DFARS Clauses Going Bye-Bye
On February 24, 2017, the President signed Executive Order (E.O.) #13777, “Enforcing the Regulatory Reform Agenda,” which established a Federal policy “to alleviate unnecessary regulatory burdens” on the American people. To carry out the POTUS’s E.O., the DoD established a “Regulatory Reform Task Force” and solicited public input. Surprisingly, the Task Force listened to the public input (at least, they listened to some of the public input) and we are now—a year after the Task Force was established—seeing the elimination of a couple of DFARS clauses.
The first clause to go bye-bye is 252.247-7006 (“Removal of Contractor's Employees”). The final rule eliminating that clause is here. According to the rule-makers (or “rule-killers,” if you will)—
The DFARS clause served as an agreement from the contractor to only use experienced, responsible, and capable people to perform the work under the stevedoring contract. The clause also advised the contractor that the contracting officer may require the contractor to remove from the job, employees who endanger persons or property or whose employment is inconsistent with the interest of military security. [However] the information conveyed in DFARS clause 252.247-7006 is directly related to performance of the work under a stevedoring contract. It is more appropriate to define what the Government considers an experienced, responsible, and capable employee to be in a performance work statement, not a contract clause, because those requirements may change depending on various factors of the work being performed. If the need to remove employees from performing under the contract exists, it should be identified in the performance work statement. The removal and replacement of employees directly relates to the contractor's ability to perform and staff the work under the contract. As such, this DFARS clause is unnecessary and can be removed.
The contract clause has been around since 1991. Apparently, DoD is just now realizing—with a push from POTUS—that the clause is unnecessary. And you thought the CAS Board moved slowly!
The second bit of unnecessary regulatory verbiage to be removed is the language at DFARS 231.205-18(c)(iii)(C)(4), which required major contractors to engage in and document a technical interchange with the Government, prior to generating independent research and development (IR&D) costs for IR&D projects initiated in fiscal year 2017 and later, in order for those costs to be determined to be allowable. We’ve written about this piece of pernicious nonsense before, more than once. (See, for example, this article.)
The rule was stillborn upon delivery. Implementation problems at the DoD coupled with contractor push-back effectively killed it. A DFARS Class Deviation acknowledged the rule was dead. But now we have a final rule that not only sticks the final nail in the coffin, but also buries that coffin at the bottom of the Mariana Trench.
According to the rule-killing comments, no public input was received and the rule is being killed at the behest of the Task Force. Well, not exactly. We know for a fact that certain industry associations were bombarding DoD leadership with respectful, but firm, demands to kill this rule. In any case, the DoD Task Force “determined that the DFARS coverage was outmoded and recommended removal, since requiring a technical interchange between the Government and major contractors is unnecessary. The objective of the interchange can be met through other means.”
So that rule went bye-bye.
Next up: Proposed regulatory language and requirements to be added to the DFARS, because hey, why not? It’s not like POTUS has a problem with regulatory burdens, right?
Transactions with Affiliated Entities
From time to time, we remind readers that government accounting is hard, and that consequences for getting it wrong tend to be a bit onerous. This is one of those times.
We have written about transactions with affiliated entities before. Sometimes they’re called “inter-company” transactions, and sometimes they are called “inter-divisional” transactions, and sometimes they are called “affiliated transactions”—but we prefer to call them “inter-organizational” transfers (IOTs). Here’s a link to one of our previous articles that gives background on the subject.
A key feature of such transactions is that (almost but not quite always) they are “make” and not “buy” transactions, meaning that they should not be treated as being arms-length transactions between two separate entities, but rather as being a single transaction within one entity. Treatment as being a single transaction within one entity has ramifications for things such as execution of Certificates of Current Cost or Pricing Data and contract type. (For example, you probably don’t want to enter into a FFP contract with an affiliated entity.)
It also impacts how profit is calculated and billed to the government customer.
It is a fundamental precept of such transactions that profit is recognized once and once only, unless an exception applies. The performing entity should not apply profit to the transaction’s costs if the requiring entity is also applying profit to the costs. When the proposal is submitted, profit should be calculated once. When the invoices are submitted, profit should be calculated once.
Even if the affiliated entities each recognize profit for their own internal reporting purposes, the official submissions to the government have to comply with the applicable government accounting rules. Compliance may require separate accounting entries or off-sheet adjustments, which is fine. That’s why government accounting differs from financial accounting. Government accounting consists of knowing which adjustments to make, and why—and then being able to explain those adjustments to a government auditor.
So here comes a brief story of what happens when somebody gets it wrong, when somebody fails to comply with applicable government accounting rules. The story comes to us—as so many do—courtesy of the Department of Justice. Although the story is brief, the number of entities involved can make it confusing. Please try to pay attention to the players.
A joint venture, Mission Support Alliance, LLC (MSA) was formed to manage clean-up work at the Department of Energy’s Hanford nuclear weapons site. It is a huge effort, one that requires several contractors working together, to manage. Originally formed in 2008, by Lockheed Martin Integrated Technology, LLC, Jacobs Engineering, and Wackenhut Services, the entity now appears to be run by Leidos. (Apparently, MSA was transferred from LMCO to Leidos in 2016 as part of the sale of LMCO’s government services business.)
A couple of months after the deal between Lockheed Martin and Leidos was consummated, the DOE Inspector General issued an audit report that asserted that MSA had violated the terms of its contract and, among those alleged violations, had permitted an IT support subcontract to be awarded to Lockheed Martin Services, Inc. (LMSI) in which profit was (allegedly) counted twice. The DOE IG wrote—
The Department may have paid unnecessary fee or profit when acquiring IT support services. Specifically, we identified potential unallowable profit of more than $63.5 million. We determined this amount by comparing the costs incurred by LMSI from January 2010 through December 2014 to the actual amounts reimbursed to LMSI by various Hanford site prime contractors. Even though Federal Acquisition Regulation required that all noncommercial goods and services sold or transferred between affiliates were not subject to additional fee or profit, our analysis identified that profit appeared to have been included in rates charged by LMSI. Prior to contract award, the Department’s contracting officer determined that the IT services provided through the Mission Support Contract were not commercial. According to Richland Operations Office officials, paying fee or profit for subcontracted work performed by LMSI amounted to both Lockheed Martin controlled organizations (MSA and LMSI) receiving fee or profit for the same work. Federal officials also told us that paying LMSI fee or profit for such work resulted in payments that amounted to total markups on LMSI’s subcontracts in excess of its costs ranging from 1 to almost 7,000 percent. MSA disagreed with the Department’s findings on the LMSI subcontract. At the time this report was issued, the Department and MSA were engaged in the resolution process to address the issue.
In addition, the IG reported that the auditors “determined that several MSA executives also held senior executive positions within Lockheed Martin Corporation,” which “resulted in the appearance of a conflict of interest. Our review found that contracts may have been awarded that were not in the best interest of the government and that the department may have paid higher costs than were necessary and allowable.”
That was in 2016, and we assume the corporate entities resolved their issues because we can’t find any more about the situation.
But this is one of those times where individuals have been held accountable for noncompliance with Federal contracting and government accounting rules. Let’s continue the story.
As the DOE press release (link above) succinctly stated—
The Justice Department announced today that Richard A. Olsen agreed to pay $124,440 to resolve claims that he violated the False Claims Act by submitting inflated prices in connection with a subcontract between Mission Support Alliance, LLC (MSA), a prime contractor at the Department of Energy (DOE) Hanford Nuclear Reservation, and Lockheed Martin Services, Inc. (LMSI), a subsidiary of Lockheed Martin Corporation (LMC). … The United States alleged that under the terms of MSA’s contract with DOE, LMSI, as an affiliate of MSA, was not entitled to receive profit on the work it performed for MSA. The United States further alleged that Mr. Olsen, while he was an employee of LMC working for MSA, falsely represented to DOE that the LMSI subcontract did not include any profit. Mr. Olsen allegedly received a payment of at least $41,480 from LMC for obtaining DOE’s consent to the inflated LMSI subcontract. ‘This settlement requires Mr. Olsen to pay back three times the amount he received from the alleged fraud and holds Mr. Olsen accountable for his actions,’ said Joseph H. Harrington, United States Attorney for the Eastern District of Washington.
The Tri-City Herald had more details. In a story authored by Annette Cary, we learned that Mr. Olsen was Finance Vice President for MSA, operating as MSA’s Chief Financial Officer. According to the story, the DOE alleged that Mr. Olsen “received at least $41,480 in kickbacks from Lockheed Martin to improperly obtain or reward favorable treatment for the Lockheed Martin subsidiary. Olsen helped draft and submit false statement[s] to the Department of Energy regarding labor rates charged by Lockheed Martin and Lockheed Martin’s anticipated profit for providing IT services at Hanford … Prosecutors alleged that Olsen was involved with submitting false and inflated claims to DOE between March 2010 and Feb. 21, 2012, and received kickbacks during that time.”
Mr. Olsen agreed to pay three times the amount he allegedly received from LMCO and to cooperate with investigators. Which may mean that we were overly optimistic when we wrote, a few paragraphs above, that “we assume the corporate entities resolved their issues.”
Which brings us back full circle to the opening of this article: government accounting is hard; consequences for getting it wrong tend to be a bit onerous. Not only for contractors, but sometimes also for individual high-level employees.
We suggest that, before you assume you know what you are doing in the complex world of government contracting, you consider checking with somebody who knows, because you probably don’t want to get it wrong.
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Beware Fixed Price Development
Congress and many policy-makers in the Department of Defense would prefer that all government contracts be firm fixed-price (FFP) types. They are convinced that awarding FFP contracts reduces the risk of cost growth, because the contract price is “fixed.” And it’s not just the Federal government; many prime contractors will only award FFP subcontracts (typically via purchase orders that contain a standard set of boilerplate terms and conditions). If they award only FFP subcontracts then they don’t have to do a lot of reviews of accounting systems and they don’t have to do a lot of cost surveillance—or so they think.
They’re all wrong, of course.
If you award an FFP contract or subcontract, you should expect change orders—perhaps a lot of them. If you have changes to technical scope or schedule, you are very likely to see changes to the previously negotiated contract price. You may find that, ultimately, it’s more expensive and time-consuming to manage the change order activity than it would have been to have awarded a cost-type contract (or subcontract). If you counted on that FFP value in your at-completion estimates, then you may be blind-sided when that FFP value grows and grows and grows, because of changes to the program.
Government programs have changes. The bigger the program, the more the changes. The more technically challenging the program, the more the changes. If you think your government program will be the first program in history to have no changes, we bet you are wrong.
Our position is that a program change management strategy should be determined at program kick-off (or earlier). This is especially true for those deluded prime contractors who have a development or LRIP prime contract and have decided to “manage” costs by awarding only FFP subcontracts. We strongly suggest that those prime contractors have a change management plan, fully staffed and ready to go—because they are going to need it.
There was a time when everybody had learned the lessons from the A-12 program (and others), and we all pinky-sweared that development contracts would no longer be awarded (or accepted) on an FFP basis. When you don’t know what you’re going to design and produce, it’s very hard to provide a solid cost estimate as to how much it’s going to cost. We all knew that, and thus we all agreed that the appropriate contract type for development contracts was some form of cost-plus. The policy was enshrined in the FAR—
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“Complex requirements, particularly those unique to the Government, usually result in greater risk assumption by the Government. This is especially true for complex research and development contracts, when performance uncertainties or the likelihood of changes makes it difficult to estimate performance costs in advance.” (FAR 16.104(d).)
We all knew that and we pinky-sweared to follow the policy … but somewhere over the past decade or so we broke our oath. The government started awarding fixed-priced development contracts and contractors started accepting them.
Oh, they don’t call them fixed-price development. They call them “fixed-price-incentive fee” (FPIF) and they pretend to believe that the FPIF development contract is, somehow, different from the FFP development contract.
It’s not different. Not really. No substantively.
The FPIF contract creates the fiction that the customer is sharing in the cost-overrun (or underrun) risk. The FAR states “A fixed-price incentive (firm target) contract is appropriate when the parties can negotiate at the outset a firm target cost, target profit, and profit adjustment formula that will provide a fair and reasonable incentive and a ceiling that provides for the contractor to assume an appropriate share of the risk. When the contractor assumes a considerable or major share of the cost responsibility under the adjustment formula, the target profit should reflect this responsibility.”
But the conundrum is still there: how can you possibly negotiate a “firm target cost” or even determine a fair “profit adjustment formula” when you don’t have a design yet? It’s a complete gamble not fundamentally different from the gamble of an FFP development contract. It is almost certain that, for a pure development effort or even an LRIP situation, the contractor is going to overrun the firm target cost. It is very likely that the contractor will suck up all the government participation in the profit adjustment formula to cover its overrun.
And when the contractor has used up all the government’s participation in the profit adjustment formula, then the contract is no longer FPIF. Instead, going forward it’s a pure FFP contract. Every overrun dollar is to be covered by the contractor (absent change orders). Period.
Does this ever happen? Sure it does! Let’s revisit the most prominent example of FPIF development contracting: Boeing’s KC-46a Pegasus aerial refueler program.
We’ve reported on that program before. Over the years we have reported on how Boeing has recorded charge after charge against earnings. It’s become an annual refrain in the company’s quarterly earnings reports. In 2016, the company recorded a multi-million dollar charge. The same thing happened in 2017. A supplier (Cobham) even recorded a charge against earnings for its role in the program.
And now, here we are again. At the end of July, Boeing recorded another charge against earnings related to the KC-46a program. This time the company recorded another $426 million—nearly a half billion dollars—for “delays in the certification process as well as ‘higher estimated costs’ for incorporating needed modifications to six flight test and two early-build aircraft,” according to this story at DefenseNews, authored by Valerie Insinna. That same story reports that Boeing’s total charges against earnings is now $3.4 billion.
Let’s be very clear: Boeing was originally awarded a $4.8 billion FPIF development contract, a contract on which it has now used up all the government’s share of the overrun plus acknowledged another $3.4 billion in cost overruns. Had the contract been cost-type, the price would have roughly doubled from the original award value.
Thus the title of this blog article. Accept a FPIF development contract at your own peril. The investment you are prepared to make may not be the investment you end up making.
The Incumbent Contractor
Debates swirl regarding whether the incumbent contractor is in the best position in a recompete situation. Certainly, the incumbent knows the current situation better than any other competitor, and it knows exactly what it will take to perform on the new contract. The incumbent has built relationships with the government program office, and with the Contracting Officer’s Representative (COR). The incumbent has recent experience and, if the CPARS are good, that experience is going to look good to evaluators. So, yes. The incumbent contractor has a lot of advantages—assuming it’s done a good job on the current contract.
On the other hand, the incumbent contractor is locked-in to what it knows to be true. It has a workforce and it is pretty much locked-in to paying the wages it currently pays, and offering the benefits it currently offers. Competing contractors have freedom to propose lower wages and to offer lower benefits (if they can convince source selection folks that doing so won’t pose too much risk). Competing contractors have freedom to offer innovative—perhaps lower-cost—solutions, and that often works to their advantage.
We saw this effect most clearly when Stewart & Stevenson (which was then a subsidiary of BAE Systems located in Sealy, Texas) lost the $3 billion recompete for the Army’s FMTV trucks to Oshkosh in 2009. The BAE Systems subsidiary had participated in the original designs, and had been making those trucks for nearly a decade when the recompete happened. The workforce was well-trained. The supply chain was mature. Presumably, they were the world’s experts in those trucks. Yet they lost and the plant was shuttered, resulting in hundreds (if not thousands) of lay-offs.
Of course, the selection of Oshkosh was protested. We reviewed the protest in this article. (Sorry for the format problems. It was early days.) Of note was the “unrealistic” Oshkosh pricing—at least in the words of BAE Systems officials at the time. In fact, they called it “unbelievable.” And perhaps it was; there is no prohibition on offering prices that create a loss (see FAR 3.501). One source asserted that Oshkosh’s pricing was 30% below BAE Systems’ pricing, and relied on “financial aid from state and local governments” in order to make a profit. In addition, while BAE Systems had the necessary tooling to build the trucks, that tooling was actually owned by the Army and could be provided to Oshkosh. Consequently, the tooling issue was not as much of an impediment as it might seem at first.
Oshkosh’s low-ball pricing overcame perceived risks and the protests were not sustained. In fact, Oshkosh is still making FMTV trucks nearly a decade later.
Thus, sometimes the incumbent is at a disadvantage. It knows too much. Innovative approaches are discarded in favor of “the way it’s always been done.” Supplier prices are firm; workforce costs are firm. None of which apply to the competing contractors, who have a blank slate to propose anything—and any pricing—that they think will be attractive to evaluators.
And sometimes DCAA knows too much about the incumbent contractor.
The Defense Threat Reduction Agency (DTRA) issued an RFP to award a cost-type contract for support to the agency’s “Balanced Survivability Assessment” (BSA) teams. The RFP told bidders the evaluators would conduct a “best-value tradeoff” to select the winning bidder. Six proposals were received and CENTRA Technology was declared to be the winner. ENSCO, Inc., the incumbent contractor, protested, claiming that the agency “conducted an unreasonable cost realism evaluation.”
The GAO opinion reported –
Cost was not to be rated or scored, but each offeror’s cost proposal was to be evaluated for realism, reasonableness, and completeness. Realism was to assess whether proposed cost elements are realistic for the work to be performed, reflect a clear understanding of the requirements; and are consistent with the unique methods of performance and materials described in the offeror’s technical approach. Reasonableness was to be evaluated using one or more of the cost/price analysis techniques defined in Federal Acquisition Regulation (FAR) section 15.404. According to the RFP, ‘[i]n evaluating reasonableness, the Government will determine if the Offeror’s proposed costs and fee, in nature and amount, do not exceed those which would be incurred by a prudent company in the conduct of competitive business.’ The solicitation notified offerors that the agency will determine the most probable cost (MPC) by adjusting the offeror’s proposed cost and fee, when appropriate, to reflect any additions or reductions in cost elements to realistic levels based on the results of the cost realism analysis. The MPC was to be used to determine best value to the government, and was to represent the agency’s ‘best estimate of the cost of any contract that is most likely to result from the Offeror’s proposal.’
(Internal footnotes omitted.)
Readers will note that, when a cost-type contract is to be awarded, the proposed costs are not dispositive because actual allowable costs will be incurred and invoiced. Thus, the FAR requires a cost realism analysis and, if necessary, adjustment of proposed costs to reflect expected costs.
CENTRA’s adjusted costs were found to be $61.85 million, less than $100,000 higher than its proposed costs. ENSCO’s adjusted costs were found to $79.9 million, about $850,000 higher than its proposed costs. ENSO argued that the cost realism analysis was flawed. You’d think that any flaws wouldn’t add up to $18 million, but the GAO didn’t see it that way. The protest was sustained because the agency evaluators only adjusted costs (specifically labor costs) for which the DCAA provided audit findings. If DCAA didn’t provide any findings with respect to labor (or other costs), then they were not adjusted. In GAO’s view, that was not much of a cost realism analysis.
Further, which contractor do you think DCAA had the most information on? On which contractor’s audit report did DCAA have the most findings? If you said “the incumbent contractor” then you should step up and accept your prize.
The GAO decision stated—
The error, in our view, is the agency’s exclusive use of DCAA-verified rates, without any meaningful analysis of the direct labor rates that were not verified by DCAA. Since ENSCO was the incumbent contractor, many of its rates were adjusted to conform to the rates paid under its incumbent contract, which negated the firm’s proposed cost reduction. In contrast, only two of CENTRA’s proposed rates were adjusted, while the remainder of the firm’s proposed direct labor rates were apparently not scrutinized. The record does not reflect any analysis of non-DCAA verified rates, even though the agency had available to it rates proposed by other offerors, including the incumbent, for comparison. The agency also had available an IGCE, which provided the government’s own estimates of the cost for each position required under the solicitation. In this regard, a review of the IGCE shows that the government’s own estimates of direct labor costs were generally much higher than those proposed by CENTRA, yet the agency conducted no comparison, and made no MPC adjustments, even though the agency will bear the cost of these employees during performance of this cost reimbursement contract. Consequently, we cannot conclude that the agency’s exclusive use of DCAA-verified rates, without further explanation--and generally only for ENSCO--was reasonable. We also agree with ENSCO that the impact of the agency’s evaluation methodology resulted in disparate treatment of these offerors. Therefore, we sustain the protest on this basis.
(Internal footnotes omitted.)
In addition, GAO took issue with the evaluation of CENTRA’s labor rates. Apparently, CENTRA had bid labor rates 30 percent below ENSCO’s incumbent workforce rates—even though CENTRA’s proposal assumed that several of its key personnel would be recruited from ENSCO. “… the record shows that in evaluating CENTRA’s proposal, the agency attributed greater confidence to CENTRA’s proposal for its approach to attempt to recruit additional incumbent employees [DELETED] without analyzing the impact of CENTRA’s significantly lower direct rates on its ability to recruit incumbent personnel. … Without such an analysis, we cannot conclude that the agency’s finding was reasonable.”
In summary, the agency evaluators relied on DCAA audit findings rather than making a thorough cost realism analysis, as the RFP had promised. Because DCAA was more familiar with ENSCO, the incumbent contractor, it received more audit findings than did CENTRA. Those audit findings resulted in more adjustments to its proposed labor rates. Further, because the evaluators relied on DCAA audit findings, they missed a significant risk in CENTRA’s proposal. It’s proposal relied on recruiting incumbent personnel at rates significantly lower than they were currently being paid.
Thus our conclusion: sometimes the incumbent is in the best position; other times not so much.
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