Measurement Of Profitability Cost Plus Fixed Fee Contracts Accounting Essay

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Focusing on Federal Cost-Plus Fixed Fee (CPFF) projects employing employ Indirect Rate provisions, this paper challenges an established practice employed during internal corporate reviews of project performance (profitability). These reviews focus on Direct Margin as the primary performance metric in determining whether projects are performing well. Based on the premise that Direct Margin equal to or above the baselined budget results in higher potential for profit and for offsetting Indirect Costs, such as Overhead, projects meeting this metric are rewarded while those that do not are scolded.

Citing the regulatory criteria for Federal CPFF contracts with Indirect Rate provisions, this paper details how any increase or decrease in Direct Margin is nullified further down in the project financial statement through the actualization of Indirect Rates. In addition, it discusses how any shifts in the estimated amount of Direct Cost (Labor, Materials, Subcontractors and other Direct Expenses) are compensated by the client without modification of the dollar amount of negotiated Fixed Fee.

Through four sample projects, this paper establishes that EBIT (Earnings before Interest and Taxes) is a better indicator of performance (profitability) when reviewing these types of projects. Furthermore, in discussing the rules for Fixed Fees and Unallowable Costs, readers are guided through the process and shown that Unallowable Costs are the only source for reduced profit, and that, by executing work under budget, the percentage of fixed fee is increased and other intangible benefits may be realized.

Lastly, the discussion highlights the mathematical illusion encountered when multiple CPFF projects are executed during the same fiscal period and why it is important for reviewers to understand any gains or losses related to the execution of the scope of work are temporary, and in premise, are fully offset through the Indirect Rate actualization process.

Introduction

After attending a series of internal corporate performance reviews for numerous Cost-Plus Fixed Fee (CPFF) projects, under a Federal Defense Contract (Program), I was struck by the notion that the method used to evaluate project performance seemed ill-suited for these particular types of projects. The method employed focused on evaluation of Direct Margin (Total Revenue less Direct Costs) as a percentage of the contract value of the respective project. Although completely appropriate for many other types of government projects and most commercial projects, it is my contention that gauging project performance by focusing on Direct Margin ignores critical aspects of the projects associated with this particular contract: Indirect Rate adjustments and Fixed Fees.

Citing the process of Indirect Rate adjustments and highlighting the regulatory conditions governing fixed fees on Cost-Plus Fixed Fee contracts, I propose that focusing on EBIT (Earnings before Interest and Taxes), which is Total Revenue less Direct, Indirect and Unallowable Costs, is a much better indicator of project performance (profitability). And therefore, is more appropriate in reviews of projects executed under Federal contracts employing Indirect Rate adjustments and Fixed Fees, such as this particular CPFF contract. The intention is to concentrate strictly on internal company reviews of profitability and not to discuss the merits of day-to-day performance management through methods such as Earned Value Management.

Indirect Rates and Cost-Plus Fixed Fee Contracts

Federal contracts employing the contract clause requiring Certification of Final Indirect Rates entail submissions of proposed indirect rates (Overhead, Cost of Money and other General and Administrative expenses, as allowed by the contract) as well as actualization of those rates on an annual basis and at the end of the contract. [1] Although technically more complicated, the basic means of determining proposed indirect rates, for billing purposes, is accomplished by way of the contractor conducting an internal assessment identifying the total of actual (approved) indirect charges incurred, as a percentage of the total direct billable labor hours or labor dollars (for the same period), from prior years' historical data; G&A calculations may be based on allocation base other than labor, if deemed more relevant. [2] The percentages of indirect rates are then reviewed and modified as necessary to account for changes in the current contractor indirects' business structure, assuming the differences are significant enough that they will result in a sizable disparity when rates are actualized later in the project; the idea being, to be as close as possible to the actualized rates.

The proposed rates are then certified by the contractor and submitted to the Contracting Officer (or another assigned Federal agency official). After a thorough review, and modification if deemed appropriate and mutually agreed by the contractor and Contracting Officer, the rates are approved for billing. Over the course of the contract, the billable indirect rates may be revised as needed, again with the mutual approval of the contractor and the Federal Client's representative. [3] 

As the respective project moves forward, the contractor performs an internal audit of the actual indirect expenditures incurred during their fiscal year. With the indirect rates actualized, the contractor performs a comparison of the charges previously billed to the client, based on the proposed indirect rates, and what the billing charges would be if the contractor were to re-bill all of that fiscal year's charges with the actualized indirect rates. The variances documented from the comparison are broken out by project and detailed as highlighted in the terms of the contract, and then submitted to the Contracting Officer as an adjusted Indirect Rate billing. The government's agent(s) reviews the submittal, and if approved, the invoiced amount is paid (or credited). If the revised rates were not approved, the contractor and the government's representative discuss the findings and work to resolve any issues so that the adjusted indirect rates may be invoiced.

For the purpose of this argument, it is assumed that the internal review results in revised rates that are accepted by the Contracting Officer and that the Indirect Rate adjustments are invoiced and paid (or credited), as required. The net effect to the contractor, for this project/contract, is that the contractor sees no loss or gain from the indirect effort associated with the performance of this project/contract, with the exception of unallowable costs (per the terms of the contract).

With Indirect Rates explained and their significance to the contractor defined, in terms of accounting for the indirect effort required to support these types of contracts, let us focus on the contract provisions associated with performance of Cost-Plus Fixed Fee contract's where indirect rates are applicable.

Cost-Plus Fixed Fee (CPFF) contracts are cost reimbursable contracts with a negotiated fixed fee. [4] When seeking to execute a scope of work under a CPFF contract, the government opens the proposed effort to bids from contractors, who, in turn, submit their estimates for the scope of work defined in the bid documents. Once awarded, the project budget is established based on the approved (negotiated) estimate submitted by the respective winner, for that specific scope of work. During the execution of the project, if the scope of work requires more effort than initially estimated, the contractor will work with the Contracting Officer to adjust the budget to allow for the completion of scope. If less effort is required to complete the scope of work, the unexpended portion of the budget is un-funded and the government saves money as compared to the initial estimate. In either case, the negotiated fixed fee (dollar amount) of the respective CPFF project remains unchanged. Fixed fee is only changed when the scope of work is altered. Therefore, the fee earned, as a percentage of the estimate at completion, may increase, decrease or remain unchanged depending on the performance of the contractor.

Although often written off as a cost of doing business, Unallowable costs play an extremely important role in the measurement of performance on contracts governed by Indirect Rate provisions with negotiated Fixed Fees. Unallowable costs are expenditures that the government does not allow to be charged to the contract or charged via indirect rates. Put simply, the government defines unallowable costs as those costs that are not reasonable or allocable given the scope of work. [5] Other factors apply in the determination of allowable and unallowable costs, but the premise is that only costs deemed relevant to the execution of the scope should be reimbursed by the government. Knowing which costs are allowable and unallowable, the contractor has full control of the amount of unallowable charges incurred by a project. If the project incurs unallowable costs while performing the scope of work, then those costs come out of the project's bottom line as reduced EBIT; please note however, that unallowable costs have no effect on Direct Margin.

Discussion of EBIT and Direct Margin; Employing Various Project Scenarios

Central to the argument that EBIT is a better indicator of performance than Direct Margin, one has to accept that on CPFF projects, with an Indirect Rate provision, that EBIT will always equal the negotiated fixed fee less any Unallowable costs (following Indirect actualization). To support the premise of EBIT being a better gauge of performance, four project scenarios are discussed: two of the projects focus on comparing self-performing either more or less work than originally estimated while the other two sample projects compare the results of finishing either under or over their respective budgets.

Table 1 (below) compares two projects: Project A - where more work is self-performed than originally estimated, and Project B - where less work is self-performed than originally estimated.

Table 1 - Comparison of Projects Where Self-Performance of Work Varies

Following the financial picture presented in Table 1, Project A and Project B both have Revenue [Budgets] of $100 with a negotiated Fixed Fee of $6 each. The Fixed Fee, for each project, as a percentage of the Total Revenue is 5.7%. Each project compares the original (base-lined) budget, on the left of the respective project, to the actual performance, on the right of the respective project. Project A was originally scoped to subcontract most of the effort while only self-performing a small portion of the work. Looking at the Direct Margin for Project A, it is obvious that self-performing more work results in higher Direct Margin. Project B presents an opposite result, where less work is self-performed, and therefore, the Direct Margin is lower than estimated, as are the billable Indirects. This occurs because any subcontracted effort includes that subcontractor's respective indirect costs associated with the performance of their work. When accounting for the subcontracting effort, the contractor lists the subcontractor's costs (direct and indirect) as a Direct Cost to the contractor. When work is self-performed, the contractor segregates their Direct and Indirect Costs. As more work is self-performed the applicable Direct Margin is increased, as are the amount of billable Indirects.

Focusing on Direct Margin, Project A appears to have performed better and provided more contribution to the company for coverage of Indirect Costs and potential profit. From the perspective of long-term planning (forecasting), Direct Margin is important, especially on Fixed-Price Contracts. The company relies on those initial estimates of Direct Margin to determine how much money will be available as contribution towards indirect costs with any remainder flowing further down the financial statements in the form of potential profit. In the performance reviews of the Cost-Plus Fixed Fee projects, such as those that I attended, projects producing less Direct Margin (than forecasted) were often scorned while those producing more Direct Margin were rewarded. From the perspective of long-term planning, producing less Direct Margin is a matter for concern. However, not underrating the worth of Direct Margin as it relates to planning, Direct Margin, as a measure of performance on CPFF projects, is flawed because CPFF projects employing Indirect Rates nullify the effects of contribution margin.

Looking back to the process of Indirect Rate adjustments, recall that Indirect Rates are calculated by applying the actual (allowable) Indirect Costs incurred, by the contractor, to the actual amount of Direct Labor. As more work is self-performed, the pool of Direct Labor increases and the actual Indirect Costs incurred by the firm are spread over a larger amount of Direct Labor, resulting in smaller percentages of billable Indirect Rates. In the end, the contractor must apply those lowered percentage of Indirects to the actual hours previously billed, which is likely to result in an adjusted Indirect Rate invoice owing a credit to the client.

Unlike other types of contracts, any additional Direct Margin gained on CPFF projects, with Indirect Rate provisions, does not result in additional profit. Prior to the annual and/or final Indirect Rate actualization, the company may show temporary gains (or losses), but the process of actualizing the Indirect Rates is meant to reverse any such gains or losses. Acknowledging that it is important for projects to meet their forecasts for Direct Margin, the concept of rewarding CPFF projects that produce higher Direct Margin is questionable since exceeding the projections of Direct Margin ultimately does not result in any greater contribution or potential for profit for the contractor. In fact, the only aspect of project execution that alters the potential for profit is control of Unallowable Costs. On CPFF projects, project profit (EBIT) is strictly a function of managing Unallowable Costs.

If the actualization and adjustment of previously billed Indirect Costs nullifies the value of Direct Margin as a measure of performance, then it makes sense that performance reviews should focus on a project's ability to improve bottom-line contribution for the contractor. In Table 1, when Projects' A and B are examined further, one can see that the only line-item capable of reducing potential EBIT is the deduction for Unallowable Costs. Assuming no Unallowable Costs are incurred, both Projects' A and B produce EBIT of $6 or 5.7% of the Total Revenue.

Table 2 (below) presents Project C and Project D, which provide a comparison of CPFF projects where one finishes under its' original budget and the other finishes over its' original budget.

Table 2 - Comparison of Projects Completed Under and Over Budget, Respectively

As previously discussed, if a project requires more funding to complete the original scope of work, the contractor must work with the Contracting Officer to revise the budget, while the negotiated Fixed Fee (dollar amount) remains unaltered. If the contractor requires less budget to finish the scope of work, any unexpended budget is de-scoped; the negotiated Fixed Fee (dollar amount) still remains unchanged and the client incurs a savings.

As with Project's A and B, Project's C and D both have Revenue [Budgets] of $100, along with negotiated Fixed Fees of $6, or 5.7% of the Total Revenue. In this example, maintaining the budgeted proportion of self-performed work, Project C accomplishes the required scope of work using only $60 of the allotted Revenue [Budget]. By completing the required effort with less direct resources, Project C suffers a 40% reduction in Direct Margin, as well as a reduction in the amount of associated billable Indirect charges. Project D, faced with challenges, requires $40 of additional Revenue [Budget] to complete the scope of work. Working with the client to revise the budget, the contractor completes the work for $140 plus the original Fixed Fee of $6, which is still unchanged. Unlike Project C, Project D's Direct Margin increases by 40%, as do the associated Indirect charges that are billable to the client.

Judging project performance, based on Direct Margin, it appears that Project D is more successful than Project C in the amount of contribution margin available to the contractor for Indirect costs and potential profit. If it were not for the fact that both of these Projects are executed under a CPFF contract with an Indirect Rate provision, these results would have Project C being scorned while praise is lavished upon the Manager of Project D. Realizing that the results of Project C and Project D each alter the size of the Direct Labor pool for which actualized Indirect charges are applied, one should now recognize that Project C's smaller pool of Direct Labor will lead to a revised Indirect billing requesting additional reimbursement, while Project D leads to a billing credit. In both cases, any initial gain or loss from more or less Direct Margin is nullified through Indirect actualization.

It is important to note that the process of actualizing Indirect Rates affects all contracts bound by Indirect Rate provisions and that the revised billable Indirect Rates are applied to all contracts active during that contractor's respective fiscal year. In the examples of Project's C and D, if these are the only active projects for this contractor, the process of actualizing the Indirect Rates will result in actualized rates that exactly match the proposed rates used in previous billings. This occurs because the 40% decrease to the Labor pool caused by Project C is fully offset by the 40% increase of Project D. In this scenario, the figures presented in Table 2 will remain unchanged once Indirect Rates are actualized. The offsetting affect of these two projects, leads the project reviewer(s) to conclude that Project D provided additional contribution while Project C performed poorly. In reality, this is a mathematical illusion and it is critical that anyone performing performance reviews understand the underlying factors related to the actualization process.

If Project's C and D were executed, with no overlap, in two different fiscal years, the influence of Indirect Rate adjustments would be obvious; the reduced size of the Labor pool caused by Project C results in an adjusted Indirect billing requesting more money, while Project D's larger Labor pool leads to lower revised Indirect Rates and an adjusting billing that issues a credit to the client. In each case, any potential gain or loss of contribution is nullified by the Indirect Rate adjustment process. As a matter of assessing performance, if the person(s) reviewing the project understands the implications of Indirect Rate adjustments, then they free their attention to focus on other tangible and intangible aspects of project performance, such as the benefit to the contractor in controlling Unallowable Costs, and certainly as important, the favorable impression on the client when completing a project under budget.

Referring back to the examples of Project's C and D, it is assumed that no unallowable costs are incurred; therefore, Project C earns 100% of the $6 Fixed Fee. As a percentage of Total Revenue, the EBIT for Project C is 9.1%, which is a 60% gain over the original EBIT of 5.7%. As a percentage of Total Revenue, with no Unallowable Costs, Project D's EBIT is reduced to 4.1%, or a reduction of 28%. When reviewed for project performance, and when the reviewer(s) account(s) for the (absolute) effect of Indirect Rate adjustments, it is apparent that the performance of Project C provides the greatest benefit, in terms of profit (EBIT), to the contractor.

In all four of the sample projects, the least discussed, yet arguably most crucial element, are Unallowable Costs. Unallowable Costs are the determining factor for project profitability. Regardless of the level of effort required to complete the scope of work, it can be assumed that the costs associated with executing that effort will be fully reimbursed by the client on a CPFF contract with Indirect Rate provisions. This leaves EBIT as the only true means of providing profit to the contractor. Knowing that EBIT is equal to Fixed Fee less Unallowable Costs, the process of reviewing a project's performance may be directed primarily at the Unallowable Costs incurred in the execution of that project with less emphasis on Direct Margin.

Conclusion

Although acknowledged as important in the aspect of planning and in evaluating the execution of work, Direct Margin, as a performance metric, ignores two fundamental elements associated with Cost-Plus Fixed Fee contracts (where Indirect Rate provisions apply): Indirect Rate adjustments and Fixed Fees. As demonstrated in the four example projects, in the interim period(s), prior to actualization of Indirect Rates, projects do see gains and losses related to Direct Margin. However, with contracts guided by Indirect Rate provisions, the government (in premise) is ensuring that all (reasonable) indirect support provided to that contract is fully reimbursed and that no gains or losses result from the execution of that effort. Recognizing that any gains are losses are temporary, it is incumbent upon the reviewer to understand the implications of Indirect Rates adjustments and Fixed Fees, in absolute terms, on Cost-Plus Fixed Fee contracts.

Additionally, reviewers must also be aware of the mathematical illusion created when actualizing Indirect Costs for multiple CPFF projects in a given fiscal year. By understanding the effect of Indirect Rate adjustments on Direct Margin, the interim gains and losses, which are often seen as the focal point, lose their distractive quality, leaving the reviewer to focus on more important aspects, such as: shifts in subcontracted effort, control of Unallowable Costs or the intangible benefit of improved client relations when a project is executed more favorably than estimated.

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Regardless of whether the scope of work is completed over or under budget, the contractor will be fully compensated for all (allowable) indirect effort related to the execution of that contract. Recognizing this, it seems more than reasonable to conclude that EBIT is the best measure of performance (profitability) on Cost-Plus Fixed Fee projects guided by Indirect Rate Provisions.

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