Apogee Consulting Inc

Another Charge for the KC-46A

Nick Sanders

There was a time, 20 or 30 years ago, when awarding a firm, fixed-price development contract was against the law. The rationale for that position was easy to discern: how can you establish a firm, fixed-price for something that hasn’t been designed yet? You can’t, as the government kept learning over and over, to its chagrin.

It’s not sufficient to say “Hey, FFP! All the cost risk is on the contractor—so who cares how much the contract overruns?” For one thing, some of those contracts had authorized progress payments, so those contractors were getting paid for trying really hard. For another thing, change orders baby. You find yourself falling behind, you’re going to start looking for what’s changed since your proposal.

Finally: bailout. As Airbus experienced with its supply chain during the last global financial crisis, it’s sometimes better to reform the contract (at a higher price) than it is to put your suppliers into bankruptcy. The cost of finding another supplier is higher than bailing out the supplier you’ve got. For an example closer to home, remember that, in 1971, the U.S. Government gave Lockheed $250 million in guaranteed loans to bailout the contractor after cost overruns on a Navy contract threatened to bankrupt the company and put thousands of Americans out of work.

So the government learned its lesson: you cannot put all the financial risk on the contractor, simply because the contractor cannot shoulder all that financial risk. And then, after a decade or two (or three), the government forgot that lesson and decided that fixed-price contracting was the way to go, even for development programs where nobody knew how to price the work.

We have elsewhere recounted the story of how Boeing came to win the KC-46A aerial refueling plane development contract—now dubbed “the Pegasus.” We have also noted, from time to time, that the program is experiencing delays and mounting cost growth. For example, the last such article is here.

Now we are back, roughly a year later, to note that Boeing has taken another charge against earnings related to its Pegasus program.

In its Third Quarter financial analysis, Boeing noted that it had recorded another $329 million in charges related to the program. The charges were split between commercial and defense businesses, with defense taking $73 million and commercial taking the rest. A year ago, Boeing's rationale for the 2016 charge cited, among other things, “concurrency between late-stage development testing and initial production.” A year later, Boeing's rationale for the 2017 charge cited, “… incorporating changes into initial production aircraft as we progress through late-stage testing and the certification process”—which seems to us to be the same rationale year-over-year.

For those keeping score, Boeing is now at “roughly $2.9 billion” (according to one report) in pre-tax charges associated with cost growth on the $4.8 billion fixed-price-incentive-fee development contract whose point of total assumption was reached long ago. (Our math says $2.4 billion, not $2.9 billion, but who knows? The point is, it’s a big number. In fact, the overrun recognized to date is equal to at least 50% of the total contract value.)

Further, at least one KC-46A supplier has also recorded reserves associated with cost growth. In February 2017, Cobham recorded a $187 million charge associated with the program, citing “an onerous commercial arrangement” with Boeing.

As we said in 2016—

There are not very many defense contractors that could have afforded to fund nearly half the development cost of a new aircraft. Fortunately for all concerned, one of them is Boeing.

Tell us again why fixed-price development contracts are preferred these days?

We stand by those words today, a year later.

Department of Energy Might Pay for Overtime Associated with Training

Nick Sanders

Readers may recall we pointed out more than a year ago that labor costs associated with employee training were unallowable if incurred on overtime (FAR 31.205-44: “Overtime compensation for training and education is unallowable.”)

It doesn’t make much sense, because sometimes the scheduled work takes up the full work week, and the only time left is overtime. But there it is and contractors have been gigged by DCAA for getting it wrong, regardless of the circumstances involved.

We are pleased to note that the Department of Energy just issued a DEARS Class Deviation that permits (but does not require) a contracting officer to approve them in advance. If there is no advance approval, the costs remain unallowable. (The Class Deviation says they are “expressly unallowable.”)

When would a contracting officer consider approving use of overtime for employee training? The Class Deviation provides three circumstances that could lead to approved training overtime. Overtime may be approved when necessary to—

Meet essential delivery or performance schedules;
Make up for delays beyond the control and without the fault or negligence of the contractor; or
Eliminate foreseeable extended production bottlenecks that cannot be eliminated in any other way

So – good job DOE!

As has become the norm, DOE is ahead of DoD with respect to managing its contractors’ costs. We can only hope that the DAR Council gets tired of being the slow student in class, and starts taking similarly innovative common-sense steps.

Subcontractor Cost and Pricing Issues

Nick Sanders

This past week we delivered our first class in our new training offering, “Subcontractor Cost and Pricing Issues.” The temptation here is to make this article an advertisement for the course, but we’ll try not to do that. Instead, we want to talk about what made it work so well for the client who hired us to bring it to his plant.

It could have been a disaster. More than 80 PowerPoint slides, a couple of discussion questions, one exercise. Over a 6 hour period. Nine people in a conference room, plus 4 more on the phone, sharing the slides via their computers. Some people brought their laptops and checked email. Others were texting on their cell phones. There was an internal audit going on at the same time, and individuals were called out during the class to respond to auditor questions.

That sounds like a recipe for the training class from hell, right?

But somehow it all worked. Afterwards, our sponsor sent an email that said “Everyone really enjoyed the training today. It was right on topic ….” It all worked and it all worked better than we could have expected. The reason it all worked so well is found in the rest of the sponsor’s email. He wrote: “It was right on topic to get our team (Finance, Procurement and Contracts) fully understanding why the process works the way it does and why documentation is so important to prevent unnecessary delays during a DCAA audit.”

See that part we italicized above?

Yeah, that part about “team” – that’s what made the training work so well.

Normally, when you talk about a one-day class in “subcontractor cost and pricing issues” you think only the purchasing department would be interested. You wouldn’t normally expect the folks dealing with prime contract issues to be in the room; and you really wouldn’t expect to have Finance folks there. What value would they find in those topics?

But this defense contractor decided there were no silos when it came to knowledge and understanding. This defense contractor decided that, if it were going to bring in an outside trainer for a day, then it wanted to get maximum value, and so representative from many functions were invited to attend.

And that’s what made the training so much more powerful than we could have hoped.

The thing about subcontractor cost and pricing issues is that they are also very relevant to prime contract cost and pricing issues—especially when the prime contract requires certified cost or pricing data and DCAA expects you to perform cost or price analysis on your subcontractors as part of the process. And if you don’t do a good job supporting your determination that the subcontractor’s price is “fair and reasonable” then you run the risk that DCAA is going to challenge you and, perhaps, question your subcontractor payments as being unreasonable and therefore unallowable. Which gets the Finance folks very concerned.

We did the exercise where people evaluated a subcontractor’s proposed pricing. We identified missing data and we discussed how to better structure an RFP to instruct potential subcontractors on what information was necessary and how to provide it, to facilitate evaluations. Then we turned it around and discussed how the company could better provide its own cost or pricing data to government evaluators, so as to minimize questions and smooth the evaluation.

It was the dual nature of the issues that created the powerful learning experience.

Whatever issues you experience with subcontractor proposal evaluations and cost/price analysis, the chances are that your prime contract customers are also experiencing similar issues with respect to your own proposal. Their own cost/price analysis is suffering, not only from your “inadequate” cost/price analysis of your subcontractors—but also from your own estimating narrative and cost or pricing data. Many issues are intertwined and this particular class reinforced that concept in a big way.

Purchasing and estimating are intertwined. It’s hard to have an adequate system in one area if the other is inadequate.

Subcontractor and prime contract issues are intertwined. It’s hard to do one area well if the other is not doing well.

So kudos to this defense contractor for ignoring internal silos and for bringing in disparate functions in a roundtable discussion that clearly demonstrated that the government contracting field is highly integrated, and that a micro-focus on subcontractor issues without discussing prime contract issues is suboptimal.

Going forward, we are going to encourage our clients to bring representative from as many functions as possible to our courses, because doing so creates a lot of unexpected value. We think that’s called “synergy.”

Third-Party Accounting System Reviews

Nick Sanders

Accountant2 Many readers know that the government has options when it comes to audits that have traditionally been performed by DCAA. For example, draft 2018 NDAA language would permit contractors to engage independent CPAs to perform audits of contractors’ claimed incurred costs in their proposals to establish final billing rates. (Since the NDAA language isn’t final yet, it’s tough to be more specific about the details.)

Another option that is becoming more and more prevalent is the use of independent CPAs to perform audits of a contractor’s accounting system.

Now, you might think that this would be an inherently governmental function. You might think that the government would have a vested interest in performing these audits, since some contract types require a contractor to have an adequate accounting system in order to receive them. You might think that completion of an official “Standard Form” 1408 would be limited to government employees.

And you’d be wrong.

Having an accounting system that has been determined to be adequate for cost-reimbursement contracting is a competitive advantage. Turning that around, we see that the act of establishing an accounting system and having that system found to be adequate for cost-reimbursement contracting is a barrier to market entry. Those contractors that can overcome the challenge(s) are in the club and able to compete for awards; whereas those that cannot are left outside, looking in.

The fact of the matter is that contractors that want to compete for cost-reimbursement contracts need to have an accounting system that has been found to be adequate for such contracts—it is absolutely crucial and it must be done. Yet another fact is that DCAA won’t perform a review of a contractor’s accounting system just because the contractor wants the audit to be performed. DCAA only goes in at a contracting officer request, and a contracting officer only requests a review when the contractor is already a bidder in a competition. Thus, the contractor has to start the bid process, spending precious B&P dollars, without knowing whether or not it has an adequate accounting system. If it gets a pass from DCAA, then great! But if not, then all its efforts have been wasted. That’s a lot of uncertainty to take into a competition that is already an uncertain proposition.

Moreover, it’s not as if DCAA were a swift messenger. It’s not as if a DCAA auditor will come to the contractor and issue a report to the contracting officer that the accounting system is adequate (or not) within a couple of weeks. Normally these things take months. We would say that 60 days would be the absolute minimum, with 90 or 120 days being a more likely duration. In the meantime, both the contractor and the contracting officer are left in the dark, wondering what the auditor is going to say and not knowing. Many a government acquisition schedule could be blown while waiting for a DCAA accounting system adequacy report….

In response to that situation, many RFPs permit a contractor to engage an independent CPA firm to perform an accounting system adequacy review. The contractor can (and should) engage that CPA firm whenever it believes it is ready to have its accounting system found to be adequate. (Never mind that, technically, only a government contracting officer can make such a determination. Contracting officers overseeing a source evaluation and selection process are almost always willing to overlook that nuance and accept whatever the independent CPA is willing to say. It is, sadly, too often a “check-the-box” thing.) Many RFPs require a contractor to have an adequate accounting system, and many RFPs are agnostic regarding who performs the review.

Which is really good news for smaller contractors.

Looking forward, we can see a time when third parties perform reviews of all six contractor “business systems,” but that’s not the focus of this article. We’re talking about accounting system adequacy today, and how third party independent CPA firms can successfully substitute for DCAA in such reviews. (Note: Apogee Consulting, Inc. is not a CPA firm.)

Three caveats on having independent CPA firms perform an adequacy review of your accounting system (or any business system, really).

First, the term “independent” has meaning and is well-defined for such firms. Independent means independent. It means that the same CPA firm that does your bookkeeping and/or taxes cannot perform that review. It means that the same CPA firm that “attests” that your accounting system is adequate cannot help you remediate any internal control deficiencies or issues identified during that review. If you decided to engage an independent CPA firm to review your accounting system for adequacy, you must go find a new firm, one that has both the necessary skills and qualifications, and you must pay them to objectively assess the adequacy of the accounting system using the government’s criteria.

Second, the government’s criteria are not entirely objective and they are tiered. The lowest tier is the Standard Form (SF) 1408 criteria. In theory, when you engage an independent third-party CPA firm to evaluate your accounting system, that’s the set of criteria that should be used. However, DCAA has its own pre-award accounting system review program, and its criteria tend to bias towards the 18 official DFARS accounting system adequacy criteria found at DFARS 252.242-7006. To our way of thinking, those criteria apply only if you have that DFARS clause in your contract. The American Institute of Certified Public Accountants (AICPA) wrote the DAR Council years ago, expressing concerns with the subjectivity of some of the 18 DFARS criteria; but of course the DAR Council did nothing with that input. Thus, in a pre-award situation you would want to focus your independent CPA reviewers on the SF 1408 criteria, because it would be a more focused (and less expensive!) audit, and it would also be easier on them. That said, if you have the DFARS accounting system clause in your contract, you may want to engage somebody to look at your system using those criteria because you should want to know if there are any concerns or issues before DCAA shows up.

Third, the format of the independent CPA “attestation” report is very important. When DCAA issues a report, it does so using its impressive government letterhead, using a standard format. You should want the report of your independent CPA firm to look similarly official. Letterhead, sections, signature. You get it. The point is that the outside firm is substituting for DCAA, and they need to be as official as possible. That creates some measure of credibility in the eyes of contracting officers who need to find that somebody has found your accounting system to be adequate. If you don’t get an official-looking attestation report on letterhead, the value of that outside review decreases dramatically.

For a real-life example of what can go wrong, let’s look at a recent bid protest decision filed at the U.S. Court of Federal Claims, in the matter of FreeAlliance.com LLC v. U.S. (H/T to WIFCON.com.) FreeAlliance was a bidder for a National Institutes of Health (NIH). The RFP was specific regarding certain requirements. It stated that offerors “must have verification . . . of an accounting system that has been audited and determined adequate for determining costs applicable to this contract in accordance with FAR 16.301.”

According to the COFC decision—

NIH authorized offerors to provide verification by any one of four sources: (1) the Defense Contract Audit Agency (‘DCAA’); (2) the Defense Contract Management Agency (‘DCMA’); (3) any federal civilian audit agency; or (4) a third-party Certified Public Accounting (‘CPA’) firm. In the event any member of a CTA relied on a third-party CPA, the verification had to be on the letter head of the third-party CPA and certified by a CPA.

Finally, the verification instruction provided that the proposal must include:

[A] contact name and contact information (i.e., phone number, address, email address) of its representative at its cognizant DCAA, DCMA, federal civilian audit agency, or third-party accounting firm and submit, if available, a copy of the Pre-Award Survey of Prospective Contracting Accounting System (SF 1408), provisional billing rate, and/or forward pricing rate agreements.

FreeAlliance had an official DCAA audit report discussing the adequacy of its accounting system. However, its two team members (HealthTech Solutions and NISH Consulting) did not have a DCAA report; instead, they chose to engage third-party CPA firms to evaluate their accounting systems. According to the COFC decision—

Neither verification was submitted on a third-party CPA letterhead. Instead, both verifications were on a brief form, not furnished by the agency. The form recites that ‘[i]n support of the CIO-SP3 Ramp On proposal, the below company has been or is proposed as part of the Contractor Team Arrangement. Determination of compliant and adequate accounting system is marked necessary for performance under this subcontract. This form or representative certification is therefore [required].

HealthTech added that it used a “DCAA-compliant” accounting system and it had purchased a “DCAA-compliant” timekeeping system. It also noted that it had engaged a third-party to review the design of its accounting system controls. NISH Consulting said even less than HealthTech did. Readers should note that there is absolutely no such thing as a “DCAA-compliant” accounting system or timekeeping system. The most that can (or should) be claimed is that such systems can facilitate compliance with FAR requirements when properly implemented and consistently applied. Further, readers will note that neither HealthTech nor NISH Consulting complied with the RFP requirements.

Unsurprisingly, the FreeAlliance team was tossed from the competition. From the decision: “NIH noted that the verification ‘simply stated that the accounting system was found to be adequate; it does not state that the accounting has been audited and determined adequate for determining costs applicable to the contract in accordance with FAR 16.301-3(a)(1) as is required.”

Oops.

FreeAlliance filed a protest at GAO. It was not sustained. FreeAlliance then filed another protest at COFC. It’s protest was similarly not sustained. Let’s quote from the decision—

In the procurement process, the offeror is responsible for ensuring its proposal complies with the requirements of solicitation; the agency has no duty to correct an offeror’s mistakes during the procurement process. The RFP provided four options for verifying an adequate accounting system: DCAA audit, DCMA audit, a federal civilian agency audit, or a third-party CPA audit. The first two options demonstrate that the agency was seeking substance in its verification of an adequate accounting system. A DCAA or DCMA audit would be performed according to a standard that would assure the government that the offeror could adequately track and account for its costs under a cost reimbursement contract.

FreeAlliance itself elected to submit to a DCAA audit, which provided a detailed review of the adequacy of its accounting system to determine costs applicable to a contract.

On the other hand, FreeAlliance’s CTA members submitted verifications using the third-party CPA option. Any verification was required to provide that the system have been ‘audited and determined adequate for determining costs applicable to this contract in accordance with FAR 16.301-3(a)(1).’ In addition, when using a third-party CPA, ‘the verification letter shall be on the letter head of the third-party CPA firm . . . .’ Neither HealthTech nor Nish provided a verification on CPA letterhead. The origin of their verification forms is uncertain; FreeAlliance stated during oral argument that they were likely from a past solicitation.

… FreeAlliance had the responsibility of meeting the RFP requirements and now bears the burden to prove that the agency was arbitrary and capricious in excluding its proposal for noncompliance. We accept the government’s insistence on compliance with the letterhead provision, because the letterhead adds credibility to the third-party verification as contrasted with plaintiff’s form, which is devoid of any comparable authentication. Further, the agency did not act arbitrarily when it read HealthTech’s footnote to mean that the required verification had not yet occurred. HealthTech’s verification was noncompliant due to its lack of third-party CPA letterhead. When the format error is combined with the ambiguous, limited substance, NIH chose a reasonable response of deeming the verification unacceptable.

… Nish’s verification similarly lacks a CPA letterhead and provides no detail regarding the depth or type of review or that the system is adequate for determining costs applicable to the contract.

Due to the deficiencies, the agency’s review of this form was not arbitrary.

[Internal citations and footnotes omitted.]

So take this lesson to heart. If you decide to bypass DCAA—and there are definitely times when that would be the correct decision—make sure that you obtain from your third-party auditor a formal report on letterhead, one that establishes the work that was performed as well as the associated results of those efforts. If you fail to do so, you may have just wasted your money.

Directed Subcontracting

Nick Sanders

We’ve all been there.

The phone rings, or an email arrives, and it’s the COTR or the PCO and they want you, the prime contractor, to acquire a thing for the contract. You will acquire it and they will take title, and you can bill the cost along with your other costs and it will be paid.

Only you know and they know the item has nothing to do with the contract’s SOW.

They want a personal computer or a cell phone or an iPad, or maybe even a hibachi, because they have a need and they can’t get the item approved through normal government channels. So they do an end-run and have you acquire it for them.

They have the authority. The COTR and/or the CO have the authority to direct you to acquire stuff, and so you probably will, even though you know and they know they really shouldn’t be asking you to take these actions. But you do, probably in the name of customer relationships. After all, why would you want to upset these folks for such a trivial amount of money—even though there’s a risk that if anybody looks hard enough, you may have some ‘splaining to do.

What’s the harm? After all, the government ends up paying for it one way or another. Either through your contract or through some other agency appropriations. At the end of the day, there’s no harm and therefore no foul.

Right?

It’s not like somebody entirely unconnected to the contract, somebody in the Government agency finance function, called you up and directed you to acquire the thing and charge it to the contract. Because that would be weird, right? It would be weird to have this stranger call you, or email you, and tell you to go to a specified vendor and issue that vendor a P.O. to acquire a thing or two, and then pay the vendor for those things and then bill the prime contract for the cost.

That would be weird and you probably wouldn’t do it.

It’s one thing when the PCO or COTR ask you do to something, but it’s quite another thing when some stranger unconnected with your prime contract asks you to do something. So you probably wouldn’t do it.

Probably.

In completely unrelated news, a former Comptroller for the Navy’s Norfolk Ship Support Activity (NSSA) was recently sentenced for accepting illegal gratuities. (Ed. Note: Are there any other kind of gratuities for government employees?) According to the Department of Justice press release—

William R. Hutsenpiller, 57, of Mount Dora, Florida, oversaw the $200 million operating budget for the NSSA while serving as the civilian GS-15 Financial Department Head/Comptroller from October 2009 through November 2013. During this time, Hutsenpiller conspired with others to essentially force a government prime contractor to use a specified subcontractor—Global Services Corporation, based in Fayetteville, North Carolina—that he knew would collaborate with him to misuse government funds. As part of the scheme, Hutsenpiller directed the prime contractor to pass government funds to Global, a defense subcontractor, and in turn, Hutsenpiller directed Global to withhold unexpended funds that should have been returned to the government or to the prime contractor.

Apparently Global used the funds to, among other things, pay “illegal gratuities” to Mr. Hutsenpiller. The DOJ press release stated—

From 2010 through 2014, Hutsenpiller made numerous requests that Global provide him with various items of value and services for his personal use, which Global agreed to purchase with government funds. The gratuities that Global provided to Hutsenpiller included a variety of personal electronic items and accessories for Hutsenpiller and his family, such as cell phone service and accessories, multiple iPads, a computer, home thermostat, and streaming television boxes.

So this GS-15 guy told the prime contractor to award a P.O. to Global for stuff, and they did. (Possibly they alerted somebody, because the guy was caught. But the article doesn’t say how he was caught so we don’t know.) For four years, the prime contractor followed the direction of this stranger and funded a subcontract.

Why?

Why would you do that?

As noted above, we don’t know why and we don’t know if they tipped somebody off—but four years seems like kind of a lot to keep on following the direction of this stranger who was completely unconnected with the prime contract and who didn’t have authority to order the prime contractor to do anything. But that’s what the prime contractor did.

And now Mr. Hutsenpiller has been sentenced to 40 months in Federal prison and sentenced to pay approximately $70,000 to the taxpayers.

No word on fines or penalties to be paid by Global.

No word on fines or penalties to be paid by the unnamed prime contractor, who was just following directions from the government.

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Page 64 of 278

Another Charge for the KC-46A

Department of Energy Might Pay for Overtime Associated with Training

Subcontractor Cost and Pricing Issues

Third-Party Accounting System Reviews

Directed Subcontracting

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