CHAPTER 7

Profit or Fee

Profit and fee considerations in pricing are important concepts that must be understood by estimators and reviewers. Price is composed of two elements: (1) cost and (2) profit or fee, sometimes referred to as markup.¹ Although cost represents the larger portion of price, markup is at least as important to the contractor in negotiations. As used in the Federal Acquisition Regulation (FAR), profit pertains to fixed-price-type contracts and fee pertains to cost-type contracts.

Despite the precise regulatory use of these terms, they are used somewhat interchangeably in casual government contracting jargon. The true profit, or net income, for a contractor is what the business earns after deductions for unallowable costs and taxes and is usually referred to as net after taxes. Profit or fee prenegotiation objectives do not necessarily represent net income to contractors. Rather, they represent that element of the potential total remuneration that contractors may receive for contract performance over and above allowable costs.

THE FEDERAL ACQUISITION REGULATION

Contractors are not required to submit details of their profit or fee objectives or to follow a particular format or rationale in their profit calculations; government agencies, however, usually must follow structured procedures in evaluating proposed profit levels. Contractors may use the government procedures, and many, in fact, do. But even those that use a different technique would be wise to become familiar with the government’s procedures in preparation for negotiations.

Contractors also should be aware of statutory limitations on profit. As stated in FAR 15.404-4(c)(4)(i), a contracting officer may not negotiate a price or fee that exceeds the following statutory limitations, imposed by 10 United States Code (USC) 2306(d) and 41 USC 254(b):

It is important to note that these limitations are based on estimated costs, not actual costs. The relationship of profit to estimated costs may not exceed these amounts; however, the relationship of profit to the actual costs may result in a percentage greater than these amounts.

During World War II, Congress established the Renegotiation Board. The express purpose of this body was to review contracts and the profit or fee each had earned. In particular, the Board reviewed fixed-price contracts for “excessive” contractor profit. Needless to say, this body was not viewed fondly by the contractor community. The enabling legislation for the Board finally lapsed and Congress did not renew it. Fortunately, no such legislation exists today. The Renegotiation Board operated with only loose guidelines regarding what constitutes “excessive profit,” lost most major contractor appeals in court, and ultimately focused on smaller companies as being less likely to appeal their rulings. Unfortunately, some government personnel still improperly refer to excess or “windfall” profits—a concept no longer supported by any regulatory basis. Often the scenarios viewed as resulting in “windfall” profit were just as likely to have resulted in “negative windfall profit” (i.e., losses) that contractors had little or no avenue to rectify.

Although the FAR does not elaborate on profit guidelines, each agency has the authority to do so in its supplement to the FAR. The Department of Defense (DoD) has established its own guidelines, as has the National Aeronautics and Space Administration (NASA). The former guidelines emphasize performance risk, contract risk, and contract financing. The latter guidelines are similar but reduce profit objectives by the amount of cost of money claimed by the contractor. Most other agencies do not have formal profit guidelines. Unofficially, some agencies’ contracting guidance and contracting personnel seek little or no profit on consultant costs, subcontract costs, and other selected cost items. This is accomplished by negotiating prices that exclude profit on the items the contracting officer believes do not warrant a profit.

DEPARTMENT OF DEFENSE PROFIT GUIDELINES

DoD has published guidelines, commonly referred to as “DoD weighted guidelines,” for evaluating a contractor’s requests for profit or fee. The current fundamentals were established in 1987 as a result of a DoD profit survey, which found that the guidelines should focus on performance rather than cost elements (i.e., avoid rewarding contractors with profit based on how much money they spend or intend to spend).

Several minor revisions have been made since 1987. Most significantly, for a period of time in the 1990s no markup was allowed on general and administrative (G&A) costs—but this no longer applies. During the time that G&A did not carry a markup, many contractors properly reclassified costs from G&A costs to overhead costs.

The DoD weighted guidelines method, which is found in the Defense Federal Acquisition Regulation Supplement (DFARS) 215.404-70, is DoD’s structured approach for performing profit analysis in contract actions where the price is to be negotiated. From at least 1963 through 1986, the guidelines were based on the contract-estimated costs, often by cost element (e.g., direct labor, direct materials, and subcontracts). In 1987 the DoD guidelines were revised in response to congressional concern that previous changes to the regulations had created profit beyond a level that was warranted. The goal of the new guidelines was to lower profit.

The guideline changes in 1987 were significant. First, guidelines for manufacturing, services, and research and development contracts were no longer separate. Second, the guidelines attempted to decrease the reliance on estimated costs and to stress the technical aspects of the proposal when establishing the profit level. Third, the guidelines integrate the financing considerations involved in the contractual terms into the calculation of profit. In other words, they make the extent of progress payments a factor in determining how much profit will be earned. Fourth, the guidelines place greater emphasis on facilities capital. This emphasis is selective, in that certain assets will generate more potential profit than other assets.

An example of the DoD weighted guidelines method is presented in Illustration 7-1.

ILLUSTRATION 7-1: Record of Weighted Guidelines Application

Profit Objective

DoD contracting officers are required to use the weighted guidelines method or an alternative structured approach to determine the prenegotiation profit objective for any negotiated contract action that requires cost analysis, except on cost-plus-award-fee contracts. An alternative structured approach can be used for contracts less than $750,000 in value, architect-engineer contracts, construction contracts, contracts primarily requiring delivery of material supplied by subcontractors, termination settlements, and unusual situations. However, the alternative approach must specifically address the same four basic elements—performance risk, contract risk, working capital-adjustment, and facilities capital employed—used in the weighted guidelines method.

DD Form 1547, Record of Weighted Guidelines Application, implements DoD’s structured approach for performing the profit analysis necessary to develop a prenegotiation profit objective. It focuses on four profit factors: (1) performance risk, (2) contract-type risk, (3) facilities capital employed, and (4) cost efficiency.

The contracting officer assigns a value to each profit factor; this value multiplied by the base results in the profit objective for that factor. Each profit factor has a normal value and a designated range of values. The normal value represents average conditions on the prospective contract compared to all goods and services acquired by DoD. The designated range provides values based on above-normal or below-normal conditions. In the price negotiation documentation, the contracting officer need not explain assignment of the normal value, but should identify conditions that justify assignment of other-than-normal values.

Performance Risk

The performance risk profit factor addresses the contractor’s degree of risk in fulfilling the contractual requirements. The factor consists of two parts: (1) technical—the technical uncertainties of performance—and (2) management—the degree of management effort necessary to ensure that contract requirements are met.

Each factor is an integral part of developing the composite profit value for performance risk. The contracting officer weights each factor according to the contractor’s performance risk in providing the supplies or services required by the contract. Although any value may be assigned within the designated range, the maximum and minimum values will be restricted to cases where performance risk is substantially above or below normal. Exhibit 7-1 demonstrates how a weighted composite profit value for performance risk is calculated. The profit objective amount is computed by multiplying the weighted composite profit value, calculated by the contracting officer (4.6 percent in this example), by total contract costs, excluding facilities capital cost of money (FCCOM).

EXHIBIT 7-1: Profit Weighting for Technical and Management Risk

Contracting officers may use the alternative designated range for research and development or for service contractors when these contractors require relatively low capital investment in buildings and equipment compared to the defense industry overall. If the alternative designated range is used, no profit will be given for facilities capital employed.

Technical Risk

This criterion focuses on the contract requirements and the critical performance elements in the statement of work or specifications. Factors to be considered by the contracting officer include the technology being applied or developed by the contractor, technical complexity, program maturity, performance specifications and tolerances, delivery schedule, and the extent of warranty or guarantee coverage.

A higher-than-normal value may be assigned where there is substantial technical risk, such as when the contractor is: (1) developing or applying advanced technologies, (2) manufacturing items using specifications with stringent tolerance limits, (3) using highly skilled personnel or state-of-the-art machinery, (4) performing services and analytical efforts of utmost importance to the government and to exacting standards, (5) reducing the government’s risk or cost through independent development and investment, (6) accepting an accelerated delivery schedule to meet DoD requirements, or (7) assuming additional risk through warranty provisions.

Extremely complex, vital efforts to overcome difficult technical obstacles that require personnel with exceptional abilities, experience, and professional credentials may justify a value significantly above normal. A maximum value may be assigned when there is development or initial production of a new item, particularly if performance or quality specifications are tight or there is a high degree of concurrent development or production.

A lower-than-normal value may be assigned in those cases where the technical risk is low, such as when the contractor is: (1) acquiring off-the-shelf items, (2) specifying relatively simple requirements, (3) applying little complex technology, (4) performing efforts that do not require highly skilled personnel, (5) performing routine efforts, (6) performing on mature programs and procedures, or (7) performing follow-on efforts or repetitive-type procurements. In addition, a significantly lower-than-normal value could be assigned for routine services, production of simple items, rote entry or routine integration of government-furnished information, or simple operations with government-furnished property.

Management Risk

This criterion considers the management effort involved on the part of the contractor to integrate the resources (including raw materials, labor, technology, information, and capital) necessary to meet contract requirements. The contracting officer’s evaluation should: (1) assess the contractor’s management and internal control systems using contracting office information and reviews made by field contract administration offices or other offices; (2) assess the management involvement expected on the individual contract action; (3) consider the degree of cost mix as an indication of the types of resources applied and value added by the contractor; and (4) consider the contractor’s support of federal socioeconomic programs, such as support for small businesses and small businesses owned and controlled by socially and economically disadvantaged individuals.

A higher-than-normal value may be assigned in those cases where the management effort is intense, such as when the value added by the contractor is both considerable and reasonably difficult, the effort involves a high degree of integration or coordination, or the contractor has a substantial record of active participation in federal socioeconomic programs. A maximum value may be assigned when the effort requires large-scale integration of the most complex nature, involves major international activities with significant management coordination (e.g., offsets with foreign vendors), or has critically-important milestones.

A lower-than-normal value may be assigned in those cases where the management effort is minimal, such as when, in a mature program, many end-item deliveries have been made, the contractor adds minimum value to an item, efforts are routine and require minimal supervision, the contractor provides poor-quality or untimely proposals, the contractor fails to provide an adequate analysis of subcontractor costs, or the contractor does not cooperate in the evaluation and negotiation of the proposal.

A value significantly below normal may be justified when reviews performed by field contract administration offices disclose unsatisfactory management and internal control systems (e.g., quality assurance, property control, safety or security) or the effort requires an unusually low degree of management involvement.

The technology factor is primarily applicable to acquisitions that include development, production, or application of innovative new technologies. The technology incentive range (shown in Exhibit 7-2) does not apply to efforts restricted to studies, analyses, or demonstrations that have a technical report as their primary deliverable. The technology incentive range should be used when contract performance includes the introduction of new, significant technological innovation. Innovation may be in the form of development or application of new technology that fundamentally changes the characteristics of an existing product or system and that results in increased technical performance, improved reliability, or reduced costs, or a new product or system that achieves significant technological advances over the product or system it is replacing.

EXHIBIT 7-2: Profit Guidelines for Standard and Technology Incentives

Contract-Type Risk and Working-Capital Adjustment

This factor focuses on the degree of cost risk accepted by the contractor under varying contract types. The working-capital adjustment is an adjustment added to the profit objective for contract-type risk. It applies only to fixed-price contracts that provide for progress payments. Although it uses a formula approach, it is not intended to be an exact calculation of the cost of working capital. Its purpose is to give general recognition to the contractor’s cost of working capital under varying contract circumstances, financing policies, and economic environments.

The extract from DD Form 1547 shown in Exhibit 7-3 has been annotated to explain the process of calculating the cost of working capital.

EXHIBIT 7-3: Annotated Extract from DD Form 1547

Contract risk values for normal and designated ranges are shown in Exhibit 7-4.

EXHIBIT 7-4: Profit Objectives (Normal Values and Designated Ranges) by Contract Type Risk

The contracting officer should consider elements that affect contract-type risk, such as length of contract, adequacy of cost data for projections, economic environment, nature and extent of subcontracted activity, protection provided to the contractor under contract provisions (e.g., economic price adjustment clauses), ceilings and share lines contained in incentive provisions, and risks associated with contracts for foreign military sales that are not funded by US appropriations.

The contracting officer will assess the extent to which costs have been incurred prior to definitization of the contract action. The assessment will include any reduced contractor risk on both the contract before definitization and the remaining portion of the contract. When costs have been incurred prior to definitization, the contract-type risk is generally regarded to be in the low end of the designated range. If a substantial portion of the costs has been incurred prior to definitization, the contracting officer may assign a value as low as 0 percent, regardless of contract type.

A higher-than-normal value may be assigned in those cases where there is substantial contract-type risk, such as when the contract involves effort with minimal cost history, is long term without provisions protecting the contractor (particularly when there is considerable economic uncertainty), includes incentive provisions (e.g., cost or performance incentives) that place a high degree of risk on the contractor, or has foreign military sales (other than those under DoD cooperative logistics support arrangements or those made from government inventories or stocks) where the contractor can demonstrate that there are substantial risks beyond those normally present in DoD contracts for similar items.

A lower-than-normal value may be assigned in cases where contract risk is low, such as when the contract involves a very mature product line with extensive cost history, is relatively short term, contains provisions that substantially reduce the contractor’s risk, or includes incentive provisions that place a low degree of risk on the contractor.

Costs Financed

The costs financed on DD Form 1547 equal total costs multiplied by the portion (percentage) of costs financed by the contractor. Total costs equal all allowable costs, excluding FCCOM, reduced as appropriate when: (1) the contractor has little cash investment (e.g., subcontractor progress payments liquidated late in the period of performance); (2) some costs are covered by special financing provisions, such as advance payments; or (3) the contract is multiyear and there are special funding arrangements.

The portion financed by the contractor is generally the portion not covered by progress payments (i.e., 100 percent minus the customary progress payment rate). For example, if a contractor receives progress payments at 75 percent, the portion financed by the contractor is 25 percent. On contracts that provide flexible progress payments or progress payments to small businesses, the customary progress payment rate for large businesses should be used.

Contract Length Factor

The contract length factor is the period of time that the contractor has a working-capital investment in the contract. The factor is based on the time necessary for the contractor to complete the substantive portion of the work and is not necessarily the period of time between contract award and final delivery (or final payment). Periods of minimal effort should be excluded, should not include periods of performance contained in option provisions, and should not, for multiyear contracts, include periods of performance beyond those required to complete the initial program year’s requirements.

The contracting officer should use the following table (Exhibit 7-5) to select the contract length factor, should develop a weighted average contract length when the contract has multiple deliveries, and may use sampling techniques provided they produce a representative result.

EXHIBIT 7-5: Contract Length Factors

For example, a contractor is to be awarded a negotiated contract for assembly work. The contracting officer’s prenegotiation cost objective for each assembly is $500,000. The period of performance is 40 months, with assemblies being delivered in the 34th, 36th, 38th, and 40th month of the contract (average period is 37 months). The contractor will receive progress payments at 75 percent (contractor portion is 25 percent), and the current interest rate is 8 percent.

The contract length factor is obtained from Exhibit 7-5 (i.e., 1.15) and used in the calculations for Exhibit 7-6 below.

EXHIBIT 7-6: Calculation of Working Capital Adjustment

Facilities Capital Employed

This factor focuses on encouraging and rewarding aggressive capital investment in facilities that benefit DoD. It recognizes both the facilities capital that the contractor will employ in contract performance and the contractor’s commitment to improving productivity.

Exhibit 7-7 shows an extract from DD Form 1547 that has been annotated to explain the process.

EXHIBIT 7-7: Calculation of Facilities Capital Employed

This form can be completed only after application of the Cost Accounting Standards (CAS) Board form for computing the cost of money (see Illustration 6-1).

In addition to the net book value of facilities capital employed, facilities capital that is part of a formal investment plan should be considered if the contractor submits reasonable evidence that achievable benefits to DoD will result from the investment, and the benefits of the investment are included in the forward pricing structure. If the value of intracompany transfers has been included at cost (i.e., excluding profit), the allocated facilities capital attributable to the buildings and equipment of those corporate divisions supplying the intracompany transfers should be added to the contractor’s allocated facilities capital. This addition should not be made if the value of intracompany transfers has been included at price (i.e., including profit).

In evaluating facilities capital employed using the following table (Exhibit 7-8), the contracting officer should relate the usefulness of the facilities capital to the goods or services being acquired under the particular contract. The contracting officer should also analyze the productivity improvements and other anticipated industrial base-enhancing benefits resulting from the facilities capital investment, including the economic value of the facilities capital (e.g., physical age, undepreciated value, idleness, expected contribution to future defense needs) and the contractor’s level of investment in defense-related facilities compared with the portion of the contractor’s total business that is derived from DoD.

EXHIBIT 7-8: Normal Values and Designated Ranges by Asset Type

In addition, the contracting officer should consider any contractual provisions that reduce the contractor’s risk of investment recovery, such as termination protection clauses and capital investment indemnification. Also, the contracting officer should ensure that increases in facilities capital investments are not merely asset revaluations attributable to mergers, stock transfers, takeovers, sales of corporate entities, or similar actions.

A higher-than-normal value may be assigned if the facilities capital investment has direct, identifiable, and exceptional benefits. Indicators are: (1) new investments in state-of-the-art technology that reduce acquisition costs or yield other tangible benefits such as improved product quality or accelerated deliveries, (2) investments in new equipment for research and development applications, and (3) investments over and above the normal capital investments necessary to support anticipated requirements of DoD programs, as demonstrated by the contractor.

A value significantly higher than normal may be assigned when there are direct and measurable benefits in efficiency and significantly reduced acquisition costs on the effort being priced. Maximum values apply only to those cases where the benefits of the facilities capital investment are substantially above normal. A lower-than-normal value may be assigned if the facilities capital investment has little benefit to DoD. Indicators are: (1) allocations of capital applied predominantly to commercial product item line items; (2) investments for furniture and fixtures, home or group-level administrative offices, corporate aircraft, hangars, or gymnasiums; and (3) facilities that are old or largely idle. A value significantly below normal may be assigned when a significant portion of defense manufacturing is performed in an environment characterized by outdated, inefficient, and labor-intensive capital equipment.

Cost Efficiency Factor

The cost efficiency factor is a special factor that provides an incentive for contractors to reduce costs. To the extent that the contractor can demonstrate cost reduction efforts that benefit the pending contract, the contracting officer may increase the prenegotiation profit objective by an amount not to exceed 4 percent of total objective cost. These criteria are used to determine whether using this factor is appropriate (from 48 CFR 215.404-71-5):

NASA GUIDELINES

Agencies other than DoD often follow different guidelines in addressing profit. NASA, in the NASA FAR Supplement, takes an approach similar to the DoD method for a structured profit or fee objective.

Of special interest to contractors is NASA’s policy toward FCCOM. According to NASA regulations, when FCCOM is included as an item of cost in the contractor’s proposal, it may not be included in the cost base for calculating profit or fee. In addition, a reduction in the profit/fee objective will be made in the amount equal to the FCCOM allowed in accordance with FAR 31.205-10(a)(2). The regulations also state that CAS 417, Cost of Money as an Element of the Cost of Capital Assets Under Construction, should not appear in contract proposals. These costs are included in the initial value of a facility for purposes of calculating depreciation under CAS 414. Illustration 7-2 shows an example of the application of NASA profit/fee guidelines (NASA Form 634).

ILLUSTRATION 7-2: Structured Approach Profit/Fee Objective

OTHER AGENCIES’ GUIDELINES

Other agencies address profit and FCCOM in varying ways. In some instances, they have incorporated a weighted guideline type of approach. In other cases, the subject of FCCOM is addressed in the supplemental regulation; however, it is seldom addressed in actual contract negotiation. Accordingly, a potential government contractor should either review the pertinent regulations of the agency it will be dealing with or seek advice from a knowledgeable professional source.

The Department of Energy (DOE) does not have specific forms for profit/fee negotiations except in narrative form. Illustration 7-3 is an example of the application of DOE guidelines. DOE has additional guidelines for construction projects.

Other federal agencies often do not accept profit on various costs such as consultants, subcontracts, travel, and any other direct cost. These restrictions are not in the FAR Supplements of these agencies; however, the agencies’ internal guidance and solicitations do contain these restrictions. Some state and local governments also impose these restrictions on profit or fee.

Note

1. In some instances (generally in commercial pricing), the term markup includes indirect costs.

ILLUSTRATION 7-3: Example of Application of Department of Energy Guidelines