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Thursday, March 1, 2018

Establishing Federal Government Compliant Small Business Systems

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I. INTRODUCTION

To effectively market a federal government contract a small business must sell on the basis of having a business system as well as technical performance infrastructure ready to run the job when a contract proposal is submitted. This dual requirement is where many small businesses fall short in their federal government contract start up planning.

Parallel thinking is required to plan for government project technical effort against a template of necessary business process infrastructure, driven by introducing Federal Acquisition Regulations (FAR) into the company. Key elements of the necessary business system infrastructure are discussed in this article which assumes that your are in the federal government services contracting business, that you plan to price your services at an hourly rate and sell them by labor categories with professional job descriptions to perform the government's statement of work and bill by the hour. This article also assumes that you are not contracting under FAR Part 12, "Commercial Contracting".

A. Labor Categories

Each skill set in the company must be specified and defined as chargeable directly to a contract, or indirectly to a cost center overhead, a material handling pool or a general and administrative pool. Each labor category must have a job description and a prospective salary range for proposal purposes.

B. Cost Center

A Cost Center is a single business entity within the company, organized for a group of business lines and clients with close similarities for technical and business management purposes. Cost centers are also driven by geographic location and the requirement to separate commercial from federal government business. Projects performed in government facilities may also require a separate cost center, since many of the associated expenses for such operations are born by the government. Cost centers usually have individual subsidiary ledgers, balance sheets and profit and loss statements and are summarized monthly to a company total. Each cost center must have job cost accounting for the contracts residing there and a cost center unique overhead rate.


Examples:

Commercial Cost Center

Federal Government Cost Center

Government Site Unique Cost Center

C. Annual Overhead Rate

An overhead pool is made up of individual Cost Center indirect expenses projected for a given year divided by the projected Cost Center direct labor dollars for that year to determine a rate. Typical Cost Center Overhead general ledger expenses are those which cannot be effectively charged direct to contracts. These include Cost Center management, building lease, telephone, fringe benefits, electricity, capital equipment, depreciation, and the like.

THUS: 2018 Overhead (OH) =

2018 Gen Indirect Exp for cost center =          $459,800
____________________________________ ______ = 110% OH Rate
2018 Projected Dir. Labor $for cost center = $418,000

The estimated annual Cost Center Overhead Rate is applied to direct labor cost estimates to price labor cost through overhead for 2018 for the Cost Center. When a contract is awarded, actual overhead expenses are allocated monthly to direct labor by contract on the basis of direct labor dollars incurred. Projected overhead rates are adjusted based on actual total cost center experience as the year progresses.

D. Annual Material Handling Rate (if required) - Corporate wide expenses specifically associated with buying, storing and shipping material for a given year divided by the projected direct material dollars projected company-wide for that year. Not all companies have business that is material intensive enough to warrant a separate pool for material handling. Where extensive buying or subcontracting is conducted out of the corporate headquarters and inventory and shipping labor are high, a material handling pool is permitted by the government when it is not administratively possible to charge these expenses directly to contracts.

The estimated annual Corporate Material Handling Rate is applied to direct material cost estimates to price material for all Cost Centers. When a contract is awarded, actual material handling expenses are allocated monthly to direct material by contract on the basis of direct material dollars incurred. The projected material-handling rate is adjusted based on actual total company experience as the year progresses.

E. Annual General and Administrative Rate (G and A) is corporate indirect expenses projected for a given year divided by the total projected direct cost plus overheads for all cost centers for that year. Typical G and A general ledger expenses include costs which cannot be charged direct to contracts or to cost center overhead expenses such as corporate executive management, headquarters building leases, legal expenses, company wide insurance, corporate advertising, and the like.

II. MANAGEMENT FACTORS

A. Success will be determined by managing the numerator in each of the above equations and winning or maintaining the projected direct cost programs in the annual denominator. If expenses increase due to unforeseen events or if the company loses more projects than planned in the annual denominator base, the associated rate will go up for estimating purposes and under cost plus or time and material contracts the rate billed to the government will also increase. Existing fixed price contracts under these circumstances will become less profitable. Pricing for future fixed price contracts must reflect the increased rates being experienced to avoid further losses.

B. Correspondingly, if expenses decrease due to unforeseen events/good management or if the company wins or grows more projects than planned in the annual denominator base, the associated rate will decrease for estimating purposes and under cost plus or time and material contracts the rate billed to the government will also decrease. Existing fixed price contracts will become more profitable. Pricing for future fixed price contracts must reflect the decreased rates being experienced.

C. For time and material and cost plus contracts, monthly billing rates utilized are "Provisional Rates" that the contractor is free to change based on experience as long as he informs contracting officers and the local Defense Contract Audit Agency (DCAA) of the changes and reasons for the changes can be demonstrated. Before time and material and cost plus contracts can be closed out, provisional rates must be adjusted to reflect actual rates experienced. The contractor will owe the government if provisional billings have been higher than actual cost history. Correspondingly, if the actual rates for cost plus or time and materials contracts have been higher than the provisional rates billed by the contractor, the government will owe the contractor at closeout. Firm, Fixed Price Contracts are not billed based on provisional or actual rates. They are billed at negotiated fixed prices by line item at contract award and paid upon final delivery and acceptance or through monthly progress payments based on incurred cost with a percent of payment retention by the government until deliveries are complete. Fixed rate contracts are billed on a monthly basis through hours incurred. The hourly rates are fixed for the contract term and do not change.

COST ESTIMATING/COST ACCOUNTING EXAMPLE

A. Consider an 12-month project priced in a hypothetical small business utilizing forward pricing "Provisional Rates." The contract begins in July of 2018 and continues to July of 2019. Direct labor rates are escalated between 2018 and 2019 by 3.5% based on the Consumer Price Index. The company decides to keep the indirect rates for Overhead and G&A the same for pricing purposes in 2018 and 2019. The company has no Material Handling Pool and charges purchasing, inventory and shipping costs direct to contracts.

B. This government contractor maintains Overhead and G&A rate databases in Excel by month by year to forward price projects such as the one in this example. The databases all utilize the same generic chart of expense accounts as a template for the Cost Center Overhead and G and A monthly expense forecasts (equation numerators). The project is priced in cost center 1 at an overhead rate of 110% and a corporate G and A rate of 10%.

C. Cost Center Direct Labor forecasts in the databases are projected by hours and salary dollars for each existing and anticipated project and then summarized to determine the equation denominator which when divided into the Cost Center Numerator B, above) yields the Cost Center Overhead forecast by month by year. Direct Labor is then burdened by the projected Cost Center Overhead and added to Material and Travel to yield a total Cost Center business summary through Overhead.

D. The G and A rate data base summarizes total direct labor through overhead, material and travel cost for all cost centers (equation denominator) and divides it into the total corporate G and A expense (equation numerator) The equation result yields the projected 
G and A rate by month by year. All cost center labor through overhead, material and travel are then summarized and burdened through G and A to forecast a total cost projection by Cost Center at "Provisional Overhead and G and A Rates.

E. A copy of the annual baseline projected rate database is adjusted with actual expense data each month in the numerator after closing. The denominator for the month is also updated with actual existing and new business developments at the cost center level and G&A monthly actuals at the corporate level. The resulting actual rate experience is then analyzed for trends as the year proceeds and utilized for making potential adjustments in provisional rates. When provisional rate changes are necessary, the government is notified in advance and provided with trend information justifying the rate change. Upon approval by the government, the baseline forecast is adjusted and utilized for billing on T&M and Cost Plus Contracts. The adjusted rates are also utilized to price all future projects. DCAA does not audit management decisions. They simply check the math.

F. Rate databases are usually fully detailed by month for the current year and 1-2 years into the future. Years 3-5 typically have summarized assumptions through use of escalation factors. Bids for out years 5-10 if required by the government definitely utilize escalation factors. Very few government contractors are willing to bid on a firm, fixed price basis beyond out year 5.

G. To comply with Cost Accounting Standards 401 and 402, this company must set up each new government contract on job cost accounting in the identical manner in which it was proposed; in effect identifying direct labor, direct material and other direct costs to each contract monthly and allocating overhead and G&A utilizing the same numerator and denominator relationships upon which the contract was originally estimated.

H. The larger the direct cost incurred on a contract in this company the greater the share of the cost center overhead and corporate G and A it will incur.

I. The entire content of this company's business system is subject to audit and verification by the Defense Contract Audit Agency (DCAA) against Cost Accounting Standards 401 and 402. DCAA validates company records by requiring "Incurred Cost Submissions" from this contractor. The submissions validate final rates for cost plus and time and material contract closeouts. Fixed price contracts are closed out when final delivery is received and accepted. Retention on monthly progress payments under fixed price contracts is released at closeout.

SUMMARY:

The software tools discussed in the December, 2017 posting at this blog DCAA AUDITS AND SMALL BUSINESS JOB COST ACCOUNTING SYSTEMS are designed to assist you in running the above process from a job cost accounting perspective. However, these tools must be set-up to reflect the unique way you are organized and they must reflect your specific business plans as discussed in this article. They will not do that for you.

Illustrations of the the rates, pricing and the long range plan utilized in the above example are available in Chapters 45 and 51 through 53 of my free book, "Small Business Federal Government Contracting" and appendices A and B. You may download the book and related documents from the "Box Net" Cube in the right margin of this site.

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