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Government Contracting: Staying Profitable in a Tough Environment

BY JULIAN ROSENBERG
GOVERNMENT CONTRACTOR INDUSTRY PRACTICE LEADER
GRANT THORNTON LLP

All the data is flowing in the same direction – unfortunately, it’s not a good direction. That’s the take away on the trends uncovered by the 18th Annual Government Contractor Survey conducted by AGC of Minnesota member Grant Thornton LLP. Revenues are down. Margins are contracting. Indirect costs are up. And there are fewer awards.

The report spells out key factors in the deteriorating environment:

Judging by the results of this year’s survey, especially as it compares with previous surveys, the government contracting environment is becoming more challenging by the day. … Government contracting has become a high-risk enterprise; today, contractors face the usual uncertainties plus the additional pressure of more-stringent regulations, the strain of contractor government representative relationships, the shifting of political priorities including reduced defense spending, and increased government in-sourcing.

How can contractors stay profitable in a federal marketplace with such tough business conditions? Here are some of the critical challenges that contractors face and strategies for meeting them.

PROFITABILITY
The deterioration in contractors’ top and bottom lines is significant. Revenue from government contracts fell for 38 percent of surveyed companies, slightly above the 36 percent who reported growth. This result reverses the pattern of recent years, in which companies who recorded increased revenue far outpaced those with declines.

The decline in revenue has been accompanied by falling profits. Some 60 percent of contractors reported profit before interest and taxes at either zero or 1 percent to 5 percent of revenue. The high percentage of margin-pressured firms is notably above the percent levels in the last three annual surveys (37, 50 and 45 percent in the 17th, 16th, and 15th surveys respectively).

Meanwhile, indirect cost rates were up for 42 percent of respondents versus 39 percent in the prior year’s survey. Indirect cost rates stayed steady at 41 percent of companies and dropped at only 17 percent — significantly below the 23 percent who saw declines in last year’s survey.

Higher indirect costs in the face of declining profitability requires immediate action. At the same time that indirect costs are rising, so are salaries. What that suggests is that salaries of idle workers are driving up indirect costs.

Contractors must ensure their indirect costs do not get out of hand. Having people sitting on the bench just won’t work in this environment. Companies either have to reduce head count or find work for people wherever they can.

There are three possibilities for new business: (1) diversify within the federal government (i.e., seek more work from different agencies); (2) find more state and local work; and (3) look to the commercial sector.

Contractors’ business mix is moving in this direction, although at this point the decline in the federal market appears to be the major factor. Surveyed companies report that 84 percent of their revenue comes from the federal government, significantly lower than results of the previous six surveys, including 93 percent in the 17th survey and 94 percent in the 16th. Looking ahead, 19 percent of companies in the current survey expect growth from state business compared with 15 percent in the prior year’s report; 32 percent expect growth from the commercial sector versus 25 percent a year before.

OUT-OF-SCOPE WORK
About 85 percent of surveyed companies report that the government either frequently or occasionally requests they perform out-of-scope work without a contract modification.
Only 16 percent say they always refuse such requests.

The high level of out-of-scope requests will likely continue. With the uncertainties of sequestration, construction companies are going to see more and more requests for out-of-scope work — and not always by the contracting officers, who have the authority to ask for it. A lot of smaller contractors are essentially doing the work for free, because they don’t want to upset the apple cart by asking to get paid; they may also think they’ll get new business that way. But that’s not a good strategy. The government isn’t looking for freebies — what it’s looking for is to pay a fair price.

There are ways for a company as an organization to better respond to out-of-scope demands. Everyone on the job needs to be aware of the roles of different government employees — contracting officers, auditors, etc. — and what they can and cannot do. Field personnel usually aren’t in a position to make a decision about an out-of-scope request. They need to immediately elevate the decision to higher management.

Contractors should document the out-of-scope work in communications with the government in every way practical. These could be in contract status reports, emails, letters, or any other form of communication that is appropriate in the circumstances. In formal disputes, it is usually helpful to be able to demonstrate that the notifications of out-of-scope work were concurrent with work performance and made repeatedly as appropriate.

RELATIONSHIP WITH DCAA AUDITORS
Some 53 percent of surveyed companies think that Defense Contract Audit Agency (DCAA) audit conclusions are arbitrary and not appropriately referenced to procurement regulations. Moreover, 60 percent believe that the DCAA is inflexible and rarely receptive to contractor rebuttals.

When working with auditors, contractors should determine what kind of audit is being completed. Be sure that what they’re requesting is what’s needed to do this audit. Contractors don’t automatically have to give over what they are asked for. And when auditors give their findings and the changes they want to see, contractors should ask them why. Is a specific regulation not being met? Or is the recommendation just something that a particular office or auditor would like to see?

EXECUTIVE COMPENSATION
The survey asked companies to identify which costs were most frequently challenged by the DCAA during incurred-cost audits. Continuing the trend of the prior four surveys, by far the most frequently challenged cost is executive compensation. This type of challenge is most common in small- to medium-sized companies where the executive compensation tends to be below the statutory ceiling in the procurement regulations.

Executive compensation is a hot button issue everywhere. Companies need to prove that their top people are paid only what they’re worth. It’s easy for executives to appear overpaid in the public sphere: the president of a smallish company can make more money than the governor of a state. What doesn’t get mentioned is that the companies and their top people are taking on a lot of risk.

The way the federal regulations read is that, if your executive compensation is in line with the market, there shouldn’t be a problem. But you need to prove that. Contractors need to avail themselves of compensation studies to evidence that their compensation levels are comparable to those at similar companies.

TIMEKEEPING
Among the many opportunities for contractors to improve their operations, make sure people are recording all their time, and that the company is complying with all timekeeping rules and regulations. That may seem obvious, but more than a few employees are lackadaisical about accounting for all their hours. In a business so heavily focused on labor costs, and with the welter of federal rules and regulations, establishing timekeeping procedures and getting employees to comply with them is absolutely critical.

CONCLUSION
The message of this year’s survey is that conditions in the government contracting market are becoming more difficult by the day. Companies need to understand how this environment is affecting their business. To survive and thrive, contractors need to incorporate the “new normal” into their business planning and adopt their strategy for the challenges ahead.

Julian Rosenberg is a director in Grant Thornton LLP’s Government Contractor Advisory Services practice based in the firm’s McLean, Va. office. With more than 30 years of government contract experience, he advises clients and leads projects assisting government contractors to comply with the complexity of doing business with the federal and state governments. He can be reached at Julian.rosenberg@us.gt.com or (703) 637-4100.