entertainment
    • Fines and penalties
    • Goodwill
    • Interest & other financial costs
    • Lobbying costs
    • Losses on other contracts
    • Membership in social organizations
    • Organizational costs

(Federal Acquisition Requirements, Title 48, Chapter 31.205)

Many states will disallow expenses to prepare the federal tax return, acquisition costs for other engineering firms, legal & collection costs for delinquent accounts receivable, all promotional trips and meals, costs associated with company brochures and even membership in professional organizations. The key to minimizing the amount of disallowed overhead costs is know the rules and use them to your advantage.

Some ideas to consider when classifying overhead expenses are:

  • With your C.P.A. or attorney, make sure that he/she describes each task performed and the cost of each task. Counsel your outside professionals as to what types of charges will not be allowed in calculating your firm’s overhead rate. Your outside professionals are usually very cooperative in organizing their invoices to help qualify their charges as allowable overhead costs.
  • If you are having a company retreat, make sure that you include topics that are beyond marketing (which may be construed as Product Advertising) and firm growth (which may be construed as Organization Costs).
  • If you are going to develop a new firm brochure, consider breaking the process into two phases. The first phase would be to document the firm’s history and capabilities for historical and business planning reasons. The second phase would be to develop and print the actual brochure. The first phase would probably be overhead allowable; the second phase would not.
  • Some state governments allow the implicit interest rate on capital leases to be overhead eligible. If this is the case for your state, it may be necessary to segregate interest expense on capital leases from interest expense on equipment loans.
  • Are you recording all of your Deferred Compensation Expense? Many engineering firms are recording only the cash paid out and not the increase of the future Deferred Compensation Cost discounted to the present value.
  • Are you recording the allowable “Cost of Funds”? Most governmental Cost Plus Contracts allow you to record an overhead amount based on the Book Value of your Fixed Assets multiplied by a percentage factor.
  • Are you sheltering employee benefits effectively with a Section 125 Plan (Cafeteria Plan). Many state governments with Cost Plus Contracts are disallowing some of the costs of health plans that they deem to be extravagant. Various engineering firms have resorted to discontinuing employer paid health plans, then increased their employee compensation to cover health care. The final step is the installation of a Section 125 Plan. The end result is that the employee is paying for the health insurance coverage but has no decrease in their take-home pay.

When your overhead rate is audited, defend your position. All too often the auditors reviewing your overhead expenses do not fully understand or want to interpret the FARs in your best interest. Be sure to negotiate the overhead expenses that are in the “gray area”.

CONSIDER WAYS TO REDUCE OVERHEAD . . .

The two converging factors for most engineering firms are the continual increase of overhead rates for their firms and the decrease in overhead cap rates allowed by government contracts. Government entities are in effect saying that they want to have Cost Plus Contracts and the accompanying administrative nuisance but expect engineering firms to control and even reduce their overhead cost. In many respects, control of overhead costs benefit both the engineering firm and the client.

Why does overhead cost tend to grow? It is a combination of three basic characteristics of professional service organizations:

  • The emphasis on client service: Most engineering firms pride themselves on being responsive and timely in meeting client needs. Therefore, there will be times when the professional staff is waiting for work to come in the door.
  • The investment in training of professional and key management positions: The amount of time and money invested in training and the “loss of capabilities” that can occur with employee layoffs causes firms to delay making personnel decisions.
  • The general characteristic of overhead: In many instances it is difficult to evaluate overhead cost. It is indeed difficult to evaluate whether an additional secretarial position can increase the efficiency of an engineering firm or if the position is a waste of money.

The primary reason to reduce overhead rate is to remain competitive. There are more pressures in the marketplace to shop for the best price. If a client can get the same services and save 10%, a “close personal relationship” with the client or the reputation of your firm may not be enough to get the job.

Ideas on controlling overhead costs include:

  • Evaluate and reward managers and professionals on their ability to keep overhead costs down.
  • Encourage principals to do client chargeable work and bill their time.
  • Be slow to add administrative help. Consider adding part-time help during the busy time of the month before adding full-time administrative help.
  • Have “programmed overtime”. Usually it is more economical to have overtime than to add new employees. The amount of overtime will vary with the engineering firm; a benchmark is 4 – 5 percent of total compensation for professional staff should be overtime pay. Expect to have overtime during the busy season.
  • Establish capital budgets and purchasing priorities. You should have a written plan that is reviewed at least quarterly.
  • Limit the number of company vehicles: Field vehicles are usually necessary; cars for office personnel should be evaluated with care.
  • Limit your interest expense by billing and collecting accounts promptly.
  • Shop your business insurance rates at least every third year. Evaluate your insurance coverage annually.
  • Control the number of administrative type meetings and limit the number of committees.
  • Shop your professional service providers (attorney, C.P.A., pension administrator, benefits advisor) every third year.

KNOW YOUR “HARD” AND “SOFT” COSTS . . .

Your intention with most contracts is to make a profit. Another way of stating the same idea is: You want to generate more revenue from the work than the associated Direct Costs to perform the work and the allocated overhead burden. There will be occasions where you may negotiate a contract that pays the associated Direct Costs of the project but not all of the overhead burden.

The amount of available work for a survey crew located in the New England area during the month of January is typically very low. Therefore, you may want to accept a contract that keeps the survey crew busy and pays all of the Direct Cost but does not pay all of the associated Overhead Costs. The process of evaluating whether to forego or accept the contract entails a process of segregating your costs into Hard Costs and Soft Costs. If the contract pays all of the Soft Costs and some of the Hard Costs, then it may be a viable alternative to having a survey crew sit in the office and do nothing.

Your Hard Costs (also known as Fixed Costs) are expenses that do not vary with work volume. Examples of Hard Costs are: office rent and insurance, deferred compensation payable to retired employees, depreciation, lease payments and purchase contracts.

Soft Costs (also known as Variable Costs) are expenses that tend to vary with levels of production. Examples of Soft Costs are: Direct Labor Costs, drafting and survey supplies.

Payroll costs can be either Hard or Soft Costs. If you lay off employees when there is no work, the classification would be Soft Costs. If you tend to retain employees even though there is no work, then the classification would be Hard Costs.

IN SUMMARY:

Billing your Overhead Costs in Cost Plus governmental contracts is almost an art. If you can bill all (or even most) of your overhead costs, then governmental contracts can be a profitable part of your business. There are vast differences in both how the contracts are administered and the allowable overhead costs among governmental entities. Individual States and cities add their own additional rules to the FARs. There are steps that can be taken to preserve your profit!

Call John Pruitt at A/E Consulting Services, Inc. 425/827-2995 for further information.

 

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