Previously, in our continuing series on selling to the government, we looked at contracting methods and the federal government's view of "fair and reasonable pricing." Let's now turn our attention to how the federal government deals with the financial and performance risks in contracting, which it addresses through contract type.
There are three main contract types: fixed-price, cost-reimbursable, and time-and-materials. The government can append incentives for good behavior to fixed-price and cost-reimbursable contracts, but not to time-and-materials contracts.
Fixed-price is the government's preferred contract type because it puts all the risk on the contractor. Fixed-price contracts are completion contracts, under which payment is contingent on delivery of a defined item or service. Because the price is fixed, the private sector takes full responsibility for all costs and the resulting profit or loss.
The government especially favors firm-fixed-price and fixed-price with economic price adjustment (FP-EPA) contracts when procuring commercial items. In theory, this works out great for everybody since commercial items should be the epitome of a well-defined item or service.
Contracting officers sometimes attempt to administer firm-fixed-price contracts as if they were level-of-effort contracts, which are meant for situations where vendors are paid for the amount of work they perform, as opposed to delivery of a specific good or well-defined service. The Department of Defense especially trains its acquisition workforce to favor fixed-price incentive and fixed-price redetermination contracts over cost-reimbursement or time-and-materials contracts wherever possible.
Cost-reimbursement contracts are level-of-effort contracts, mostly of the cost-plus variety -- that is, the government pays vendors their costs plus a "fee," which is how the government often refers to profit. Under level-of-effort contracts, the vendor is paid for work rendered irrespective of whether the intended goal gets accomplished.
The Federal Acquisition Regulation (FAR) bans cost-reimbursement contracts for acquisition of commercial items, so by definition these contracts are to be used when an agency cannot define its requirements with precision, or for when those requirements are out of the ordinary.
An inherent danger of even well-managed cost-reimbursement projects is "scope creep" -- an easy trap to fall into when requirements are inexact. And companies have an incentive to rack up costs despite the safeguards baked into the terms and conditions of cost-reimbursement contracts.
One such safeguard is a cap on vendor profit of no more than 10 percent of the contract's initial estimated cost, unless the work is for research and evaluation, in which case the margin is 15 percent, or for architect-engineer services, in which case it's 6 percent. It's illegal for the government to calculate a vendor's fee as a percentage of actual costs instead of initial estimated costs.
Yet safeguards can't control for some facts of life. Contracting officers extend contracts or raise contract ceilings, and rare is the company witnessing scope creep that does anything except go along or even encourage it.
NEXT: Cost Accountingclass>Keeping track of costs properly requires a robust government cost accounting system. A private-sector entity holding a federal cost-reimbursement contract is subject to government cost principles and might also be subject to federal cost accounting standards (CAS), which prescribe in great detail accounting methodologies.
A fully spun-up cost accounting system spans estimating, purchasing and earned value management and requires records retention, documentation and compliance with directions only expert accountants can stomach. Those standards are found in the FAR appendix, commonly referred to as FAR 99 because it reprints chapter 99 of Title 48 within the Code of Federal Regulations. Because federal cost accounting standards have no private-sector equivalent, most companies are rightly fearful of the expense and time it takes to set up a financial department capable of implementing them.
Accepting a cost-reimbursement contract does not automatically mean you must stand up a cost accounting system, however. For example, small businesses are exempt, even if they have a cost-reimbursement contract. Even large companies selling exclusively commercial items can skirt by without having to install and maintain a FAR 99 cost accounting system because commercial item pricing is based on a how a company sells commercially, not cost accounting.
Time-and-materials contracts also are level-of-effort contracts that share much in principle with cost-reimbursement contracts, but they have a few significant differences.
First, the hourly rate under time-and-materials includes company profit. This brings us to the second major difference between these contract types: because the labor-hour rate includes profit, the federal government doesn't separately incentivize good performance by tying profit to performance.
This means that contractors have the clearest motivation to bill for as many hours as possible, leading policymakers to perceive time-and-materials as the riskiest contract type. To mitigate that risk, time-and-materials contracts come equipped with a ceiling amount that vendors exceed at their own risk, although a contracting officer can increase the ceiling. Finally, the FAR doesn't exclude commercial items from procurement through time-and-materials contracts as it does with cost-reimbursement types.
To mitigate risk to the government, T&M contracts require reams and reams of documentation. Companies submit time cards and evidence that employees meet the labor category qualifications before a contracting officer will process payment. Time-and-materials contracts are also a favorite target for federal auditors, so companies with these contracts should be ready to justify every expense to a team of skeptical examiners who might show up one day to commandeer your conference room.
Federal contracting, as you've no doubt come to appreciate, can get complicated. Even contracting officers often are not fully aware of all of its complexities. So it's easy to slip into a variety of pitfalls. Working with people who understand the particulars is the best way to stay out of trouble.
This article was adapted and digested from the book "The Inside Guide to the Federal IT Market," published by Management Concepts Press. For more information, visit www.insideguidetofederalit.com. Steve Charles is a co-founder of immixGroup, which helps technology companies do business with government. He is a frequent speaker and lecturer on technology and the federal procurement process. He can be reached at Steve_Charles@immixGroup.com.
PUBLISHED JULY 3, 2013