Infotech and the Law

Contract Profit and Incentives: Surviving in a Thin Market

Richard Rector

As procurement spending declined and the industrial base consolidated over the past 10 years, the federal market became a tougher place in which to turn a profit.

A much smaller group of companies now compete for a shrinking set of high-revenue programs, and the thinning market has triggered a survival instinct that, in some sectors, has resulted in fierce, competitive decision-making.

In addition, there are fewer legacy programs that afford contractors a steady, sole-source stream of revenue over a product's life cycle. Indeed, defense spending on spares procurement has declined significantly over the past five years, weakening a traditional pillar of contractor financial performance.

To these challenges, add the financial pressures of uncertain program funding and slow payment by the government ? and a new economy that sparkles in contrast ? and it is no wonder companies continue to look beyond the federal marketplace in search of better shareholder value.

In January, Jacques Gansler, undersecretary of defense for acquisition, technology and logistics, responded to this concern by asking the Defense Science Board (DSB) to review Defense Department acquisition policies and report upon specific changes that would strengthen the health and competitiveness of the industry.

The DSB Report allegedly was drafted by May and recommended changes in contract financing, contractor sharing of cost savings related to restructuring and increased research and development investment.

Unfortunately, the report was never issued. Thus, despite the continuing demands of a thin market, the relief promised by the Defense Department at the beginning of the year has not materialized.

Despite this delay, there have been three significant developments in 2000 that hold promise for the future financial health of the industry.

First, the Defense Department proposed changes to its outdated profit policy and "weighted guidelines" methodology for calculating contractor profit, which was developed in 1985 before the industry's downsizing.

The principal changes include:
  • Addition of a "technology incentive" factor for technical risk, which would allow elevated profit levels for contracts involving development or production of innovative or new technologies.
  • Addition of general and administrative expenses to the cost base used to establish profit objectives.
  • Addition of a special "cost efficiency" factor, which would allow increased profit rates up to 4 percent to reward companies that undertake meaningful efforts to reduce contract costs.
  • Gradual elimination of facilities investment as a factor in establishing profit objectives.

    Industry groups welcomed some of the proposed changes, but also cautioned that the changes would not significantly increase contractor incentives. In fact, one group warned the proposed changes actually may reduce profits for companies that are producing hardware for the Defense Department.

    So while the proposed changes are a step in the right direction, it is not clear that, as presently proposed, they would provide further incentive for contract performance.

    The second significant development is a recent notice from the Office of Federal Procurement Policy announcing an ambitious initiative to "fundamentally examine the manner by which the government develops and applies incentives to its contract vehicles."

    The notice, which requests public comments by Dec. 26, explained that the Office of Federal Procurement Policy plans to consider approaches that would "fundamentally restructure" the government's contractual relationships.

    The goal of the initiative is nothing less than the creation of a "new contracting paradigm" that would encourage the use of effective, non-fee incentives. Such an initiative, if successful, could create new opportunities and value for federal contractors in the future.

    The third development is the creation of the Commission on the Future of the U.S. Aerospace Industry, which was mandated by Congress in the fiscal year 2001 Defense Authorization Act. The 12-member commission has been established to study a broad range of issues affecting the relationship between the government and the aerospace industry.

    No later than March 2002, the commission must issue a final report in which it recommends actions that the government can take to maintain a "robust" aerospace industry in the future.

    There is a strong consensus on the need for policy changes to enhance the future of the U.S. industrial base. There is a risk, however, that the issue will be studied to death for the next two years, while adverse market forces continue to affect the industry's health.

    The time for action is now. The Defense Science Board should issue its long-awaited report, and the government should begin the work of ensuring the future health and competitiveness of the industry.

    Richard Rector is a partner in the government contracts group of Piper Marbury Rudnick & Wolfe LLP in Washington.
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