Ch 11 - Analyzing Profit or Fee

• 11.0 - Chapter Introduction
• 11.1 - The Factors Affecting Profit/Fee Analysis
  • 11.1.1 - Identifying The Need For An Agency Structured Approach
  • 11.1.2 - Considering Contractor Profit Motivation
  • 11.1.3 - Identifying Factors To Consider
• 11.2 - Developing An Objective Using The DoD Weighted Guidelines
  • 11.2.1 - Applying The DoD Weighted Guidelines
  • 11.2.2 - Identifying Exempted Contract Actions

11.0 Chapter Introduction

This chapter identifies points that you should consider as you analyze contract profit/fee.

Requirement for Profit/Fee Analysis (FAR 15.404-4(b)). Profit/fee is the dollar amount over and above allowable costs that is paid to the firm for contract performance.

Most contract prices include either profit or fee, but contract profit/fee analysis is not required unless cost analysis is required to determine contract price reasonableness. When cost or pricing data are required, you must use profit/fee analysis to determine the reasonableness of any profit/fee included in the contract price. When cost information other than cost or pricing data are required, you may need to use profit/fee analysis to determine the reasonableness of any profit/fee included in the contract price.

Actual Profit/Fee May Vary (FAR 15.404-4(a)(1)). As you perform your profit/fee analysis, remember that (just as actual costs may vary from estimated costs) the contractor's actual realized profit/fee may vary from negotiated profit/fee, because of such factors as:

• Contract performance efficiency;
• Incurrence of unallowable costs; and
• Contract type.

11.1 Factors Affecting Profit/Fee Analysis

This section presents the general factors that you must consider when analyzing profit/fee as part of a contract cost analysis.

• 11.1.1 - Identifying The Need For An Agency Structured Approach
• 11.1.2 - Considering Contractor Profit Motivation
• 11.1.3 - Identifying Factors To Consider

11.1.1 Identifying The Need For An Agency Structured Approach

Each Agency Must Use a Structured Approach (FAR 15.404-4(b)). FAR only prescribes the factors that must be considered in establishing the profit/fee objective. It does not prescribe specific Government-wide procedures for profit/fee analysis.

Each agency making noncompetitive contract awards over $100,000 that total $50 million or more each year, must use a structured approach for determining the profit/fee prenegotiation objectives in those acquisitions that require cost analysis. An agency may develop its own structured approach, or use another agency's structured approach if that approach will meet its needs.

Exemptions May Be Authorized Where Approach Is Inappropriate (FAR 15.404-4(b) and 15.404-4(c)). Agencies may exempt certain types of contract actions from the application of the agency's structured approach to profit/fee analysis. However, even in situations exempted from application of your agency's structured approach, you must follow the general FAR requirements for profit/fee objective development.

Examine your agency's guidelines to determine what specific exemptions apply.

11.1.2 Considering Contractor Profit Motivation

Underlying Assumption (FAR 15.404-4(a)). The underlying assumption behind Government structured approaches to profit/fee analysis is the belief that contractors are motivated by profit/fee. Structured approaches provide a discipline for ensuring that all relevant factors are considered in developing Government profit/fee negotiation objectives.

Profit/Fee Analysis Goals (FAR 15.404-4(a)(2)). It is in the Government's best interest to offer contractor's opportunities for financial rewards sufficient to:

• Stimulate efficient contract performance;
• Attract the best capabilities of qualified large and small business concerns to Government contracts; and
• Maintain a viable industrial base to meet public needs.

Inconsistent Practices Regarding Profit/ Fee Reward (FAR 15.404-4(a)(3)). If the Government is to use profit/fee to motivate contractor performance and achieve the above goals, practices primarily intended to reduce profit/fee or diminish the impact of profit/fee analysis are not in the Government's best interest. The following are practices that are inconsistent with Government profit/fee goals:

• Negotiations aimed at reducing prices by reducing profit/fee without proper consideration of the profit function.
• Negotiation of extremely low profits/fees.
• Use of historical average profit/fee rates without regard to the unique circumstances of the immediate negotiation.
• Automatically applying predetermined profit/fee percentages without regard to the unique circumstances of the immediate negotiation.

Profit/Fee Ceiling (FAR 15.404-4(a)(3) and FAR 15.404-4(c)(4)). Profit/fee calculations must consider the unique circumstances of the immediate negotiation. However, contract fee cannot exceed statutory limits that apply to cost-plus-fixed-fee contracts as identified in the following table:

11.1.3 Identifying Factors To Consider

Factors That Must Be Considered (FAR 15.404-4(d)). While each agency is responsible for developing its own structured approach, the FAR stipulates factors that must be considered unless they are clearly inappropriate or not applicable.

Other Profit/Fee Considerations (FAR 15.404-4(c)). The factors identified above form the basis for agency structured approaches to profit/fee analysis. There are two other elements that you must consider when developing Government profit/fee objectives.

• Eliminate Facilities Capital Cost of Money from the Profit/ Fee Base. FAR requires that you base profit/fee prenegotiation objectives on the prenegotiation cost objectives. However, you must exclude any dollar amount for facilities cost of capital before applying profit/fee factors.
• Consider Basic Contract Profit/Fee for Contract Modifications. FAR requires that you consider profit/fee objectives based exclusively on the contract action being negotiated. The only exception is the negotiation of contract change or modification.
  • When you negotiate contract modifications, you may use the basic-contract profit/fee rate as your negotiation objective rate if both of the following conditions are met:
    • The contract modification is for the same type and mix of work as the basic contract.
    • The modification is of relatively small dollar value compared to the total contract.
  • If the contract modification does not meet both of the above conditions, perform a profit/fee analysis to establish the appropriate profit/fee objective.

11.2 Developing An Objective Using The DoD Weighted Guidelines

This section covers the DoD structured approach to profit/fee analysis -- the Weighted Guidelines.

• 11.2.1 - Applying The DoD Weighted Guidelines
• 11.2.2 - Identifying Exempted Contract Actions

11.2.1 Applying The DoD Weighted Guidelines

Different Approaches for Different Products (DFARS 215.404-4(b), DFARS 215.404-71-2(c), and DFARS 215.404-71-4(c)). DoD contracting officers must use the weighted guidelines method for profit/fee analysis unless use of the modified weighted guidelines method or an alternate structured method is appropriate. The weighted guidelines define a structure for profit/fee analysis that includes designated ranges for objective values as well as norm values that you may tailor to fit the circumstances of your specific acquisition.

Examining the Weighted Guidelines Form The DD Form 1547 (available in Adobe Acrobat (PDF) format), Record of Weighted Guidelines Application, depicted below, provides the structure for DoD profit/fee analysis and reporting.

DD FORM 1547, JUL 2002 PREVIOUS EDITION IS OBSOLETE.

The DD Form 1547 provides an excellent guide for review of the DoD weighted guidelines approach to profit/fee analysis. For the review, we will divide the DD Form 1547 into the 10 parts identified in the table below:

Acquisition Identification Information. Items 1-12 of the form define DoD requirements for basic acquisition information related to the profit/fee analysis including information about: the contractor, the contracting office, and the contract itself. The form requirements in this area are not considered in this chapter.

Cost Objective by Cost Category. Items 13-20 of the form detail the Government's prenegotiation objectives (less any facilities capital cost of money) by cost category. This information serves as the base for several of the profit/fee calculations made during analysis.

• Be sure to exclude any facilities capital cost of money included in your cost objective from this portion of the DD Form 1547.
• Item 19 must include General and Administrative (G&A) expenses and all Independent Research and Development (IR&D)/Bid and Proposal (B&P) expenses.

The cost information in the table below is taken from the DD Form 1861 in Chapter 10.

Performance Risk Profit/Fee Analysis (DFARS 215.404-71-2). Items 21-23 of the form are designed to reward contractors who undertake contracts with more performance risk. To analyze performance risk, you must evaluate risk associated with fulfilling contract requirements. For profit/fee analysis, performance risk is subdivided into two types: technical and management/cost-control. The following table outlines factors that you should consider as you analyze each type of risk.

• Performance Risk Importance Weight. In the "Assigned Weighting" column of the DD Form 1547, weight the two elements of performance risk, considering each element's relative importance to proposed contract performance. The total of the weights must always equal 100 percent.

Example 1: For a development contract, you might assign the following weights:

Example 2: For a production contract, you might assign the following weights:

Performance Risk Profit/Fee Value. The column marked "Assigned Value" permits you to assign a profit/fee value based on the level of risk associated with the elements of performance risk. The range of values that you can assign depends on the acquisition situation.

• Standard Value Range: The standard designated range applies to most contracts and is used for both technical risk and management/cost control risk. The designated value range is 3% to 7% with a normal value of 5%. Evaluation criteria for technical risk appear in Table 11-1 below. Evaluation criteria for management/cost control risk appear in Table 11-3 below.
• Technology Incentive Range: Contracting officers may apply this range to the technical factor only when an acquisition includes development, production, or application of innovative new technologies. This range may not be used for acquisitions restricted to studies, analyses, or demonstrations that have a technical report as their primary deliverable. Evaluation criteria for the technology incentive range appear in Table 11-2 below.

• Calculate Composite Performance Risk Value. The "Performance Risk (Composite) Assigned Value" (Item 23), is the weighted average -- calculated using the weight assigned and the value assigned to the two types of performance risk. For example, the following calculations depict weighted value calculation:

• Identify Performance Risk Profit/Fee Base. Enter the value from Item 20 as the "Performance Risk (Composite) Base," Item 23. Remember that the value in Item 20 is the total contract cost excluding facilities capital cost of money.
• Calculate Performance Risk Profit/Fee Objective. To calculate the "Performance Risk (Composite) Profit Objective," Item 23, multiply the "Performance Risk (Composite) Assigned Value," by the "Performance Risk (Composite) Base" as shown in the example below:

Contract-Type Risk Profit/Fee Analysis (DFARS 215.404-71-3). Item 24 of the form focuses on the degree of cost risk accepted by the contractor under various types of contracts.

• Select the Appropriate Profit/Fee Range. The designated profit/fee ranges and the normal values for major contract types are described in the following table:

Note that fixed-price contracts with financing have lower profit/fee ranges and normal values than fixed-price contracts with no financing. The lower values consider the fact that the contractor assumes less financial risk when the Government provides financing.

• Assign Appropriate Profit/Fee Value. Use the normal value for each contract type unless you can justify a higher or lower value.
  • The elements that you should consider include:
  • Length of contract,
  • Adequacy of cost data projections,
  • Economic environment,
  • Nature and extent of subcontracted activity,
  • Contractor protection under contract provisions (e.g., economic price adjustment clauses),
  • Ceilings and share lines contained in incentive provisions, and
  • Risks associated with contracts for foreign military sales (FMS) which are not funded by U.S. appropriations.
  • When the contract contains provisions for performance-based payments:
    • The frequency of payments,
    • The total amount of payments compared to the maximum allowable amount specified at FAR 32.1004(b)(2), and
    • The risk of the payment schedule to the contractor.
  • In determining the appropriate value to assign, assess the extent to which costs have been incurred prior to definitization of the contract action. Your assessment must consider any reduced contractor risk on both the contract before definitization and the remaining portion of the contract. When costs have been incurred prior to definitization, generally regard the contract type risk to be at the low end of the designated range. If a substantial portion of the costs have been incurred prior to definitization, you may assign a value as low as 0 percent, regardless of contract type.
  • Within the range prescribed for a particular contract type, the assigned profit/fee value should be consistent with the value for performance risk. It would be incongruous to assign a high value for contract type risk and a low value for performance risk, or vice versa.

• Contract-Type Risk Profit/Fee Base. Enter the value from Item 20 as the "Contract Type Risk Base" (Item 24).
• Calculate Cost Risk Profit/Fee Objective. To calculate the "Contract Type Risk Profit Objective" (Item 24), multiply the "Contract Type Risk Assigned Value," by the "Contract Type Risk Base" (Item 20) as shown in the example below:

For example: A firm fixed-price contract with normal progress payments, normal risk, and the cost structure presented in earlier in this chapter would require the following calculations.

Working Capital Profit/ Fee Adjustment (DFARS 215.404-71-3). Item 25 of the form recognizes contractor working capital investment, the money required to finance contract expenses until contract payment is received. It only applies to fixed-priced contracts with Government financing.

• Calculate the Costs Financed.
  • Identify contract "Total Costs Objective" (excluding facilities capital cost of money) in Item 20.
  • Reduce the "Total Costs Objective" as appropriate when:
    • The contractor has little cash investment (e.g. subcontractor progress payments liquidate late in the period of performance).
    • Some costs are covered by special financing provisions such as advance payments.
    • The contract is multi-year and there are special funding arrangements.
  • Calculate the portion of contract cost financed by the contractor. Normally that is 100% minus the customary progress payment rate. On contracts that provide flexible progress payments or progress payments to small business, use the customary rate for large businesses.
  • Calculate the "Working Capital Costs Financed" by multiplying "Total Costs Objective" by the percentage of costs financed by the contractor.
• Select the Appropriate Contract Length Factor. The "Length Factor" (Item 25) is related to the period of time that the contractor will have a working capital investment in the contract.
  • The period of substantive performance that you use to select the length factor:
    • Is based on the time necessary for the contractor to complete the substantive portion of the work.
    • Is not necessarily based on the entire period of time between contract award and final delivery (or final payment). It should exclude any periods of minimal contract performance.
    • Should not be based on periods of performance contained in option provisions
    • Should not, for multi-year contracts, include periods of performance beyond that required to complete the initial program year's requirements.
    • Should be based on a weighted average contract length when the contract has multiple deliveries.
    • May be estimated using sampling techniques provided the sampling techniques produce a representative result.
  • After you determine the period of substantive performance use the following table to select the appropriate contract length factor.

• Identify the Interest Rate. Identify the "Interest Rate" determined semi-annually by the Secretary of the Treasury under Public Law 92-41.

This rate is also known as: Renegotiation Board Interest Rate; Prompt Payment Act Interest Rate; Contract Dispute Act Interest Rate; and Facilities Capital Cost of Money Rate. The rate can be found on the Bureau of the Public Debt's Prompt Payment Act Interest Rate webpage.

• Calculate Working Capital Profit/Fee Objective. To calculate the "Working Capital Profit Objective" (Item 25), multiply the "Costs Financed" by the "Length Factor" and then multiply the product from that calculation by the "Interest Rate" as shown in the example below. The adjustment must not exceed four percent of the "Total Costs" in Item 20 of the form.

For example: Using the above approach with a contract cost of $742,000, progress payments of 80 percent, substantive period of performance of 25 months, and an interest rate of 5.25 percent, the calculation would be:

Step 1. Calculate the Costs Financed:

Total Costs Objective x (1.00 - Progress Payment Rate)

$742,000 x (1.00 - .80)

$742,000 x .20

$148,400

Step 2. Select the Appropriate Contract Length Factor:

.65 is the length factor for a 25 month substantive period of performance.

Step 3. Identify the Interest Rate:

5.25 percent is the interest rate.

Step 4. Calculate Working Capital Profit/Fee Objective:

Costs Financed x Length Factor x Interest Rate

$148,400 x .65 x .0525

$5,064 (rounded down from $5064.15)

The figures in Item 25 of the form would appear as follows:

Facilities Capital Employed Profit/ Fee Analysis (DFARS 215.404-71-4). This section recognizes contractor investment in equipment.

• Determine the Facilities Capital Employed. As you learned in Chapter 10, total facilities capital employed is calculated by dividing the facilities capital cost of money allowed on the contract by the cost of money rate using the DD Form 1861, Contract Facilities Capital Cost of Money. The total facilities capital employed is then distributed into three components, land, buildings, and equipment, using Section 7 of the DD Form 1861. The facilities capital employed dollar figure for each component is then transferred to the appropriate "Amount Employed" column of DD Form 1547 -- Item 26 for land, Item 27 for buildings, or Item 28 for equipment.
• Select the Appropriate Profit/Fee Value Range. After transferring the facilities capital employed to the DD Form 1547, assign a profit/fee value to equipment capital employed. Facilities investments in land and buildings are not rewarded in profit/fee analysis because the Government does not appreciably benefit from investments in land and buildings. The following table shows the designated ranges and normal values for each:

• Assign Appropriate Profit/Fee Value.
  • As you assign a profit/fee objective value to equipment employed:
    • Relate the usefulness of the equipment to the goods or services being acquired under the prospective contract.
    • Analyze the productivity improvements and other anticipated industrial base enhancing benefits resulting from the investment in equipment, including:
      • The economic value of the equipment, such as physical age, undepreciated value, idleness, and expected contribution to future defense needs; and
      • The contractor's level of investment in defense related equipment as compared with the portion of the contractor's total business which is derived from the DoD.
  • Consider any contractual provisions that reduce the contractor's risk of investment recovery (e.g., a termination protection clause, capital investment indemnification, and productivity saving rewards).
  • You should assign the normal value unless you can justify a higher or lower value. Consider the following table:

• Calculate the Facilities Employed Capital Profit/Fee Objective. Using the above approach, normal assigned values, and facilities capital employed figures from Chapter 10, Section 6 could look like this:

The Cost Efficiency Factor. (DFARS 215.404-71-5) This is a special factor that encourages contactors to reduce costs. Contracting officers may use this factor to increase the prenegotiation profit objective by an amount not to exceed 4% of total objective costs (Block 20 of the DD Form 1547). Contracting officers may use this factor only when the contractor can demonstrate cost reduction efforts that benefit the pending contract.

The contracting officer shall consider criteria such as the following in evaluating whether or not to use the cost efficiency factor:

• The contractor's participation in Single Process Initiative (SPI) improvements;
• Actual cost reductions achieved on prior contracts;
• Reduction or elimination of excess or idle facilities;
• The contractor's cost reduction initiatives (e.g., competition advocacy programs, technical insertion programs, obsolete parts control programs, spare parts pricing reform, value engineering, outsourcing of functions such as information technology). Metrics developed by the contractor such as fully loaded labor hours (i.e., cost per labor hour, including all direct and indirect costs) or other productivity measures may provide the basis for assessing the effectiveness of the contractor's cost reduction initiatives over time;
• The contractor's adoption of process improvements to reduce costs;
• Subcontractor cost reduction efforts;
• The contractor's effective incorporation of commercial items and processes; or
• The contractor's investment in new facilities when such investments contribute to better asset utilization or improved productivity.

When selecting the percentage to use for this special factor, the contracting officer has maximum flexibility in determining the best way to evaluate the benefit the contractor's cost reduction efforts will have on the pending contract. However, the contracting officer shall consider the impact that quantity differences, learning, changes in scope, and economic factors such as inflation and deflation will have on cost reduction.

Example: The contracting officer has evaluated the criteria listed above and decided that a cost efficiency factor of 1.5% is appropriate based on the contractor's adoption of process improvements and small cost reductions achieved on a prior contract. The entry on the DD Form 1547 would appear as follows:

Total Profit/Fee Objective. The total profit/fee objective is the sum of all profit/fee objectives calculated in Parts 2 - 6 of the DD Form 1547. For the on-going example used throughout this section, the total profit/fee objective would be:

Negotiation Summary (DFARS 215.404-76). This part of the DD Form 1547 summarizes the proposed, objective, and negotiated cost and profit/fee positions. The section is primarily used for reporting to higher headquarters. Questions often arise regarding Line 35, "Markup Rate." The markup rate calculation includes both profit/fee and facilities capital cost of money as markup. As a result, offhand evaluations of the size of the markup can be misleading. The figures for on-going example would be:

Contracting Officer Approval. After completion of the negotiation, the DD Form 1547 must be signed and dated by the contracting officer.

Completed Price/Fee Analysis The example below depicts a DD Form 1547, completed through Item 35 for the Government objective, using the figures from the on-going example used throughout this section.

11.2.2 Identifying Exempted Contract Actions

Exemptions From Required Weighted Guidelines Use (DFARS 215.404-4(c)(2), DFARS 215.404-72, and DFARS 215.404-74).

In the DoD, you generally must use the weighted guidelines approach for profit/fee analysis when you perform cost analysis of cost or pricing data to determine price reasonableness. However, you:

• May use an alternate structured approach for the following:
  • Contract actions under $500,000;
  • Architect-engineering or construction contracts;
  • Contracts primarily requiring delivery of material from subcontractors;
  • Termination settlements; or
  • Contracts for which the weighted guidelines would not produce a reasonable overall profit/fee and the head of the contracting activity approves use of an alternate approach in writing.
• Must use themodified weighted guidelines (described in DFARS 215.404-72) for contract actions with nonprofit organizations other than FFDRCs.
• Must not useweighted guidelines or an alternate approach for cost-plus-award-fee contracts. Instead follow the guidelines presented in DFARS 215.404-74.

Using an Alternate Structured Approach (DFARS 215.404-73). When using an alternate structured approach, you may design your profit/fee analysis to meet the requirements of the acquisition situation. However, the alternate approach must:

• Consider the three basic components of profit--performance risk, contract type risk (including working capital), and facilities capital employed.
• Include an offset for any facilities capital cost of money included in contract cost. To calculate the offset, reduce the overall prenegotiation profit objective by one percent of the total cost or the amount of facilities capital cost of money, whichever is less.

When you use an alternate approach, you must still complete a DD Form 1547, however, you are not required to complete Items 21 through 30. The profit amount in the negotiation summary of the DD Form 1547 must be the profit figure after the offset for facilities capital cost of money.