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A Unique Approach to Timekeeping Fraud

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As far as we knew, the epitome of timekeeping fraud wasn’t mis-reporting actual time worked but, instead, altering FICA (Social Security) withholdings to inflate amounts withheld on an employee’s W-2, which would then entitle that employee to a corresponding tax credit. That was the most creative approach we knew.

But then came Michelle Holt, a secretary with U.S. Air Force, Air Combat Command, Communication Support Squadron, at Joint Base Langley-Eustis. She took creative timekeeping fraud to the next level, raising the bar for the next fraudster.

Ms. Holt was a salaried employee on the General Schedule (GS) grade for the federal civilian workforce. As such, she was entitled to overtime pay if authorized by her employer, was also entitled to other forms of holiday and annual leave, and premium pay for any federal holidays worked.

According to this Department of Justice press release

Holt falsely claimed over 42,000 hours in unauthorized overtime for hours she did not work, as well as other amounts of unauthorized holiday leave, sick leave and annual leave, all amounting to losses to the United States of more than $1.4 million. In recent years, Holt’s overtime pay was over double that of her regular salary.

The timekeeping fraud was perpetrated for nearly 17 years, apparently with nobody being the wiser that one employee had found a means to effectively triple her secretary’s salary through claiming overtime hours (among other things) for which she did not work. To put that fraud into perspective, that’s about 2,500 hours of overtime claimed per year. And nobody noticed.

How did Ms. Holt accomplish this feat? According to the DOJ—

Holt accomplished the fraud by making manual retroactive adjustments to protected computer time and attendance systems to add overtime, reverse leave taken and reverse holiday leave. In doing so, Holt used another employee’s log-in information without that employee’s knowledge or authorization.

Essentially, then, Ms. Holt falsified her identity with respect to accessing the timekeeping system and made “manual retroactive adjustments” to change her timekeeping records after they had been reviewed and approved by her supervisor. By doing so, she bypassed one of the primary timekeeping controls, which is that somebody reviews and approves the timecard before it is entered into the system.

Nice.

Ms. Holt was sentenced to four years in prison plus she was ordered to repay the $1.4 million she had obtained from her scheme.

Now that we know this is a possibility, now that we know somebody can bypass a supervisor’s review and manipulate the labor data after it has been input, how might we detect such wrongdoing?

First, let’s look at overtime. What kind of compensatory control can we devise?

We can run a report, either monthly or quarterly or annually, that shows overtime hours recorded by salaried employees (or by hourly employees). We can organize that report from highest to lowest. We can decide that anybody recording less than a certain amount of overtime hours can be dropped from the report. For example, let’s run the report quarterly and say that anybody recording less than 40 hours of overtime in a 13-week quarter will not be reported—but that anybody who recorded more than 40 hours will be reported, and that we want to see who recorded the most right at the top of the report.

Had such a report been run, we bet Ms. Holt, who was claiming roughly 625 hours of overtime per quarter, would have been right at the top.

A simple phone call to Ms. Holt’s supervisor would have revealed that the timecards that had been approved did not have such quantities of overtime hours on them … which would have led to further investigation, we presume. In other words, Ms. Holt’s scheme would have come to light within the first quarter or two of being initiated, rather than surfacing only after nearly 17 years had passed.

Now let’s talk about the Paid Time Off (PTO) manipulations.

How about we design a report that shows the PTO elements by employee, including starting and ending balances? Let’s run that report once a year.

For the average employee, there will be a starting vacation (leave) balance and an ending vacation balance. The ending balance will equal starting balance plus annual leave earned during the year, minus any leave taken. If the employee didn’t take any leave then the ending balance will equal the starting balance plus the annual accrual.

Let’s limit our report only to those employees who didn’t take any leave during the year—i.e., to those employees whose ending balance equals starting balance plus annual accrued leave. There won’t be that many employees who are on that report, because most employees take vacations. (In fact, if you work at a bank you are required to take vacations.)

For those few employees on that list, we’ll make a phone call to the supervisor to confirm that the employee didn’t take any vacation during the year. (Most supervisors know if their employees were out for a week or two; often it’s on a calendar somewhere.) If the supervisor indicates that the employee did indeed take a vacation (leave) during the year, then we’d follow up with further investigation.

Again, if we implemented that compensatory control, any shenanigans would come to light within a year or so.

Finally, holiday leave. Each company has its own holiday policy but every government contractor offers at least the Federal minimum holidays. There are 10 Federal holidays. Let’s assume eight labor hours a day. Eight times ten = 80 hours of holiday time per year. That’s what we expect to see. Sure, there are times when people work on holidays, but those exceptions are known.

We can design a report that identifies any employee who recorded less than 80 hours of holiday time per year. (You can tailor the report to match your company’s holiday policy.) There will not be very many employees listed on that report.

For each employee listed, we will make another phone call. If we learn that the supervisor was unaware an employee had worked through a holiday, we’ll investigate further.

The point is, this is not rocket science. The labor hour information you need is almost certainly in your labor accounting system. All you have to do is to design and run the reports, and then have the wherewithal to make the (few) phone calls required.

By the way, if you learn that the employee’s hours were legitimate but the supervisor was clueless about hours worked (even though that same supervisor signed-off on the timecards), then you will have learned something valuable about your primary timekeeping accuracy control. And you will also have learned something valuable about the competency of that supervisor.

We would thank Ms. Holt for prompting us to think along these lines, but that “thanks” doesn’t seem appropriate at this time. Maybe we’ll offer them in four years, or perhaps earlier if she receives time off for good behavior.

 

CASB Staff Discussion Paper – A Call to Reasonableness

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The CAS Board recently issued a new Staff Discussion Paper (SDP) that covered conformance of CAS with GAAP requirements in general, and conformance of two specific Standards with GAAP. This article will not rehash the 49-page SDP in detail. Follow the link and read it for yourself.

Instead, we are going to focus on significant issues/questions raised within the SDP. These are issues and/or questions for which the CAS Board staff has requested input from stakeholders—including contractors. We will probably submit input (time permitting). Will you?

The SDP states—

The growth in GAAP content presents potential opportunities to modify or eliminate overlapping CAS requirements where GAAP standards may be applied reasonably as a substitute for CAS to support contract cost and pricing. Such reductions might help to reduce overall burden in the procurement process by allowing contractors to more heavily rely on GAAP, which they are already using to report on their daily business activities. … At the same time, rolling back CAS and relying on GAAP may create challenges where the standards are similar, but not the same, and leave the Government vulnerable to future GAAP changes that, as explained above, are implemented with a purpose that differs from the goals of CAS.

CASB organized the existing 19 Standards into four groups: (1) Standards focused primarily on cost measurement and assignment of costs to accounting periods; (2) Standards focused primarily on allocation of costs; (3) Standards with complex rules satisfying unique needs of Government contracting; and (4) Standards that are generally foundational principles of Government contracting.

Unsurprisingly, the Board started with examining the Standards associated with the first group, which includes CAS 404 (Capitalization of tangible assets), CAS 407 (Use of standard costs for direct material and direct labor), CAS 408 (Accounting for costs of compensated personal absence), CAS 409 (Depreciation of tangible capital assets), CAS 411 (Accounting for acquisition costs of material), CAS 415 (Accounting for a the cost of deferred compensation), and CAS 416 (Accounting for insurance costs).

In this SDP, CASB focused on only two of the Standards in the first group: CAS 408 and CAS 409. The Board promised to issue another SDP focusing on “two other Standards in the first group,” which are currently unidentified but may include CAS 411, a Standard that is woefully outdated and does not address use of ERP systems to acquire goods via aggregated demand.

The Board has invited input regarding its planned approach. For example, is the grouping of the Standards appropriate? Have the Standards been bucketed in the correct groups? Has the Board properly prioritized its efforts?

Another issue for which CASB invites input is whether the existing whether the existing CAS clause found at 9903.201-4 (“Cost Accounting Standards, July 2011) should be revised “to protect the interests of the Government and contractors,” because the current language does not address noncompliances with GAAP. What do you think?

One problem may be that the single CAS clause found in the regulations has been split into seven separate solicitation provisions and contract clauses by the FAR Council (see 52.230-1 through 52.230-7). When discussing the single CAS clause, it is easy to get confused by the individual requirements of the FAR provisions/clauses. We suggest sticking to the CAS language since that’s the only thing CASB has authority to change. (Of course, if the CAS language changes, presumably the FAR Council would need to make conforming changes to their provisions and clauses.)

When looking at both CAS 408 and 409, the SDP asserts that GAAP largely covers the same requirements as CAS does. Of course, the coverage is not exactly perfect and gaps remain. (No pun intended.) Input to the Board should address whether the coverage is sufficient to permit elimination of the Standard(s) altogether, or whether the existing Standard should be rewritten to cover the remaining gaps in coverage. The answer may turn on whether the cost of compliance exceeds any foreseeable benefit that the contracting parties may receive. The opinion of contractors should carry significant weight.

For example, with respect to CAS 408 conformance, the SDP requests input on “whether the GAAP requirement of generally assigning the cost of benefits in the year the employee performed services upon which the benefit was earned would result in a materially different result than the requirement in CAS 408-40(a) to accrue only vested benefits earned.” Moreover, the SDP solicited input regarding “the magnitude of compensated personal absence costs that accumulate but don’t vest, as described in GAAP, taking into consideration the reduction for estimated forfeitures.” Importantly, the SDP requests input on noncompliances with CAS 408. The SDP asks for –

… facts and data of the history of CAS 408 non-compliance issues raised and how they were resolved. In particular, what is the frequency and magnitude of the issues identified on Government contracts? Furthermore, could the issue raised have been considered non-compliant with GAAP, other CAS or FAR?

Looking at CAS 409 conformance, the SDP requests input regarding “what detailed records contractors would keep and for what purpose (e.g., GAAP compliance) if the requirement in CAS 409 to support service lives with actual historic records was eliminated?” Additionally, the SDP solicits input regarding “about the impact to estimated service lives used, if any, anticipated if the requirement to use estimated service lives based on contractor historical experience was eliminated?”

One potential issue identified by the Board is the CAS requirement to “assign to the transferor the gain/loss on disposition of an asset transferred in an other than an arms-length transaction and subsequently disposed of within 12 months of transfer”—a requirement not found in GAAP. Thus, the SDP requests input regarding “the frequency of such transfers and data about the magnitude of the gains/losses experienced on the assets transferred. In addition, how could the selection of service life, depreciation method, and residual value mitigate the risk of a significant gain/loss at disposition?”

Moreover, “The Board is interested in public comments about how contractors set residual or salvage values for categories of assets and the frequency that for a particular asset the residual value used for CAS and a salvage value used for GAAP are the same.”

Finally, as was the case with the CAS 408 discussion—

The Board is interested in public comments with facts and data of the history of CAS 409 non-compliance issues raised and how they were resolved. In particular, what is the frequency and magnitude of the issues identified on Government contracts? Furthermore, could the issue raised have been considered non-compliant with GAAP, other CAS or FAR?

In summary, it’s been a long time—roughly 15 years—since the CAS Board indicated significant interest in revising its regulations or Standards. Contractors are being offered a rare opportunity to help shape at least two Standards, with the promise of another opportunity to help shape two more in the future. We have written about several specific areas of input requested by the Board, and there are other areas buried deep in the CAS-to-GAAP comparison charts included in the SDP.

If you are concerned about the burdens and complexities of CAS compliance—and aren’t we all?—we urge you to read this SDP carefully and provide the Board with your constructive input. Importantly, if you can speak to the burdens the two Standards create and what savings might be achieved from reduction or elimination, we hope you will do so.

If you don’t speak up now, then we feel you will have no right to complain later if the regulatory revisions don’t go the way you think they should have.

Last Updated on Monday, 18 March 2019 18:19
 

OTs and NTDCs

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We’ve written about nontraditional defense contractors (NTDCs) several times on this blog, the most recent of which is this article. We noted in that article that a new DFARS rule permitted contracting officers to treat goods and services offered by NTDCs as commercial items, meaning that no certified cost or pricing data would be required to support the prices being offered.

Which is, of course, a good thing—at least, if you are an NTDC. (NTDCs are defined as any business that “is not currently performing and has not performed any contract or subcontract for DoD that is subject to full coverage under the cost accounting standards … for at least the 1-year period preceding the solicitation of sources by DoD for the procurement.”)

Subsequently we noted that Don Mansfield had opined that the definition of an NTDC might result in the situation where every small business is potentially a NTDC (because, by definition, small businesses are exempt from CAS coverage). Don suggested that they would thus be eligible under DFARS 212.102(a)(iii) for Part 12 commercial item procurement procedures, regardless of whether the small business’ goods/services had been formally determined to be commercial items.

Well, maybe. It makes sense, but our experience tells us that when an interpretation of an acquisition rule makes sense, somebody is going to disagree with it.

Anyway, on March 5, 2019, the Acting Principal Director of Defense Pricing and Contracting (DPAC) issued a guidance memo regarding use of NTDCs and Other Transactions (OTs). The memo makes clear that the purpose of both OTs and NTDCs is to speed access to the innovative technologies of commercial entities.

*Sigh*

We have written many times about DOD’s love/hate relationship with innovation. It’s almost funny that DOD would love to have the innovation offered by commercial entities but doesn’t really want anything that might disrupt the status quo. Think we’re exaggerating? Check out our articles on Palantir’s attempts (including several lawsuits) to try to get a foot in the acquisition door in order to provide DOD with its leading intelligence fusion software.

DOD has an empirically proven love/hate relationship with innovation and with acquisition of commercial items, which is why both Congress and the Section 809 Panel keeps telling DOD to do better in those areas. Over and over again.

So now comes another guidance memo that reminds contracting officers that DFARS permits use of streamlined acquisition methods, including OTs and NTDCs, to facilitate access to that sweet, sweet, privately developed innovative technology. But who will force the COCOMs to require that technology?

One more thing: the memo clarifies that, when a contracting officer uses the NTDC rule to acquire goods and services, that is not the same thing as making a commercial item determination (CID). The memo states “The decision to apply commercial item procedures to the procurement of supplies and services from a nontraditional defense contractor does not require a commercial item determination, and does not mean the supplies or services are commercial.”

That’s a good clarification. It’s consistent with the actual DFARS language. But it leads us to the question regarding whether a NTDC should insist on a CID rather than accept a quick-‘n’-dirty Part 12 acquisition? We mean, accepting streamlined NTDC procedures solves one immediate problem (submission of certified cost or pricing data), but it doesn’t really solve the underlying concern—which is to get DOD to accept a good or service as being a commercial item whose pricing is based on market forces rather than a detailed cost buildup.

In other words, it’s a bit of a trade-off.

The contractor has the leverage to the extent that DOD wants that cheap innovative technology, and once DOD has the tech, much of the leverage goes away. Why should DOD take the time and effort to consider a CID if it doesn’t need to? But if the CID isn’t made, then the contractor will be right back where it started from at the next acquisition. The problem will not have been solved; it will simply have been kicked down the street.

OTs and NTDCs give DOD something it wants: streamlined access to privately funded innovative technology. We suggest that proper consideration for that access should be a commercial item determination, when doing so can be justified by the FAR.

 

Cyber-Security and CPSRs

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There are those who listen and prepare, and there are those who do not listen and are therefore surprised. Which are you?

Which is your company?

Let’s find out.

Question #1: How long has Apogee Consulting, Inc. been warning its clients and blog readers about the importance of cyber-security?

Answer: Nearly 10 years. Our first article that mentions cyber-security was posted in November, 2009. We wrote: “We frequently report on advances in aerospace and defense technology. As the AW&ST article reminds us, our adversaries are making advances as well, perhaps in areas in which we are vulnerable to exploitation. In 21st century warfare, securing the lines of command, control, communications, and computers (C4) and making effective use of ISR information may be more important than securing the lines of supply.”

It would not be our last article on the topic. Just a few months later, we discussed some proposed DFARS contract clauses and opined that “it seems entirely appropriate for the DOD to consider issuing basic standards of minimum cyber protection to its industrial base, and to require reporting (including root cause analyses) when network breaches occur and data is compromised. And we applaud the opportunity offered industry to help shape the rule and its implementation. We hope knowledgeable companies will help DOD craft a good rule that is easily implementable. After that, companies will need to comply with the requirements of the new contract clauses, or else risk accusations of breach of contract (or worse).”

Those early articles were followed by many more. Our point is: had you listened and acted, you would have had nearly a decade to get ready for DOD’s current emphasis on cyber-security.

Question #2: Is your Purchasing System cyber-ready?

Answer: Probably not. It caught many folks by surprise when DOD decided to verify contractors’ cyber-readiness and cyber-compliance via reviews of contractor purchasing systems (CPSRs). It was only last month that DOD’s approach became apparent. We told you about the situation almost immediately.

Question #3: Forget cyber-security. Let’s talk about good ol’ supply chain management. You know: interaction with suppliers after award of a subcontract. Does your company place the proper emphasis on that aspect of program management?

Answer: Almost certainly not. And it’s a shame, too. Apogee Consulting, Inc. is not just a bunch of beancounters; we have chops in the program management space as well. And with respect to supply chain management, we have been exhorting readers to focus on this area for, quite literally, years. Here’s one good example from 2010, where we told readers “The risks demand a serious and near-term response.  Our goal should be to establish a “product pedigree” for our supply chain through creating an unbreakable chain of custody from first source through the various manufacturing and fabrication and assembly and finishing steps.” That was nine years ago. And that wasn’t even our first article on the topic! We continued to beat that drum over the past nine years, including this straight-in-your-face posting (also from 2010) that opined: “Listen, folks: Whether you call it Supply Chain Management, supplier management, or subcontractor management, it is the key to success. Period.” (Emphasis in original.)

And so, having recited the litany of our reporting on this issue, having clearly supporting the assertion that “we told you so,” we now tell readers that the latest DCMA CPSR Guidebook has been updated. In the words of one contractor’s purchasing compliance lead, the result is “ugly” for contractors. Appendix 24 of the Guidebook states—

When DFARS 252.204-7012 is applicable, the contractors must implement the security requirements specified in the National Institute of Standards and Technology (NIST) Special Publication (SP) 800-171, Protecting Controlled Unclassified Information in Nonfederal Information Systems and Organizations. The Contractor's purchasing system will be evaluated to assess that:(a) The contractor’s procedures ensure contractual DoD requirements for marking and distribution statements on DoD Controlled Unclassified Information (CUI) flow down appropriately to their Tier 1 Level Suppliers [and] (b)The contractor’s procedures to assure Tier 1 Level Supplier compliance with DFARS Clause 252.204-7012 and NIST SP 800-171.

That bit above is not really anything new; it is almost a verbatim recitation of the policy letter we discussed last month. But what may be “ugly” is the following direction to CPSR teams:

The PA should ask the contractor to demonstrate their ability to protect CUI in accordance with DFARS 252.204-7012 and NIST SP 800-171. The PA will review subcontracts/POs to determine if the contractor has flowed down DFARS 252.204-7012 in all applicable procurement files within the selected sample. The PA should validate that CUI is properly marked in procurement files containing DFARS 252.204-7012 and be aware that no CUI should be present in procurement files where DFARS 252.204-7012 is not included. The contractor must demonstrate how the CUI was transferred to their subcontractor. The PA should request that the contractor provide prime contracts containing CUI which was transferred to a subcontractor. The contractor must exhibit examples of CUI data transfers to demonstrate their ability to comply with this requirement.

(Emphasis added.)

But wait. There’s more:

  • The prime contractor must validate that the subcontractor has a Covered Contractor Information System (CCIS) that can receive and protect CUI. The prime contractor must show documentation that they have determined that the subcontractor has an acceptable CCIS to include an adequate System Security Plan (SSP).

  • The PA must ask the contractor to demonstrate how they are managing and documenting their subcontractors’ request for variances.

  • The PA must ask the contractor to demonstrate how they are managing and documenting their subcontractors’ incident report numbers.

It is becoming clear that the ability of a contractor to comply with DFARS 242.204-7012 (Safeguarding Covered Defense Information and Cyber Incident Reporting) is going to affect how the CPSR team scores compliance with Purchasing System adequacy criteria associated with supply chain management.

To wrap this all up, you and your company should be ready for the CPSR review team’s questions in this area. You should do fine.

Unless, of course, you haven’t been reading this blog. In which case, this sudden emphasis on cyber-security and secure supply chains may be coming as an unpleasant surprise demanding quick and expensive action.

Or—and this would be worse—you’ve been reading our warnings in these areas and you’ve been ignoring them. These posts have just been rants for your amusement, not to be taken seriously. In which case, shame on you.

 

A Fair Profit

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A frequently heard question is “How much profit should I expect on my contract?” It comes up during preparation of the initial cost proposal; it comes up during negotiations; and it comes up when companies are considering entering the Federal marketplace to sell their goods and services.

What’s a fair profit?

As you might expect, government negotiators and contractors differ with respect to their answers to that seemingly straightforward question.

Here is what the regulations say:

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. 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).)

(Emphasis added.)

Right away, it is clear that the government expects a contractor to propose, and actually make, a reasonable profit on the work performed. That’s the official policy, as expressed in the FAR.

However, when cost analysis is performed, a contracting officer must evaluate the contractor’s proposed profit using a technique called “structured approach” that ensures a consistent methodology in that evaluation. According to FAR 15.404-4(d), the structured approach should consider the following factors:

  • The complexity of the work and the resources required of the prospective contractor for contract performance.

  • The degree of cost responsibility and associated risk that the prospective contractor will assume as a result of the contract type contemplated and considering the reliability of the cost estimate in relation to the complexity and duration of the contract task.

  • The degree of support given by the prospective contractor to Federal socioeconomic programs, such as those involving small business concerns, small business concerns owned and controlled by socially and economically disadvantaged individuals, women-owned small business concerns, veteran-owned, HUBZone, service-disabled veteran-owned small business concerns, sheltered workshops for workers with disabilities, and energy conservation.

  • The contribution of contractor investments to efficient and economical contract performance.

  • Measures taken by the prospective contractor that result in productivity improvements, and other cost-reduction accomplishments that will benefit the Government in follow-on contracts.

  • Recognition of independent development efforts relevant to the contract end item without Government assistance.

Those are the FAR-based factors to be considered. The Department of Defense has developed its own structured approach to profit analysis, called the “weighted guidelines” method. The contracting officer’s analysis is documented in Form DD 1547 (Record of Weighted Guidelines Method Application). According to DFARS 215.404-71, the weighted guidelines method focuses on four factors—

1. Performance risk

2. Contract type risk

3. Facilities capital employed

4. Cost efficiency

The methodology for applying the weighted guidelines profit evaluation is explained in the DFARS as follows—

The contracting officer assigns values to each profit factor; the value multiplied by the base results in the profit objective for that factor. Except for the cost efficiency special factor, each profit factor has a normal value and a designated range of values. The normal value is representative of average conditions on the prospective contract when compared to all goods and services acquired by DoD. The designated range provides values based on above normal or below normal conditions.

Seems simple enough, right? There are four factors; each factor has a range from low to high. The contracting officer puts in a number for each factor and then adds all the numbers up to get to the profit that has been determined to be fair and reasonable. (But note that the number is only a prenegotiation objective; the actual value will depend on how negotiations go.)

It seems simple, but if you look at the actual factors in the DFARS, you see subfactors and weightings and it turns out to be fairly complex and not very simple at all. For example, with respect to contract type risk, the contracting officer is directed to offer 5.0% (as much as 6.0%) for a firm, fixed-price contract; whereas a cost-plus-fixed-fee contract has a contract type risk maximum of 1.0%, with 0.5% being the standard.

We made a simple Excel model following the DFARS rules, and it looks to us as that if the contracting officer maxed-out every possible factor and subfactor in the contractor’s favor, the maximum amount of profit that would be considered to be fair and reasonable would be 15%. That’s it. If the standard values were used, the profit rate looks to be in the neighborhood of 10% (FFP) or 6% (CPFF). So those become a DCMA contracting officer’s prenegotiation objectives and the expectations for “success” at the bargaining table.

Thus, while the DOD is not applying predetermined profit percentages (which would violate the FAR policies quoted above), it is certainly applying predetermined profit ranges that, depending on your point of view, might not be super attractive. With that said, of course, one needs to factor in cash flow and, typically, the Federal government is a good customer with respect to cash flow. Over in the commercial world, it does no good to make a 50% profit if your customer never pays you. The complete story, then, is not solely about profit; but profit is what we are talking about today.

The story of profit does not end with the FAR and DFARS rules about “structured approach” and “weighted guidelines,” because there are also some FAR-based rules (implementing statutes) that put a hard limit on the amount of profit (expressed in percentages of estimated cost) that may be paid. (See FAR 15.404-4(c)(4).) Contracting officers simply cannot exceed those statutory limits. Period. The limits are:

  1. For experimental, developmental, or research work performed under a cost-plus-fixed-fee contract, the fee shall not exceed 15 percent of the contract’s estimated cost, excluding fee.

  2. For architect-engineer services for public works or utilities, the contract price or the estimated cost and fee for production and delivery of designs, plans, drawings, and specifications shall not exceed 6 percent of the estimated cost of construction of the public work or utility, excluding fees.

  3. For other cost-plus-fixed-fee contracts, the fee shall not exceed 10 percent of the contract’s estimated cost, excluding fee.

So, other than the three specified profit limits above, the sky’s the limit (officially) with respect to profit limitations. The contractor is permitted to propose as high a fee as it thinks it can support. The contracting officer will use “structured approach,” including “weighted guidelines,” to evaluate the proposed profit. To be clear: if you are not proposing a CPFF contract or an A/E contract then, in theory, you could propose 1000% profit on your estimated costs.

Of course, a proposed profit of 1000% is going to present a challenge for your contracting officer, especially if that contracting officer works for DCMA and has to fill out a DD 1547 and your proposed profit blows all the predetermined ranges out of the water.

If that’s the situation, it is for sure going to be an interesting negotiation.

But we’re not done yet.

The Department of Defense Office of Inspector General (DoD OIG) has its own viewpoint with respect to the profits a defense contractor should be earning. Would you be interested to know that the DoD OIG believes that a reasonable profit should never, ever, exceed 15 percent of costs, regardless of what the FAR might say the government policy is or what the DoD “weighted guidelines” might say the appropriate profit should be?

If you would be interested, then keep reading. Otherwise, see you later.

On February 25, 2019, the DoD OIG published Report No. DODIG-2019-060, entitled, “Review of Parts Purchased from TransDigm Group, Inc.”

Bottom-Line Up-Front: The audit report concluded that TransDigm “earned excess profit on 46 of 47 parts purchased by the DLA and the Army.”

Important factual detail: “contracting officers followed the FAR and Defense Acquisition Regulation Supplement (DFARS) allowed procedures when they determined that prices were fair and reasonable for the 47 parts at the time of contract award. … Contracting officers used FAR and DFARS-allowed pricing methods, including historical price analysis, competition, and cost analysis to determine whether prices were fair and reasonable for the 47 parts.”

Another important factual detail: OIG auditors “used 15 percent as a reasonable profit and determined any profit over 15 percent to be excess profit.” In other words, if TransDigm made more than 15 percent of its costs, that was judged to be excessive. Even though “TransDigm was the only manufacturer at the time for the majority of the parts competitively awarded, giving TransDigm the opportunity to set the market price for those parts.” In other words, it was “buy from TransDigm or go fabricate your own parts.” DoD chose to buy TransDigm’s parts – and forego the costs of fabricating its own parts (assuming it even could do so) – and thus had to pay the price at which TransDigm offered those parts.

This situation made the DoD OIG unhappy. It is almost as if the DoD OIG is not a proponent of free market capitalism.

We could rant on other topics related to this so-called “audit report,” but the conclusion would still be this: A fair and reasonable price is the one at which the seller agrees to sell and the buyer agrees to buy. Period. Contracting officers have Certificates of Appointment (warrants) because they have been trained to analyze prices in order to determine whether the Federal government is willing to be a buyer at those prices. That’s their job. They don’t need second-guessers criticizing them—especially when the second-guessers start the criticism with admitting that (1) the contracting officers followed all the rules and regulations, and (2) any profit greater than 15% is excessive (which violates the FAR policy we quoted at the beginning of this article). When the Monday-morning quarterbacks support their criticism by such admissions, we believe those conclusions are unwarranted. Taking it a step farther, we believe those criticisms are unworthy of professional auditors.

TransDigm had the parts. The DoD could choose whether to buy those parts, or not, at the prices set by TransDigm. Admittedly, this is a bit of a role reversal, because normally the DoD has all the negotiating power and the contractor has almost none. Competitive pressures usually push contractor profits down to the bare minimums; and if they don’t, then the “weighted guidelines” will. But in this case, the contractor set the price and the DoD had to accept it, or walk away. It chose to accept the pricing and now the OIG is upset at the unfairness of it all.

That’s not how the free market works.

Last Updated on Monday, 04 March 2019 20:55
 

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Effective January 1, 2019, Nick Sanders has been named as Editor of two reference books published by LexisNexis. The first book is Matthew Bender’s Accounting for Government Contracts: The Federal Acquisition Regulation. The second book is Matthew Bender’s Accounting for Government Contracts: The Cost Accounting Standards. Nick replaces Darrell Oyer, who has edited those books for many years.