Some particulars in proposing T&M rates

[sakowitzm]

Company X, a small business, is eager to win an award on a T&M ID/IQ contract with an element of the Navy. Using industry-accepted salary survey data and their actual burden rates for fringe, overhead, and G&A, Company X develops their labor category rates for this bid. On review, they discover that when compared to other T&M contracts that this element of the Navy has let, Company X?s rates are 20% higher. In a desire to be competitive and win the single-award contract, Company X simply reduces their rates by 20% across the board. They do not have any "backup" that would show how they developed the submitted rates. Company X submits their proposal without any explanation of how they developed their rates, and wins the award.

Question 1. Has Company X done anything wrong?

Question 2. If Company X has done something wrong, what exactly have they done wrong?

Question 3. How will the Government come to learn that Company X has done something wrong?

Question 4. Following submission of proposals, and prior to award, is the Government allowed to require Company X to explain how they derived their rates? Is the Government allowed to do so following award?

Question 5. Suppose Company X has done nothing wrong. They have a great deal of success on the new contract, and a year later their revenue is now split ? 50% comes from cost-type contracts with the Army and 50% comes from this T&M ID/IQ with an element of the Navy. Since their bid rates on the T&M contract do not cover their actual costs for fringe, overhead, and G&A, Company X substantially raises their burden rates the following year. Moving forward, Company X?s Army contracts are now subsidizing Company X?s Navy contract. Is this a valid conclusion? Is this fair?

[Guest Vern Edwards]

Q1: I do not think that company X has done anything wrong by setting its labor rates below cost.

Q4: Well, there is no rule against asking for an explanation. The question is whether Co. X has to give one. Unless there is some clause in the T&M contract that I don't know about, I think the answer is no.

Q5: I don't know how underabsorption of indirect costs under a T&M contract would justify an across-the-board increase in indirect cost rates. Indirect cost rates should go up if the pool has increased relative to the allocation base or the allocation base has shrunk relative to the pool. I don't see how underabsorption due to below-cost pricing justifies an increase in rates. Co. X might be in trouble if it increased those rates without accounting justification in order to recover the underabsorption under the cost-reimbusement contracts.

[here_2_help]

Not too much to add to Vern's reply, except with respect to item/question number 5. I have a bit of a problem with the terminology used by sakowitzm in the original question, which I think was vague and ambiguous in any case.

I think we need to distinguish between "bid rates" and "billing rates". And "actual costs," as well.

In this scenario, Company X has agreed to T&M billing rates that are lower than its total costs would have normally led it to accept. So what? Company X's T&M contract still absorbed all costs allocated to it; it just agreed not to bill all of those costs in its billing rates. In other words, after contract award bid rates are irrelevant (except perhaps in a defective pricing dispute), and what matters are the billing rates that the parties agreed-to. Actual costs are always going to be actual costs regardless of what gets billed, in every situation.

In other words, there is no underabsorption in any case. Contract type has nothing at all to do with cost absorption. The Navy contract always absorbed its fair share of direct and indirect costs, and continues to do so.

A year later, after "a great deal of success," 50% of the company's revenue now comes from its Navy T&M contract. I would speculate that as Company X generates more and more revenue, the delta difference between its Navy contract total cost and the amount of revenue it generates through T&M bilings (i.e., "negative gross margin") would decrease, since I would expect actual indirect cost rates to trend down as the business base increases, thus approaching the agreed-to T&M billing rates.

To be clear, Company X's Army contracts do not now, nor have they ever, "subsidized" the Navy T&M contract.

[woops85]

Other things happen behind the scenes - (1) at annual raise time, employees on the Navy contract get a smaller percentage raise than their counterparts on the Army contract because the contract is a "loss leader". (2) People start leaving the Navy contract and the company tries to replace them with a much cheaper person in terms of direct labor rate so the load is closer to what it should be.

At least that's the way it worked at my old company when the boss slashed the rates on a T&M contract so he could win.

[Guest Vern Edwards]

here_2_help:

I misused the term underabsorbed overhead. Thanks for pointing that out. I should have said unrecovered overhead. However, you said: "The Navy contract always absorbed its fair share of direct and indirect costs, and continues to do so." You assume that the overhead costs were allocated properly. I don't think we know that as a matter of fact. The poster said: "Since their bid rates on the T&M contract do not cover their actual costs for fringe, overhead, and G&A, Company X substantially raises their burden rates the following year." I find that statement worrisome. Do you? Am I off the mark?

[woops85]

But if the company is performing cost plus work, it is getting approval on it's provisional indirect billing rates from someone. Don't see how it could increase all those rates based on not recovering all the costs the previous year. The auditor isn't going to allow it. And the Government should be getting a copy of the provisional rate letter to support the indirect billing rates. Those costs were incurred the prior year and you can't "add" the unrecovered costs from last year as an item in this year's projections. I think the company has just lost potential profit for the year in the long run. Granted you may not know until audited rates come back (in however many years they are behind)

[sakowitzm]

Thank you all for the discussion.

Vern Edwards: You are correct ? Company X does not recover all of their indirect costs, due to the fact that they slashed the T&M rates they bid, in order to win the contract.

Woops85: It was not my intent to suggest that Company X would try to recover last year?s costs through higher rates. ?Last year? is done and gone. My question was this. For the coming year, when preparing their provisional rates, the T&M revenue would only cover less than half of indirect costs; let?s say 40%. We know that if Company X proposes the same fringe, overhead, and G&A as last year, then their cost-type revenue with the Army would recover 50% of their costs. So would not/could not/should not Company X seek to raise their fringe, overhead, and G&A for the coming year, so that their cost-type revenue with the Army would recover the 60% not covered by the T&M revenue with the Navy? (Putting aside the negative ramifications of raising one?s rates substantially.)

There would not be an issue of ?justifying? the higher rates ? the costs are real, and the T&M and cost-type contracts are in place. Isn?t Company X entitled to set their rates at an appropriate level so that they recover all of their costs?

And thus, if this happens, the cost-type contracts with the Army would be subsidizing the T&M contract with the Navy???

TIA for your continued insights.

[Guest Vern Edwards]

The cost-type contract is not subsidizing the T&M contract if it recovers only those indirect costs that are properly allocable to it. If the rates applied to the cost-type contract are set to permit recovery of the indirect costs that are properly allocable to the T&M contract, then there is a serious problem. It is is being done intentionally, the problem could be extremely serious.

[here_2_help]

Vern's latest post (7:48 AM) is spot on.

sakowitzm's contention that a contractor can unilaterally raise its contractually set rates because it is not otherwise recovering allocable costs is incorrect. In this scenario, doing so would be equivalent to buying in with a subsequent attempt to get well. No. Company X bought into the original contract by establishing contractually fixed rates (the "T" part of the T&M billing) and must stay bought in throughout the life of the contract.

The error in the original post is being perpetrated and Vern's post of 11:15 AM corrects that error. Contracts professionals who are not strong in accounting need to understand the difference between cost accounting and billing. Cost accounting is what drives cost allocations, and is subject to various rules including CAS. Those rules demand (among other things) equitable allocations and consistent application. Under the rules, each contract (or "final cost objective") absorbs its fair share of costs and no more. Cost acccounting that violates GAAP, or CAS when applicable, or even the basic FAR Part 31 allocability rules, can result in unallowable costs. Cost accounting that intentionally violates applicable rules can easily lead to (as Vern says) "extremely serious" problems. For example, a Google search of the term "louis berger group fraud" would lead one to stories about a SWA contractor that just paid nearly $70 million to settle allegations that it intentionally mis-allocated costs to the detriment of the U.S. Government.

Cost accounting is cost accounting and billing is billing. Costs accumulate and, to the extent permitted by contract terms, are billed. We all need to avoid confusing the two concepts.

Finally, sakowitzm may wish to review FAR 31.205-23 ("Losses on other contracts"), which prohibits recovery of the "excess of costs over income" associated with one contract on another contract.

In sum, Company X cannot unilaterally set its T&M rates at a higher rate simply to get well when it intentially bought-in. If the contract permits out-year hourly billing rates to be set based on the contractor's actual cost experience--as opposed to being contractually set at the time of award or escalating at a contractually fixed rate--then in my view the contract is not T&M but is instead cost-type. If the contractor submits a Request for Equitable Adjustment asking the Contracting Officer for an increase, solely to cover its allocable indirect costs, then in my view the CO would be justified in rejecting the REA, citing FAR 3.501-2(a)(1).

[sakowitzm]

Thanks again for the discussion. I continue to learn. As is obvious by now, I am not an accountant nor a contracts person, nor do I play either of the above on TV.

If we may, let's go back to the original question.

The consensus of the answers is that Company X is fully entitled to bid rates that do not fully account for their costs.

So let me re-arrange the question just a bit.

Company X develops T&M bid rates, and then analyzes those rates against other existing contracts with the same customer.

That analysis shows that Company X could easily raise their bid rates 20% and likely still win the contract.

So this they do. They simply multiply all rates by 20%, submit their proposal, and win the contract.

Has Company X done anything wrong?

[Guest Vern Edwards]

A contractor can propose any fixed price or T&M labor rates that it wants to propose. The fixed price or T&M rates that it asks for need not bear any specific relationship to the costs of performance.

(However, multiplying initial bid rates by 20 percent (0.20) will not yield rates that are 20 percent higher. It will yield rates that are only 20 percent of the initial rates. If the contractor wants to increase a rate by 20 percent it should multiply the rate by 1.20.)

[here_2_help]

Has Company X done anything wrong?

Not necessarily.

Unless Company X told its customer that its proposed rates were based on its actual or projected costs. Then Company X lied--i.e., made a False Statement. That would be a problem for Company X.

Unless the contract action was subject to Truth-in-Negotiations Act, in which case Company X had a duty to disclose its actual costs even if it chose not to use them in establishing its proposed rates. If there was a duty to disclose but no disclosure was made, then Company X committed "defective pricing".

Otherwise, as Vern said, a company can propose whatever fixed rates it wants to. The Contracting Officer is supposed to review those rates and made a determination that they are fair and reasonable. If the CO says the rates are fair and reasonable, then they are, absent one of the situations I noted above.

Hope this helps.

[Guest Vern Edwards]

It is true that the contractor cannot lie about the basis for its pricing. But we must be clear -- TINA is a disclosure rule, not a price setting rule. The contractor must fully disclose and certify cost or pricing data under TINA, but TINA has no bearing on what the contractor can propose as a fixsd-price or T&M labor rate. It does not matter what its cost or pricing data say, the contractor can propose whatever prices or T&M labor rates it wants.

[sakowitzm]

Excellent! Thank you all very much.