Defense Business: These Are Nervous Times for Contractors

By Sandra I. Erwin

Speaking to a room of government contractors recently, defense officials insisted that there is no witch-hunt.

Contrary to industry perception, government overseers are not hammers looking for nails, said Deputy General Counsel for Contractor Responsibility at the Department of the Air Force Rodney A. Grandon.

Grandon made a case that contractor policing is changing. The emphasis is not on trying to rack up the numbers of suspensions and debarments, he said, but on working preemptively with companies to make sure they have vigorous ethics and compliance programs.

“The focus today is no longer on numbers. The focus today is on contractor responsibility,” he told a federal procurement conference last month in McLean, Virginia, organized by the consulting firm BDO USA.

It is a fact of life that misconduct will occur, so the government is paying more attention to what companies are doing to prevent and respond in such situations, said Grandon. He commended federal contractors that have “invested in very robust advocacy and compliance programs.” The government counts on companies to self-police, he said. “Contractors must have in place procedures and willingness to engage government to take immediate steps when misconduct occurs. Our role is to buy down the risk for our acquisition community so they don’t have to worry that the contractor they’re dealing with has a lack of integrity or past performance problems.”

Senior officials from the Pentagon’s auditing and contract management agencies echoed that message, stressing that the government is not out to punish contractors and is seeking to work more constructively with the private sector. The Defense Contract Audit Agency last year arranged 74 seminars to help small businesses “demystify” government contracting, said Kenneth Saccoccia, DCAA deputy director. Federal procurement regulations are explained “step by step,” he said. “I think we have gotten great results from this. It all has to do with explaining expectations.”

Another bit of good news for contractors: The backlog of contracts under review at the Defense Contract Management Agency is shrinking from $53 billion a few years ago to $43 billion currently. “We are trying to get the number down,” said DCMA’s executive director for contracts Timothy Callahan.

Robert Craig, managing director of government contracting advisory services at BDO USA, said industry executives appreciate the collegial tone and positive message of these senior government officials. But noted that the business climate is much chillier in day-to-day contracting operations. Enforcement agencies are under pressure from Congress to show that contractors are being punished for misconduct. And auditors constantly have to prove they are challenging vendors over every penny of questionable spending billed under government contracts.

“The sentiment that I get from my clients is that the government is definitely out to get companies,” Craig told National Defense. The emphasis appears to be on “What can I uncover?”

In its latest report to Congress, DCAA highlighted its successful “return on investment” to the government, Craig said. This shows that challenging contractors’ costs is indeed a top priority. The environment is generally adversarial, Craig added. Despite high-level efforts to ease tensions between contracting officials and suppliers, the reality is that the “metrics are driven by what they uncover or question,” he said. The idea that the volume of suspensions and debarments is not considered a “measuring stick for success” doesn’t square with the fact that it is the metric most commonly used, said Craig. “What type of behavior does that drive? It drives people to suspend companies.”

New initiatives by the DCAA to educate companies are helpful, he said. “I think they are trying to create a kinder and friendlier image.” The agency wants contractors, especially small businesses that may not have in-house government contracting expertise, to become familiar with the standard form 1408, which is a checklist that DCAA follows to prescreen companies and determine if their accounting systems are acceptable to bid on government cost-plus contracts. These contracts require companies to undergo extensive audits of their expenses.

As compliance with federal procurement regulations becomes more intricate, industry watchers have been perplexed by the government’s increasing outreach to the technology sector in an effort to attract new vendors to the federal market. The Defense Department especially has made a full-court press in Silicon Valley, Boston and other hotbeds of innovation.
It is hard to see how companies set up to sell products commercially can navigate the regulatory maze, said Craig. “Innovation really requires nimbleness and flexibility, he said. “Operating in the government environment makes that difficult.”

Even the federal government’s most streamlined process for procuring technology — the General Services Administration schedule — is unloved by many companies because of its pricing policies.

The “price reduction clause” requires vendors to make sure that the government gets the same discounts on products and services as any other commercial buyer throughout the entire duration of a contract. “We’ve had significant cases where hundreds of millions of dollars have been paid back to the government because a discount was extended to a client and did not flow down to the government,” said Craig. “In order to successfully work in the GSA schedule a company needs internal controls to make sure they don’t violate the price reduction clause.” This is a “major concern for a commercial company that wants to sell to the government.”

The GSA recently floated the possibility to do away with the price reduction clause and, instead, to require vendors to provide sales data for the government to determine if it is getting fair and reasonable pricing. Craig said this proposal has not been well received in the industry.

Another issue causing heartburn in the contracting world is how the Defense Department decides whether a product is a commercial item and is fairly priced. “This is a widespread problem,” Craig said. Oftentimes the government challenges contractors to prove that a product is commercially sold and seeks documentation to back up a company’s assertion that the price is reasonable. “I’ve had several clients that have come to me with the same story: They provided products to the government for years as commercial items and now they’re being challenged.”

BDO consultant Derek Shaw said Pentagon rules on commercial terms were put in place for legitimate reasons but in recent years have been made exceedingly complex with new clauses. “It reflects the tension between wanting commercial companies in the marketplace and these other policy requirements,” he said. “The growing complexity is not consistent with the original intent of commercial items rules.”

Callahan, of DCMA, said the Defense Department buys at least $60 billion a year worth of commercial products. The issue for many contractors is how to deal with a growing category of items that have been sold in the past as commercial items but now are only offered to the government. That puts the burden on the company to provide sales and cost data to justify the pricing quoted to the government.

“The topic is getting a lot of attention,” said Callahan.

New rules have been drafted to comply with language in last year’s National Defense Authorization Act. Congress has pressed the Pentagon to simplify the contracting process to attract new entrants. NDAA provisions passed two years ago require the Defense Department to increase its staff of contracting experts with expertise in commercial item determination and pricing. DCMA operates a site in St. Petersburg, Florida, where cases are reviewed. The agency will be opening five new “centers of excellence for commercial item determination and pricing” in Boston, Philadelphia, Indianapolis, Denver and Phoenix.

The centers are expected to be ready for business by the end of June, said Callahan. They will be staffed by contracting and technology specialists to “help with the market research and understanding the manufacturing process” of products that the Defense Department buys, he added. “One of the challenges is finding experts that have the experience in commercial processes and techniques that industry uses. That is something we’re working on.”

The Pentagon intends to hire more pricing experts and train its existing workforce on commercial item determination. One of the toughest issues is how to articulate specific definitions of commercial items that can be applied consistently by contracting officers, said Callahan. Companies have complained that decisions have not been consistent.

“We have fairly robust debates,” he said. Officials are considering negotiating agreements with vendors that would commit a company to provide specific information to assist the government in making a commercial item determination. “We’re trying to sit down with suppliers to discuss what information they have that they are willing to share with the government,” Callahan said. “Some companies jealously protect pricing information. It’s something we’re trying to reach agreement on.”

At the root of disagreements over what products are really commercial are Pentagon concerns about being overcharged. Many vendors sell items to the government that no longer are bought by commercial customers, so the government will question how prices were determined. In sectors where there are few competitors, officers have little market information to do a proper price analysis so they ask for companies’ internal cost data. Some items fall into a gray area called “commercial of a type,” or products that are somewhere in between commercial off-the-shelf and custom made.

“That area is now under a lot of scrutiny,” said Craig. “What is the threshold before something is not a commercial item? A lot of companies are struggling with that today.” The government has to certify that a price is reasonable, he said, and the “pendulum has been swinging more and more in the direction of more scrutiny of commercial item determinations. They are asking for more information than they have in the past.”

Also causing anxiety in the industry are stringent requirements on prime contractors to monitor their suppliers and ensure they comply with new federal rules that could get companies banned or criminally charged. These include the use of counterfeit parts, human trafficking and minerals that come from conflict areas.  

Grandon cautioned that contractors have to worry about their supply chain. “How do you take what you can impose at the prime level and push it through the supply chain’s lower tiers?” he asked.

“That’s a huge challenge for contractors and for the government.”

These “flow down requirements” are troubling for many contractors that do not have the resources to monitor subcontractors, Craig said. “The onus is on the prime to determine if the subs have a robust monitoring process for human trafficking and counterfeit parts,” he said. “These are more complicated things than standard day-to-day operations. The pressure is on primes to staff up to audit and monitor their subs.”

Topics: Business Trends, Defense Contracting, Procurement

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