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Government Contracting

Yes, It Can Be Profitable!

By John Pruitt, CPA

GOVERNMENT AUDIT: Two dreadful words that most of us hate to hear. Besides turning the workweek upside-down, the feeling of “what in the world is the auditor going to come up with this time” causes many stomachs to churn. Most middle and larger sized A/E firms experience multiple government audits. Often firms have “favorite” auditors and perhaps even an “auditor from Hell”.

We will explore in this article the foundations of government contracting and how to more than survive, but to prosper in the government contracting arena.

The Federal Acquisition Regulations System (FARs): Bigger Than a Bread Basket.

Government ContractsThe FARs are the rules published by the Executive Departments of the U.S. government. They are part of the Code (Title 48) or law of the land. The intent of the FARs is to have both the government contracting agencies and government contractors be treated fairly. Over the years, the creative geniuses at some of the larger A/E companies have exploited loopholes in the Code. In turn, the government has sought to plug the loopholes.

The results are that all companies have an extremely complex government contracting “rule book” to follow. The same complex government contracting rules for multi-billion dollar companies are used for A/E firms that have just a few employees. Adding to this complexity, various government agencies layer their specific rules and interpretations of the FARs on top of the published FARs regulations. Yes, it is not uncommon to have an expense be an allowable overhead cost by one government agency and disallowed by another. This was certainly not the intent of the drafters of the FARs.

Fair Profits

The rules on how the government will acquire A/E services show foresight and wisdom. The following is a synopsis of how the FARs address “profit” [48 CFR 15.901(b)]:

  • Profits should stimulate efficient contract performance.
  • Profits should attract the best capabilities of qualified large and small business.
  • Profits should help maintain a viable industrial base [not just a few providers] of government contractors.

The intent of the FARs is to provide a level playing field for both contracting parties.

The FARs state, “Negotiation of extremely low profits…do not provide proper motivation for optimum contract performance” [48 CFR 15.901(c)]. The same FARs section continues, explaining that “…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.”

The FARs specifically explain how government entities will use a structured approach for determining the profit or fee objective of the contract. A structured approach for determining the amount of profits is not a government contract option, but a requirement. The detailed structured approach will be the subject for a future article.

A/E Selection Criteria

Demonstrated competence and qualifications to perform services at fair and reasonable prices is the primary selection criteria for A/E firms. The concepts of reasonableness and judgment are ever present in the FARs.

The actual selection criteria for A/E firms are found in Sub-part 36.602-1 of the FARs. The selection criteria include:

  • Professional qualifications.
  • Specialized experience and technical competence in the type of work required.
  • Capacity to accomplish the work in the required time.
  • Past performance on contracts.
  • Location in the general geographical area of the project and knowledge of the locality of the project.

There is no specific mention of price in this Sub-part of the FARs. The FARs actually instruct government contracting agencies that A/E fees shall not be considered in the selection of “at least three of the most highly qualified firms” that are short-listed for the project.

So…Where Is The Rub?

Architectural and engineering firms often do business with government agencies on a Cost-Plus-Fixed-Fee (CPFF) or a negotiated rate basis. Both contracting methods usually require an audit of overhead (or indirect) costs. Sub-part 31.2 of the FARs contains specific rules and general guidelines regarding what types of overhead costs are permissible to include as FARs allowable overhead costs.

The “rub” is three fold:

  • First, understanding the government auditor’s duties and responsibilities.
  • Second, substantiating overhead cost positions whenever costs fall in the “gray” areas.
  • Third, coping with caps on overhead rates.

Let’s look at the auditor’s duties and responsibilities: Often the FARs instruct government auditors to question and even throw-out costs with very little consideration of the reasonableness of the cost. An example of this action is compensation for owners of closely held corporations. The FARs state that auditors will give “special consideration” to compensation for owners of closely held corporations. Many auditors interpret this directive as an automatic disallowment of any increases in compensation or any bonuses paid to employees with any ownership position within an A/E firm.

Yes, often the auditor disallows the cost with the expectation that the A/E firm will then provide the substantiation to allow the questioned compensation. The auditor’s limerick seems to be:

If in doubt…

Throw it out.

Let them prove…

To them it’s due.

There are many other instances in the FARs where the auditor is instructed to question various overhead costs and require additional documentation to substantiate the allowability of the cost. Being prepared with the proper cost information often makes the difference between an “easy” audit and one that seems to go on forever.

Substantiating “gray” overhead cost areas is both challenging and rewarding. Many of the so called gray areas are unequivocally allowable if one knows where to find the FARs regulations to bolster the defense, and also how to present a convincing presentation of the facts. An example of where additional information can change a disallowed overhead cost to an allowable cost is the expense for company brochures. Auditors are usually quick to point out that the FARs specifically disallow brochure expenses [48 CFR 31.205-1(f)(5)].

Most auditors, however, do not share the information that the key issue of whether the brochure expense is an allowable cost is how the brochures are used. If the brochures are used in mass mailings, then the cost is not an allowable cost. However, if the brochures are handed to potential customers and used as a part of an A/E firm’s direct selling efforts, then it is an allowable overhead cost [48 CFR 31.205-39(c)(1)].

There are many other areas in the FARs that can be viewed as either allowable or unallowable overhead costs, depending on the circumstances, how well the costs were documented, and even the title of the account in which the cost is classified. The other ingredient that leavens the decision of whether the overhead cost is allowable is the auditor’s judgment as to what is reasonable. The FARs offer the “prudent person in the conduct of competitive business” test in determining what is reasonable.

The third “rub” is maximum allowable overhead rate caps that many State government agencies have in place. Overhead rates are usually stated as a percentage of indirect costs as compared to direct labor costs. An example is an overhead rate of 150%: This means for every dollar that is associated with a client project, there is a dollar and fifty cents associated with indirect costs (e.g., employee benefits, office rent, depreciation, etc.).

Over half of State government agencies have caps on the allowable overhead percentage. These caps vary from a high of 165% to a low of 123%. The FARs expressly state that “…[government] agencies shall not (1) establish administrative ceilings or (2) create administrative procedures that could be represented to contractors as defacto ceilings” [48 CFR 15.901 (c)]. The statutes declare there will be no overhead caps, however many government agencies defend their use of overhead caps by rationalizing that any overhead rate over their cap is “unreasonable”.

How do A/E firms work in the financial environment with overhead caps as low as 123%? Obviously, A/E firms providing services in such an environment would need to minimize their overhead costs. It is paramount that all direct costs be billed to clients such as copies, mileage, phone charges, computers, etc. and not be included in the overhead cost pool. The other factor is personnel chargeability or utilization. Staff members must be highly client chargeable.

Key executives of A/E firms have joked that to survive with low overhead caps, they must be on the phone talking with a client while at the same time accomplishing design work for another client. Whether the overhead squeeze is actually saving taxpayer dollars is a much debated question.

Be Prepared…

A/E firms wanting to contract with government agencies must know how to do business with them. Setting up job cost and financial information systems to capture the necessary information is a requirement for successful government contracting. The FARs state that “Costs that are expressly unallowable…shall be identified and excluded from any billing, claim, or proposal applicable to a Government contract” [48 CFR 31.201-6(a)]. Therefore specific cost accounts often need to be created to accumulate unallowable overhead costs.

Many “gray” areas can be clarified in advance with government contracting officers by using advance agreements. The allowability of costs such as fully depreciated assets, pre-contract costs, selling costs and professional services can be clarified before the start of a government project. Contracting officers cannot agree to contract terms that are expressly forbidden in the FARs. However, they can agree to the proper interpretations of the FARs and what is a reasonable cost.

Government auditors usually coordinate their work schedule with that of the firm being audited. Therefore, the A/E firm can and should be ready to convincingly present their interpretation of the FARs as it applies to their overhead costs. Often A/E firms expect the auditor to review their in-house financial statements and “discover” the unallowable costs. However, A/E firms have the obligation according to the FARs, to present to government agencies a proposed FARs allowable overhead cost schedule. This overhead schedule should have the undisputed unallowable costs removed (e.g., interest expense, advertising, etc.).

Remember, an auditor’s proposed disallowed cost may be an invitation by the auditor to have the A/E firm provide additional information to clarify the questioned cost. Perhaps all that is needed is some additional corroborative information.

Can Eighty Percent Be Wrong?

Most A/E firms contract with some government agency. Industry survey results confirm that approximately eighty percent of A/E firms engage in government contracts. Ten years ago, government contracts often were more profitable that those in the private sector. This has turned around in most parts of the country. There has been and continues to be a squeeze on profits and overhead rates in the government sector.

Completing your “due diligence” checklist is becoming more and more important when contracting with the government. More than ever before, A/E firms must follow detailed requirements and technicalities to even be paid. Firms that operate from a position of knowledge of the specific administrative and contract performance requirements contained in their government contract, and also the applicable contract regulations contained in the FARs, will be the profitable government contractors.

Yes, reasonable profits can be made with government contracts. Those firms that have thoughtfully designed their information and project management systems to accommodate the requirements for government contracting will be the ones who prosper.

John Pruitt, CPA, is President of A/E Consulting Services, Inc. He has extensive experience in interpreting the Federal Acquisition Regulations System (FARs) and has negotiated numerous overhead audits on federal, state, municipal and city contracts. John works with firms nationwide on a variety of issues including ownership transition planning & valuations, strategic planning, merger & acquisitions, and government contracting. For additional information, you are invited to contact John at A/E Consulting Service, Inc., 1623 Second Street, Kirkland, WA 98033 or call (425) 827-2995.

 

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