At a time when defense programs are under growing pressure to control
costs and increase efficiency, it is important for the industry
to be attuned not only to customers’ needs but also to the
way government officials view contractors’ profits.
there is a widespread perception that defense contracts yield healthy
profits, in reality, the way government officials view profits can
be drastically different from the way industry measures that profit.
First, let’s review the basics. Firm fixed-price profit levels
can be whatever the awarded contract cost structure calls for. By
law, a typical “cost-plus,” fixed fee research-and-development
contract caps industry profits at 15 percent of the cost of the
project. Some are limited to 10 percent.
But no matter how the profit margin is determined, industry and
government see the margin differently. In one example cited by Jack
Cash, a professor of business management at the Defense Acquisition
University, a project with costs estimated at $9 million might come
with a $1.35 million profit fee, or 15 percent. The same contract,
as described by industry accountants, only shows a profit margin
of 6.53 percent, rather than 15 percent. The difference is attributed
to unallowable costs the industry must pay (such as interest on
loans, advertising and bad debt expense) and income taxes. These
take a huge bite out of the profit margin.
Government officials generally don’t see profit the way it’s
looked at in the commercial world, Cash points out. “The average
person working in a program office doesn’t see it.”
While the policy is structured to pay a reasonable profit, the perception
in government circles is that contractors are making far more than
what they are.
Under new policy guidance issued by the Defense Department less
than two years ago, contracting officers are being asked to change
the way they negotiate profits with industry, and are emphasizing
areas that traditionally did not factor into contractor profits.
Unlike previous practices, the government no longer rewards contractors
for investing in facilities or equipment. As a matter of fact, the
government wants to discourage industry from spending money on facilities,
and wants, instead, to increase the focus on technical innovation
and efficiency, notes Cash. In the past, he says, it used to be
that the government wanted to motivate contractors to invest in
manufacturing plants and buildings.
The new method for determining fair profits takes into account
the level of technical complexity in a program, and whether a company
is providing true innovation. During negotiations, a contracting
officer will ask questions such as: Is the company pushing the state
of the art? Is it buying things off the shelf? How complex is the
job to manage, to control costs? What is the company doing technically
that hasn’t been done before?
This approach marks a drastic departure from the way business has
been done thus far. The Defense Department, clearly, wants to ensure
that its money is spent wisely. One of the objectives of this approach
is to secure a fair profit margin for the contractor. “The
government’s profit policy is very sound,” says Cash.
Things like innovation, however, are hard to quantify. According
to Cash, it becomes a judgment call. A company, in fact, could convince
the government to boost the profit margin if it can demonstrate
Cost-efficiency is another new factor now coming into play. If
a company can show it can save the government money, the reward
could be a higher profit margin, also to be negotiated.
These so-called “weighted guidelines,” can work to
the benefit of the contractor. Companies negotiating a contract
always should fill out the Defense Department Form 1547, “Record
of Weighted Guidelines Application,” before entering negotiations.
Another technique that the government recently introduced is “performance-based
payments,” as opposed to guaranteed progress payments, which
cover the contractor’s costs.
Under the performance-based approach, the government and contractor
stipulate that a company will be compensated based on meeting specific
objectives, rather than with guaranteed payments. The benefit to
the contractor is that these performance-based payments can reach
up to 90 percent of the program costs, compared to 80 percent for
progress payments. That can make a big difference in the contractor’s
Another potentially exciting reason to move to the performance-based
payments is the opportunity to expand the defense contracting market
to commercial suppliers. With progress payments, only companies
that have defense-unique accounting systems can bid for contracts.
Now, commercial firms can bid on contracts, because the performance-based
approach does not require those accounting systems.
These are, obviously, complex issues that will require much study
and analysis on the part of industry and government. Contracting
officials, particularly, will need to learn how industry measures
profits and how contracts can be negotiated so that both parties
One issue potentially of great concern to NDIA members, however,
is the government’s new policy to discourage investment in
facilities and equipment. Although that would make sense from a
cost-efficiency standpoint, it has the potential to undermine our
nation’s manufacturing capabilities. With that in mind, the
defense industry needs a structured approach to managing facilities,
so that critical capabilities can be preserved, without saddling
the government with huge overhead costs.
Other observations are worth noting. First, not all program managers
use the “weighted guidelines,” even though it is the
methodology that the government recommends. Secondly, even when
the guidelines are used, a maximum margin is available to the contractor
of approximately 20 percent. When this is applied to the standard
income statement (and accounting for unallowable expenses), the
contractor will be lucky to achieve even half of that. Finally,
even though the law allows a 15 percent profit on cost-plus contracts,
we see some major programs imposing arbitrary limits below that.
We need to continue to emphasize that the defense industry competes
in the capital and human resource markets with all firms, including
the commercial sector. For the viability of the industry in the
long term, we need a fair and a competitive return for defense firms.
Please email me your comments to Lfarrell@ndia.org