Creative Pricing Strategies for Government Contractors

Scott ButlerCreative Pricing Strategies for Government Contractors
Presented by Scott Butler
Beason & Nalley, P.C.
Contact Scott at sbutler@bn-cpa.com

May 15, 2001

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Summary

Topics covered in the workshop include:

  • Indirect cost pools
  • Computation of contractor wrap rate
  • Establishing service centers
  • Advantages of a lower G&A rate


Complete Transcript

Session Moderator: Welcome everyone, and thank you for joining us today! I am happy to introduce Scott Butler, of Beason & Nalley, P.C. in Huntsville, Alabama, who will discuss creative pricing strategies for government contractors.

Scott currently leads Beason & Nalley's government contract consulting and audit team. He writes articles, leads training courses around the country, and consults with contractors on many issues. He has served on the board of directors for the Huntsville Downtown Redevelopment Authority and is past treasurer for Crisis Services. He is a member of the Greater Huntsville Rotary Club, Huntsville Association of Small Advanced Technical Businesses, and currently serves on the board of directors for SouthTrust Bank in Huntsville.

Welcome, Scott!

Scott Butler: Good Afternoon!

How many of you currently have Gov't. contracts?

Before we begin with creative pricing strategies that impact a contractor's indirect cost pools and in particular the G&A pool, I want to start with the basics.

Indirect cost pools in general:

The FAR requires contractors to establish and consistently follow criteria for distinguishing between direct and indirect cost. A cost is direct if it can be identified with only one cost objective. For a typical service type government contractor this would be direct labor. An engineer charging his or her hours directly to a contract would be direct labor. If that same engineer takes paid leave or attends an education and training seminar then those activities do not benefit one cost objective but are considered indirect and must be accumulated in an indirect cost pool. All indirect cost can be classified as either overhead or G&A. Overhead includes all indirect cost incurred for the production of goods or services, while G&A expenses are overall costs of running a business.

Are all of you familiar with these types of cost pools?

H. Philips: yes

Scott Butler: How many different overhead pools do you have?

In a typical service type government contractor that uses direct labor as its allocation base, the following types of overhead costs associated with direct labor follows:

Indirect salaries (When the direct labor employee attends a seminar or working on activities that doesn't benefit a direct cost objective)

Facilities cost: (Rent, maintenance, telephone, janitorial, utilities for those direct labor employees)

Other: (Office supplies, training, copier cost, indirect travel, indirect business meals, depreciation, etc.)

While overhead is allocated to products and services, G&A is allocated to cost accounting periods and for that reason should not be accounted for in the same indirect cost pool.

Any questions so far?

G&A cost in a typical service type government contractor consists of the following:

Indirect salaries of those functions that benefit the entire company. (Accounting, Human resources, Management information systems, Security, Contract Administration, CEO and staff, etc?)

Fringe benefits: (Leave, holiday, retirement plan, payroll taxes, insurance, etc.)
Scott Butler: Other: (Office supplies, training, copier cost, indirect travel, indirect business meals, depreciation, etc.)

Legal and accounting fees

Bid and proposal and Independent Research and Development Cost

The total of a company's G&A expenses as a percentage of all cost incurred (All direct and indirect cost other than G&A cost) is the company's G&A rate.

Unallowable costs: These type costs must not be included in either the overhead or G&A pools of a government contractor. A contractor must be familiar with FAR Subpart 31.2, which covers these types of costs.

Some examples are: (Entertainment, interest, political contributions, excessive compensation, employee morale, bad debts, public relations, advertising, certain legal fees, organization costs, goodwill, etc?)

Any questions about the basics?

In today's discussion I am keeping the format simple to include just one overhead pool. The FAR does not specify the number of cost pools a contractor should have. I prefer to keep a clients cost structure as simple as possible and always look at the cost benefit relationship in maintaining multiple overhead pools.

The greater the number of cost pools the more complicated the process of accumulating, allocating, and cross-allocating indirect costs becomes. In our area we sometimes see two overhead pools. One for the direct labor employees that actually reside in the contractors facility and one for the direct labor employees that reside at a government facility.

In today's highly competitive government contracting environment you must position your company to be cost competitive. The various overhead and G&A rates company's employ may be vastly different from one company to the next depending upon how they classify direct and indirect and the number of pools and allocation bases they have. You have to look at the total costs allocated to the final objective. In the end the total costs one company bids and incurs on a contract may be the same as another but with very different overhead and G&A rates. The mix between these pools and the rates can offer a competitive advantage depending on the circumstances.

Hello FAR? You must be an expert! Does everyone know what FAR stands for?

FAR: Federal Acquisition Regulations?

Scott Butler: Way to go FAR!

Lets look at the following example:

Computation of contractor Wrap rates
Cost Element Company
A. B.
Direct Labor $1.00 $1.00
Overhead 0.75 0.61
Subtotal 1.75 1.61
Total Cost $1.96 $1.96

Are you with me so far?

G&A 0.21 0.35

This line should have been between subtotal and Total Cost.

Company A: Overhead rate=75%, G&A rate=12% Combined wrap rate = 1.96 or company A must spend $96 for every $100 just to absorb all of the overhead and G&A expenses on $100 of direct labor.

Company B: Overhead rate=61%, G&A rate=22% Combined wrap rate = 1.96 or company A must spend $96 for every $100 just to absorb all of the overhead and G&A expenses on $100 of direct labor.

Even though these companies employ different methods for accumulating costs within their overhead and G&A pools they still end up with the same result in total.

Any questions so far?

Lets pause for a moment and look at how Company B. who has a G&A rate of 22% might not fare as well as Company A in a competitive cost shoot out even though their cost structure in total is the same.

Lets assume that the contract being bid by Company A and B has a significant amount of subcontract and travel cost. No overhead is applied to these types of cost since both companies only apply overhead to direct labor. Company A would apply G&A of 12% to all subcontract and travel and Company B would apply 22% to all subcontract and travel. That is a 10% swing on cost that gets applied to a fairly menial activity. The processing of subcontractor invoices and travel and expense reports takes some effort but in this example Company B would be applying more G&A cost than A on these type activities. On the flip side Company B would be applying less overhead to direct labor efforts than Company A.

Maybe Company B has a lower fringe benefit rate or has less expensive facilities than company A and that is why their overhead associated with their direct labor is less. Either way you have to determine if Company A stands to gain an advantage even though the playing field should be level given the two company's wrap rates. There is a perception among some contracting officers that G&A is administrative fluff and they may focus in on that difference which would give A an advantage.

In the discussion that follows I will discuss a creative way for Company B to lower it's G&A pool by allocating certain traditional G&A costs into service centers and have them re-allocated out to the company's overhead pool. The theory is pretty simple but your accounting system must be able to accommodate multiple service centers

Like most all government contractor's Company B's G&A pool includes human resource, security, management information systems, contract administration and payroll departments. Our goal will be to take each of these functions out of the G&A pool and put them into service centers where they will be accumulated and then reallocated back to both overhead and G&A based on logical and consistent allocation bases.

Human Resources:

The human resource department obviously benefits the whole company meeting the criteria as a G&A cost, but the group also benefits all employees of the company. The fundamental costs of the majority of Company B's employees are maintained in the overhead pool, which is where these costs will be charged as the Company grows

The human resource group exists to provide a service and benefit to all corporate employees. As the Company grows and the number of employees rise, the human resource group expenditures increase with increased recruiting cost and the need for additional human resource employees to provide services to a growing work force.

Although many companies still consider this function to be a period cost which is kept entirely within their G&A pool, one may argue that allocating the cost of this group to the entire Company provides a more equitable matching of cost to cost objective. Company B may take all of its human resource employees and their proportionate share of facilities and fringe benefits, training, travel, recruiting cost, publications, etc. and combine all of the cost into a separate service center pool.

Since the human resources group benefits all employees of Company B then the allocation basis for all incurred human resource cost would be the total number of employees. The total accumulated human resource cost for the period would then be allocated out of the service center back into both the overhead and G&A pools where the proportionate number of employees reside.

Since most of the company's employees reside in the overhead pools then most of the human resource group cost would be allocated to the overhead pool. The shift is dramatic but consistent with the cost/benefit relationship and must be consistently applied in a like manner each period.

Security

In certain circumstances the security function may be included with the human resources service center as long as you can prove that the relationship security bears to the total company mirrors that of the human resource group.

If not, then you may create a separate service center for the security function and allocate the cost using another acceptable basis for allocation. The security employee's labor, fringes, facilities and other indirect cost associated with that function would be accumulated into this service center pool.

Once you have accumulated all of the security pool cost, then you may allocate these expenses to the final project. To determine the proper allocation base for the security function you must first look at the groups that directly benefit from this function.

A typical security group in a DOD environment may be seen as benefiting all employees of the company. In this case you could justify using the same principle for allocation of these expenses as used in the human resource group allocation. If certain security employee's work for the benefit of one cost objective and charge direct to a contract then these employees would not be a part of the indirect pool that benefits the entire company.

Management Information Systems Group

Companies will often include the cost associated with its internal information system group within its G&A expense pool. The types of cost frequently incurred by this function are salaries for technical support and MIS support team members, associated facility and fringe cost, computer related depreciation expense, web page support, and other MIS related expenses. The service that this group provides generally benefits each individual that has computer access and receives support indirectly from this group. In determining the proper allocation base you should study this activity carefully to best determine the beneficiaries of their support. An allocation base for this service center pool could be the total computer terminals by cost pool, or some other means of determining the benefits provided to the end user.

Scott Butler: Does everyone agree with these allocation methods?

Karri: yes

Scott Butler: Contract Administration

Similar to security personnel you may have contract administrators who support specific contracts. Cost for these activities would not be included in any indirect cost pool. It is also common to have contract administrators who administer multiple contracts on an ongoing basis and have all of their costs and associated fringes, facilities, training, etc. accumulated within the G&A pool.

For the same reasons contractors have placed the human resource, management information system and security functions inside the G&A pool, many companies consider this type of administrative activity to be more easily accounted for as a G&A expense. The decision to group these costs within a service center must be approached with similar forethought and planning as was used in the human resource, security and MIS decisions. The materiality of the cost and the cost/benefit relationship of the accounting for these costs should play a major role in your decision. The allocation base for contract administration could be the total number of contracts administered and included within each overhead pool. If your company has only one overhead pool then this function would probably already be included as an overhead pool function rather than a G&A function.

The next cost area is payroll.

The size of your payroll staff and the cost associated with that effort would determine whether or not it is feasible to segregate this function from G&A and maintaining it as a separate service center. The theory is the same as the human resource pool, and it stands to reason that the payroll function benefits all employees. The labor, fringe and facilities costs associated with the payroll function as well as publications, tax guides, associated supplies and other costs could also be broken out and allocated to the total number of employees.

In our example above Company A utilized these service center approaches to traditional G&A expenditures and had an approved accounting system for accomplishing their objectives. Company B continued to account for the cost of these functions as a G&A expense. There is no real difference in the two companies but there is a perceived difference among those evaluating the cost structures of the two.

Do any of you have a material handling rate in your cost structure?

Karri: Yes. What points should a company consider in order to determine whether they should change their pool structure?

Scott Butler: Thanks for the question Karri, we are about to cover some of the considerations.

Before Establishing Service Centers for Traditional G&A Cost You Must Consider the Following:

The allocability of costs has been the subject of government cost principles for many years, although the Armed Services Procurement Regulation, the Defense acquisition Regulation (DAR), and the Federal Procurement Regulation contained little actual guidance on how to allocate costs.

The FAR defines a “cost objective” as “a function, organizational subdivision, contract or other work unit for which cost data are desired and for which provision is made to accumulate and measure the cost to processes, products, jobs, capitalized projects, etc.” FAR 31.001.

This definition may encompass as cost objectives administrative service centers such as computer services, human resources, security, contract administration and even the payroll function of a company.

Many companies today include all of these activities within their G&A expense pools rather than segregating them into separate service centers and then subsequently reallocating them to the final cost objectives, which in our example above are both overhead and G&A pools. All indirect costs may ultimately be classified as overhead or G&A expenses. While overhead includes all indirect cost incurred for the production of goods and services, G&A expenses consist of the administrative costs of running a business.

Overhead is allocated to products or services while G&A is allocated to cost accounting periods. For that reason, overhead and G&A cost should not be accumulated in the same indirect cost center; they are not considered homogeneous. Contractors have considerable discretion in deciding how to allocate costs to contracts. In numerous cases, the Board of Contract Appeals has established that a contractor-selected allocation method should not be altered by the government unless the method produces inequitable results.

The contractor's method does not have to be the best alternative, but merely an equitable method. DOD auditors recognize that contractors may modify accounting systems to achieve this end. The basic restriction in making any accounting system modification is that proper procedures must be followed in notifying the government of the change and negotiating a cost impact.

Because of the Cost Accounting Standard requirement to compute a cost impact statement for accounting changes, the timing of a cost structure change should consider the status of existing contracts, the fiscal period, and expected date of significant new contracts. These restrictions do not apply to contractors not yet covered by Cost Accounting Standards.

Are any of you CAS covered?

Karri: Please explain the CAS requirements.

Scott Butler: Karri, we have a flowchart on our website www.bngov.net, that will take you through the determination of CAS coverage.

Your accounting system must be able to accommodate multiple service centers. The cross allocations can become complex. If two or more cost pools provide services to each other, determining the amount of costs to be allocated between the pools is a circular process.

In theory, it is impossible to know the total costs of Pool A until Pool A receives the allocation it should receive from Pool B, but the allocation from Pool B cannot be made until Pool B has received its share of Pool A's costs. Several approaches can be used to solve this problem. We suggest you first look at your software capabilities and employ the use of a consultant familiar with cost allocation techniques as well as your particular software package.

What accounting software are you currently using?

Jamie Fee: Scott, where can we find a consultant like that, I am in New York?

Scott Butler: We have an airport just up the street!

Karri: I have heard that Deltek/Costpoint is a good software. Do you have knowledge of this software?

Jamie Fee: Okay! Thanks

Scott Butler: Karri, we have four full time Costpoint consultants.

Treavor Wilson: Deltek, are they are software company?

Karri: I take it that they can take the airplane also.

Scott Butler: The software was written with the government contractor in mind.

Deltek also has other products like GCS Premier.

Yes Treavor, they are a publicly traded software company.

Anyone using anything other than Deltek products?

To summarize:

To insure your company maintains its competitive edge, you must continuously evaluate your cost structure and stay abreast of the cost trends in your industry. The G&A rate does matter and it is important to manage your G&A cost effectively.

Creative strategies allocating traditional G&A cost to overhead pools must be well thought out.

The impact these types of shifts have on your existing contract backlog and your forward pricing rate structures could be significant and you should carefully consider the impact of these potential changes on your business.

Any other questions?

Karri: What are some good analytical reviews on the rates do you perform that you could share with us?

Scott Butler: Budget to actual, period to period, and also against industry data. You can find surveys that give you an idea of competitive ranges for overhead rates.

Do any of you bid "if-win" scenarios? By this I mean, showing the effect of a new procurement on your current rate structure.

We have about 5 minutes left, any specific questions?

Karri: Have you encountered any advanced billing type contracts with the credit cards? If so, how have you handled these?

Scott Butler: Karri, are you talking about GSA?

Karri: yes

Scott Butler: The advance billings are more of a GAAP question than government contract if you are talking about revenue recognition.

Michael Platt: Thank you Scott, great job! We appreciate you taking the time today.

Scott Butler: Thanks for all of your participation.

Session Moderator: There's a lot of excellent information here - thank you so much, Scott, for sharing your expertise!

Karri: Thanks!

Scott Butler: Goodbye, and thanks again.


Biography

Scott Butler currently leads Beason & Nalley, P.C.’s government contract consulting and audit team. He writes articles, leads training courses around the country, and consults with contractors on myriad issues. He and his wife Cheri have 3 daughters and reside in Huntsville, Alabama. He has served on the board of directors for the Huntsville Downtown Redevelopment Authority and is past Treasurer for Crisis Services. He is a member of the Greater Huntsville Rotary Club, Huntsville Association of Small Advanced Technical Businesses, and currently serves on the board of directors for SouthTrust Bank in Huntsville.

Originally from Atlanta, Mr. Butler is an avid sports fan. He plays golf and tennis and enjoys running in 10k road races. He also coaches his girls’ basketball and softball teams and enjoys teaching youth Sunday School with his wife Cheri.

E-mail: sbutler@bn-cpa.com
Web site: www.bngov.com


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