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BUS315 Week 10 SolarCal Case Analysis

Government Policies Regarding Profit and Preferred Measure and Processing of Equitable Adjustments

Participants:

Sally- Intern

Dominic- CEO of SolarCal

Luke- Head of Productions

Jake- Head of Accounting/Finance

Melissa- Head of Government Contracting

Dominic: Welcome back Sally! I hope you enjoyed working with me last week and gained some valuable knowledge about the Facilities Capital Cost of Money we went over last week. This will also be your last week at SolarCal, we are really going to miss having you around.

Sally: Thanks Dominic, I’ve learned so much while I’ve been here and I’m excited for my final lesson! Who will I be working with this week?

Dominic: Since this is you last week here, I would like to work with you on some of the final key concepts related to the field of government contracting. I hope you are ready to conclude your internship and training!

Sally: I am ready to go and am looking forward to adding these last key tools to my cost and pricing analysis belt!

Dominic: That is fantastic! I thought we would start off with analyzing how profits are set by a company.

Sally: I believe I know a little bit about this topic. I recall that a company will set its profits based on whatever it believes it can get after considering the cost of doing the work. I know that when the market is highly competitive, the company will set an initial price based largely on what it believes its competitors would charge. The company will then examine its own costs to do the job and decide whether the profit that would result is worth the effort. I do wonder though what would happen if the market wasn’t highly competitive and the demand was low?

Dominic: That as great question! To answer your question, if the market is not highly competitive and the demand is high, the seller is motivated to get high profits. The only significant deterrent is that the buyers may choose to do without, seek substitutes, or aggressively develop competition.

Sally: That makes a lot of sense now! Thanks for clarifying that for me.

Dominic: Not a problem at all. Let’s now move onto misconceptions about profit and fees. Federal acquisition regulations point out a consideration sometimes misunderstood by government people who are negotiating cost, profit, and price. This misconception is that the negotiated profit or fee is what the contractor will actually get. When we negotiate a cost-plus-fixed fee contract, we typically think of that fee as a firm figure. Sally, who do you think pays the fixed-fee?

Sally: I believe it would be the government that will pay the fixed-fee in addition to the allowable costs. However, I recall that if the contractor incurs some costs that are disallowed, it takes a loss on those costs.

Dominic: Very good! One of the major areas of government contracting is detailed government policies. Keep in mind that federal acquisition regulations state that negotiation of extremely low profits, use of historical averages, or automatic application of predetermined percentages of total estimated costs do not provide proper motivation for optimum contract performance. Based on your schooling, what can you tell me about government contracting officers and their policies?

Sally: I know that government contracting officers must adhere to certain requirements. I also remember that contacting officers are required to use government pre-negotiation cost objective amounts as the basis for calculating the pre-negotiation profit objective.

Dominic: Excellent response! To elaborate on what you said, when calculating the profit or fee objective, the contracting officer is required to exclude any facilities capital cost of money that was included in the pre-negotiation cost objective.

Sally: Aren’t there also three statutory limitations used for prices or fees?

Dominic: Why yes and thanks for bringing that up. The first limitation is used with experimental, developmental, or research work under a cost-plus-fixed-fee contract, where the fee must not exceed fifteen percent of the estimated cost, excluding the fee. Secondly, for other work under a cost-plus-fixed-fee contract, the fee must not exceed ten percent of the estimated costs, excluding the fee. Lastly, for architect-engineer contracts, the contract price or the estimated cost plus fee must not exceed six percent of the expected cost of the public work, exclusive of the architect-engineer fee.

Sally: That is quite interesting! Could you tell me a little more about the six major factors used by agencies when they develop their structured profit approaches?

Dominic: I will gladly answer this question. You are correct, federal acquisition regulations list six major factors to be used by agencies in developing their structured profit approaches and they include the following:

Contractor Effort;

Contract Cost of Risk;

Federal Socioeconomic Programs;

Capital Investments;

Cost Control and Other Past Accomplishments; and

Independent Development.

Sally: That makes a lot more sense now. Aren’t there also certain approaches that can be used as well?

Dominic: Right you are! The first approach I want to share with you is the structured profit approach. Keep in mind that all of the structured profit guidelines take the same general approach. They establish a total profit objective by adding profit increments for various major cost inputs and for other contract factors.

Sally: Thanks for sharing that approach with me, I never heard of that approach being used. I however remember from school another approach; I recall it was the reasonable cost approach. I recall that there were two general principles used when measuring equitable adjustments. First, some cost impacts must result from the contract change. The second principle says that both parties, the contractor and the government, are to remain whole.

Dominic: Great job Sally! You seem to have a great understanding of that approach. Let me now tell you about indirect costs and profit in equitable adjustments. Overhead and general and administrative expenses are normally indirect costs associated with contractor work. However normal allocation rules cover the application of indirect costs to the equitable adjustment for a contract change. Keep in mind as well that an equitable adjustment is based on the changes in the contractor’s actual costs created by the contract change; although some indirect costs can also be relatively fixed.

Sally: Dominic isn’t profit specifically excluded from equitable adjustments resulting from suspension of work?

Dominic: You are quite right but also take notice that all other equitable adjustments include profit as a long- standing practice.

Sally: What can you tell me about the processing aspect of equitable adjustment? I know that ideally, the contracting officer and the contractor will work together to negotiate the price for the equitable adjustment – without resorting to the courts and the boards of contract appeals but I’m not too sure of much else.

Dominic: I think you have a great foundation for this topic but let me explain this topic to you a little more. It is good that you understand that the contracting officer and the contractor will work together to negotiate the price for the equitable adjustment, as this approach is quite effective for most claims for equitable adjustment. Keep in mind that the changes clause requires that the contractor submit its claim for equitable adjustment within thirty days after receipt of the change. The contracting officer can also extend this period if the circumstances justify doing so.

Sally: I think I have a better grasp of this concept now. I will definitely keep this in mind moving forward.

Dominic: Let me now tell you about timeliness and segregated costs. Make note that it is important to negotiate and settle change orders as soon as possible. These change orders can also be settled more quickly when their frequency is kept to a minimum. However, when there is a failure to negotiate and settle equitable adjustments soon after the directed changes there can be several negative effects.

Sally: I think I’m good on this first part of the importance of timelines. What about the segregated costs contractors use?

Dominic: I’m getting to that part now. Experienced contractors will try to segregate the costs for performing changed work. They usually accomplish this by assigning special accounting codes to those transactions attributed to the changed work. The contractor has a very strong case when their actual cost records clearly identify the direct costs related to the changed work. Also, actual costs are far easier to validate than estimates.

Sally: Thank you for going over that with me. I also recall that there are four approaches for establishing equitable adjustments in specific cases. I know the first approach is referred to as the reasonable cost approach. This approach attempts to keep the contractor in the same profit position on the unchanged work after the change than it was before the change. I also know that this approach should be used whenever accurate information is available concerning contractor costs affected by the modification.

Dominic: Very good! I will now talk about the second approach. The second approach is the total cost approach. This approach infers that all costs incurred in excess of the original estimate were attributed to the contract change.

Sally: The third method would then be the jury verdict method which is used when the contractor is clearly due an adjustment but there is no clear way to identify the associated costs for reasonable cost analysis. While using this method both sides attempt to isolate the costs identifiable with the change in such a way that a third party is able to pass judgment on their reasonableness and the general allow-ability of the adjustment.

Dominic: I will now explain the last approach that can be utilized. To begin, until 1963, reasonable value approach was the basis frequently used to estimate the change in contract value that resulted from the contract modification. This approach was tested and to a large extent rendered obsolete by the court of claims decision in Bruce Construction versus United States. As a result of the court of claims decision, the reasonable value approach has been replaced by the reasonable cost approach. Do you recall anything about the format for submitting proposals?

Sally: I actually know quite a bit about this topic. I recall that when submitting certified cost and pricing data, the contractor must follow the procedures delineated in Federal Acquisition Regulation 15.48, table 15-2, Instructions for Submitting Cost/Price Proposals. I also remember that this formal procedure is a methodical way to document the calculation of the equitable adjustment.

Dominic: To add on to your response, part three-b in this regulation provides instructions for calculating equitable adjustments specifically for change orders, modifications, and claims. In accordance with these instructions, the net cost of a contract modification is shown on this slide.

Dominic: Now I want to talk about an issue that we sometimes run into our program and we see prevalent in our field. Sometimes government action or inaction delays contract completion, extending the contract performance beyond the anticipated completion date. In many of these delays the contractor will incur additional costs during the delay period; as a result certain fixed overhead costs will continue even during the delay period.

Sally: Won’t the incremental overhead costs be unabsorbed in the absence of replacement work or an equitable adjustment?

Dominic: Fantastic question! The problem of unabsorbed overhead is a major source of court and board of contract appeals cases. There is no question that contractors incur extra costs during these government delays. When they do occur, the contractor must establish two major points. First, the government caused delays, entitling the contractor to an equitable adjustment. Secondly, the amount of the claim for the unabsorbed overhead is justifiable.

Sally: That makes a lot of sense now; your explanation definitely made things a lot clearer.

Dominic: I’m glad I could help clarify that for you. The last concept I want to go over with you is the Eichleay Formula. What do you know about this formula?

Sally: I recall that the Eichleay Formula is the most widely used method to find the normal fixed overhead allocable to a contract that is identified and expressed in terms of a daily rate. I also remember that the daily rate is then multiplied by the days of delay to arrive at the total amount of unabsorbed overhead.

Dominic: Excellent work Sally! To add to this, although, the basic Eichleay formula is widely used, unless it is appropriately adjusted, it may yield inequitable results. It is important for you to note that the basic Eichleay calculations are based on several assumptions which include:

Overhead costs include only fixed costs;

The contractor cannot replace the suspended work with other work;

There is a total work stoppage;

The cost of the delay is the same regardless of the percentage of contract completion; and

The facilities are operating at or near capacity.

This is everything I wanted to cover for our final week; I feel you are now prepared to go through your final weekly review of the main topics we covered this week.

Dominic: Eichleay Formula is the most widely used method to find the normal fixed overhead allocable to a contract that is identified and expressed in terms of a daily rate. The basic Eichleay Formula is widely used, unless it is appropriately adjusted, it may yield inequitable results. It is important to note that the basic Eichleay calculations are based on several assumptions which include:

Overhead costs include only fixed costs;

The contractor cannot replace the suspended work with other work;

There is a total work stoppage;

The cost of the delay is the same regardless of the percentage of contract completion; and

The facilities are operating at or near capacity.

Dominic: The Reasonable Cost Approach attempts to keep the contractor in the same profit position on the unchanged work after the change than it was before the change. This approach should be used whenever accurate information is available concerning contractor costs affected by the modification.

Dominic: The Importance of Overhead Analysis involves the government awarding a firm-fixed-price contract and then being committed to pay that price. Because overhead cost is part of the price, the government analysis of the overhead rate must be as precise as is possible under the circumstances. The purpose of the analysis is to come up with a bottom line price that is reasonable, remembering that we can never predict future costs with total accuracy.

Dominic: The Jury Verdict Method is used when the contractor is clearly due an adjustment but there is no clear way to identify the associated costs for reasonable cost analysis. While using this method both sides attempt to isolate the costs identifiable with the change in such a way that a third party is able to pass judgment on their reasonableness and the general allow-ability of the adjustment.

Dominic: Great work on the review materials. You did excellent and I think you really have a solid foundation for the concepts we discussed this week.

I would now like to summarize what we went over this week to fill in any gaps you may have had. Please feel free to add on to anything I say as we go through. I will start off our final weekly review.

Dominic: First, we learned about how companies set profits. You learned that a company sets profits based on whatever it believes it can get after considering the cost of doing the work. These profits are based on competitiveness of the market.

 

Sally: Next, we talked about a common misconception that negotiated profits or fees are what the contractor actually gets. I learned that this is because if a contractor incurs some costs that are disallowed, they take a loss on those costs. In effect, those losses reduce their profit for that work.

 

Dominic: Very good! Then, I went over the Structure Profit guidelines, which establish a total profit objective by adding profit increments for various major cost inputs and for other contract factors.

Sally: After that we learned about the two general principles for measuring equitable adjustments. First, we talked about equitable adjustments being made if the change causes an increase or decrease in the contractor’s costs or time of performance. Secondly, I learned that both parties, the contractor and the government, are to remain whole.

 

Dominic: I also told you to make note that profit is included as a proper part of an equitable adjustment. It is excluded from equitable adjustments resulting from suspension of work but otherwise, is still considered a long-standing practice.

 

Sally: Then, we recognized that change orders should be negotiated and settled as soon as possible and that a failure to do so has several negative effects.

 

Dominic: Glad to see you were paying attention. We later talked about the four approaches that are generally relied upon in establishing equitable adjustments and took a closer look at each

Sally: I definitely took notes when we went over that section, there was a lot of information I thought was important. I then defined the two major points that must be established when there is a delay caused by government action or inaction.

 

Dominic: The last thing we talked about was the Eichleay Formula, which is used to calculate unabsorbed overhead cost.

Sally: Thank you for the review Dominic and the many experiences I had while being your SolarCal intern. 

Dominic: It has been my pleasure to be working with you and the rest of the team is sad to see you go as well. I wish you the best of luck in your future endeavors and hope that you stay in touch.

I would now like for you to complete your final weekly discussion questions based on the key concepts we covered this week.

Take care Sally and we will definitely miss having you on our SolarCal team. So long!

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