Pricing Handbook

12. Profit/FEE

12.1 Overview of Profit/Fee

12.2 Considerations for Profit/Fee Analysis

12.3 Use of a Structured Approach for Profit Analysis

12.3.1 Weighted Guidelines Using DOT Form 4220

12.3.2 Weighted Guidelines Using DD Form 1547

12.3.3 Differences between DOT 4220 and DD 1547

12.4 Summary

Profit represents revenue in excess of applicable costs of contract performance. Simply stated, profit equals the negotiated contract price less applicable contract costs. Fixed-price contracts place a maximum burden of cost risk on the contractor: profit is reduced one dollar for each dollar that the contractor spends above the anticipated contract cost. Conversely, each dollar that the contractor does not spend toward the anticipated contract cost increases profit by one dollar. Thus, in a fixed-price contract, the amount of profit the contractor earns is ultimately a function of incurred contract costs. Since contract costs are the responsibility of the contractor, the level of profit (or loss) depends on the contractor�s cost performance.

Fee, which is associated with cost reimbursable contracts, represents a flat charge paid as compensation for services or supplies provided. It may be fixed fee or it may vary based on incentive structures.

Labor-hour and time and material contracts represent hybrid arrangements. The term profit is associated with these hybrid arrangements, but the cost risk assumed by a contractor is low, much like that assumed under cost reimbursement contracts. Therefore, profit is evaluated like fee in structured analysis approaches applied to labor-hour contracts and time and material contracts.

Profit/fee is an important cost element because it provides several incentives which are regarded as beneficial to the Government. For instance, profit/fee plays a vital role as a stimulant for efficient contract performance and as a reward for risks assumed by the contractor.

If the contractor is not properly rewarded, the following consequences may occur:

• The contractor may incur a loss which will diminish its ability to perform satisfactorily.
• Contractors may shy away from future procurements.
• If profit/fee is too high for the risks assumed, the contractor may lose motivation to perform efficiently.

When cost analysis is required, profit/fee is included as an element of analysis. Profit/fee is not formally analyzed when price analysis is conducted; however, it is reviewed as a component of the overall price of an item or service.

When analyzing profit/fee, the following factors should be considered by the analyst:

1. Contractor effort: The analyst should consider the complexity of the work and the resources required to perform the contract. As the complexity of the effort increases, the risk of failure or setbacks increases. Furthermore, more coordination is required among managers at high levels as the complexity or importance of an effort increases. Profit/fee should increase as each of these factors increases.
2. Contract cost risk: the analyst should determine the level of cost responsibility assumed by the contractor. Contract type will determine the extent of cost risk borne by the contractor. A firm-fixed-price contract, for example, will place the full burden of performance (within a set price constraint) directly on the contractor. Higher profit/fee is justifiable in a fixed-price contract, unless there are provisions in the contract such as an Economic Price Adjustment (EPA) clause that mitigate cost risk. Under a cost-plus-fixed-fee contract, the contractor is guaranteed a fee regardless of cost overruns. As a result, little cost risk is assumed by the contractor; therefore, the profit/fee determination should reflect the minimal risk involved.
3. Federal socioeconomic programs: the analyst should consider the amount of support given by the contractor to Federal socioeconomic programs. Greater profit/fee opportunity may be provided to contractors who display unique initiatives in these programs.
4. Capital investments: the analyst should consider the contractor�s investment contributions to efficient and economical contract performance. The government may award higher profits/fees to contractors who provide investment in facilities that are a direct benefit to the government.
5. Cost-control and other past accomplishments: the analyst should consider any previously demonstrated effectiveness in cost control or if the contractor has taken measures resulting in productivity improvements. Higher profit/fee may be awarded to those contractors demonstrating cost control.
6. Independent development: the analyst should consider if the contractor provided independent development efforts relevant to the contract end item without Government assistance. Higher profits/fees may be awarded to contractors providing these efforts.

Use of a Structured Approach for Profit Analysis

The above factors provide a framework for the analyst to determine a pre-negotiation position for profit/fee. Structured approaches will assist in determining profit/fee prenegotiation objectives by providing discipline for ensuring that all relevant factors are considered. These approaches promote uniformity and consistency in providing profit/fee analysis.

The current Federal Aviation Administration Acquisition Management System (FAA AMS) policy states: "for the purposes of establishing a negotiation position the CO may use some structured method (e.g. agency mandated weighted guidelines) for determining profit/fee appropriate for the work to be performed" [FAA AMS Toolbox Guidance T3.2.3, Section A-8, par. c]. The most commonly used structured approach is called weighted guidelines.

The weighted guidelines method is a common means of determining profit/fee in most Government arenas. This method provides an organized and structured approach to evaluate and weigh the factors and cost risks inherent in a contract, and is also a source of documentation to the analyst and contracting officer. most federal agencies use the weighted guidelines method in some variation.

Weighted guidelines analysis involves the breakdown of the various risks associated with a given contract. Each factor is evaluated in terms of the weight it carries for successful contract completion as well as its respective degree of risk.

Currently two forms are utilized by most federal agencies for completing weighted guidelines analysis, DOT Form 4220 and DD Form 1547. These forms are discussed below.

Weighted Guidelines Using DOT Form 4220

DOT Form 4220, when completed accurately, assists the analyst in calculating a profit/fee according to:

• the risk of the contract type,
• the risk on the contractor�s effort,
• the cost risk associated with the contract, and
• the amount of facilities investment employed.

To use the standard DOT weighted guidelines method, shown as Figure 12-1, the analyst needs to categorize the contract as a manufacturing, research and development (R&D), or a services effort. This is important because different risks are associated with each type of contract. The weighted guidelines demonstrates this by providing different weightings for each of these three contract categories.

Figure 12-1. DOT Form 4220

Completing DOT Form 4220

The analyst must first complete Part I, Contractor Effort (lines 7 through 15). This section measures how much the contractor is expected to contribute to the overall effort necessary to meet the contract performance requirements in an efficient manner. The evaluation of this factor requires an analysis of the cost content of the proposed contract. The format of this section relates to cost elements generally contained in most contract pricing proposals. The analyst should use the total dollar amount proposed for each item and apply it to the associated profit/fee weight range. Table 12-2 provides further explanation of each of the cost elements and the range of risk values.

Part II, Contractor risk, compensates the contractor for their risk. A contractor�s risk is usually minimal under cost reimbursement type contracts but much higher in fixed priced contracts. This part is calculated by using the total effort from Part I and profit weightings addressed in Table 12-2.

Part III, Facilities Investment relates to the consideration to be given in the profit/fee objective in recognition of the investment risk associated with the facilities employed by the contractor. The measurement base is taken from DD Form 1861 (see Chapter 11, "Facilities Capital Cost of Money").

The profit/fee objective (line 18) is calculated by summing the products of Parts I, II and III. This objective number can be used as a recommendation in the analyst�s pre-negotiation position.

Part IV, Special Factors, is used when the contractor should be recognized for investment in productivity, for independent research and development or other special factors (i.e. socioeconomic programs, performance). The productivity factor is applied when the acquisition is a follow-on manufacturing effort, actual cost data are available to establish a baseline, and changes in item configuration are not large enough to invalidate price comparability. The dollar amount inserted under the measurement base is based on the estimated cost reduction that can be attributed to productivity gains. The independent development factor should use as its measurement base the development costs that were incurred by the contractor and not recovered (directly or indirectly) by the government. The "other" category allows the analyst to provide a (-5 or +5) range to the profit base based on the contractor�s participation in federal socioeconomic programs.

If the contract is for research and development or services, the Facilities Capital Cost of Money is subcontracted from the profit/fee objective in line 21. This is done because services and R&D efforts do not require the type of facilities investment that a contractor would need to be motivated to do on a manufacturing effort.

Weighted Guidelines Using DD Form 1547

Unlike DOT Form 4220, DD Form 1547 (Figure 12-2), does not distinguish among cost categories for the purposes of giving each element an individual impact on profit/fee. Instead, all cost elements are summed into a total cost base which is applied to the various risk factors detailed on the form. There are three factors given consideration: performance risk, contract type risk, and facilities capital employed.

Weight ranges for the three risk factors should be determined for each specific contracting action. Median weightings, as well as a range of prescribed values have been established based on contract type and circumstances. Typically, the median value is assigned to a risk area unless the contractor notes unusual circumstances and can justify a deviation from the median. Extreme conditions in a risk factor or subfactor may deem a change in weighting to ensure that an appropriate profit/fee is established.

Figure 12-2. DD Form 1547

Table 12-3. Risk Considerations and Weightings for DD Form 1547

Table 12-3 on the prior page lists by risk category the factors to consider as well as standard and alternate risk weightings to be utilized when preparing DD Form 1547. An alternate range of values is available for each risk factor should a contract merit deviation from the standard range. Under performance risk, Research and Development (R&D) and service efforts with low capital investment in buildings and equipment will be subject to an alternate, higher range of values. Minimal capital investment will diminish the amount of profit/fee given for facilities capital employed, and, therefore, the overall calculated profit/fee objective. As a result, the overall calculated profit/fee percentage for contracts involving a significant degree of contractor risk may be understated. The higher alternate range of values for performance risk is therefore designed to adequately compensate contractors with low capital investment for risks incurred during contract performance. However, when alternate performance risk values are utilized, no profit/fee is to be given for facilities capital employed.

Fixed-price contracts with provisions for progress payments are the recipient of alternate, lower values under the contract type risk factor. When progress payments are made to a contractor, the contractor�s contract type risk is substantially reduced because the Government is financing a significant portion of the working capital needed for a particular contract. The contractor does not have the burden of raising working capital for the entire contractual effort, nor does the contractor have to meet such a high degree of interest payments to debtors. Standard weightings are therefore only applied to contracts with limited or no provisions for progress payments.

Finally, R&D and service contracts performed by highly facilitized manufacturing firms will mandate an alternate, lower range of values under the facilities capital employed risk factor. These values are designed to balance the method used to allocate facilities capital cost of money, which may produce a disproportionate allocation of assets by a contractor for these types of efforts.

Completion of Form DoD 1547

When completing this form, the analyst should first break down the Government�s negotiation objective position by cost category (items 13-20). Each cost element dollar value will be input into the corresponding item�s space. However, the Facilities Capital Cost of Money cost category is not included in the breakdown. Item 19 is General and Administrative (G&A) Expense and further includes all Internal Research and Development (IR&D)/Bid and Proposal (B&P) expenses. The cost categories are summed in Item 18. Item 20 then equals the sum of Item 18 and the G&A cost category to arrive at a total cost figure. This cost information will later serve as a base for several profit/fee weights assigned in further analysis.

The next section attempts to quantify the contractor�s degree of risk in fulfilling the contract requirements. It is comprised of three subfactors listed in Items 21-23.

• Item 21: Technical Risk accounts for technical uncertainties of performance with regard to the complexity of the Statement of Work (SOW) specifications.
• Item 22: Management Risk assesses the contractor�s degree of involvement in integrating and coordinating the contracting action.
• Item 23: Cost Control Risk addresses the expected reliability of the contractor�s cost estimates, as well as the initiative regarding cost reduction and management.

These subfactors are each assigned a weight relative to their importance to contract performance. The total of these weights must always equal 100%. The items are typically weighted:

The performance risk elements are next assigned a profit/fee value. A breakdown of standard percentages are shown below. The normal value should be assigned unless there is specific justification for any deviation.

A Composite Performance Risk for Item 24 can be calculated by multiplying each element�s respective weight by its corresponding value. The three subfactor�s weighted values are now summed to arrive at the performance risk composite. This figure is multiplied by a base amount (item 18) to determine the profit/fee objective for this risk factor.

Items 25-26 evaluate the degree of contractor cost risk based on contract type. A contract type that carries a high degree of risk, i.e. firm-fixed price contract types, will then carry a higher assignable value and range. If the contract is firm-fixed price in nature but does not include provisions for progress payments, Item 25 can be determined by identifying the contract type and finding the corresponding risk associated with it, which can be found on Table 12-4. As is typical with other risk assignments, the normal value should be applied unless otherwise warranted by the contracting officer. This value, as done with the performance risk value, is now multiplied by a base amount (Item 18) to produce the profit/fee objective for contract type risk.

Table 12-4. Contract Risk

Should a firm-fixed price contract that includes a provision for progress payments be identified, alternative values for the normal applied risk and range of risk are provided. In addition to these different risk values, Item 26 (working capital) now becomes a necessary component in determining the overall profit/fee objective. First, input the total contract cost (value from Item 20) excluding Facilities Capital Cost of Money and place it under "% Financed". The value under "Costs Financed" is calculated by multiplying total contract cost by the portion of the contract financed by the contractor (100% minus the progress payment rate). The "Length Factor" is the period of time that the contractor has a working capital investment in the contract. Select the contract length factor from Table 12-5.

The value input under "Interest Rate" is the most recent interest rate set by the Secretary of Treasury.

The Profit/Fee Objective for working capital is the end product of multiplying the costs financed by the length factor and then multiplying their product by the interest rate.

Items 27-29 analyze three investment areas: land, buildings, and equipment. This factor is intended to reward investment in facilities that benefit the DoD or other Government agency. The "normal" value should be assigned unless the contracting officer provides justification for any deviation. Values for these categories are assigned using the following table:

Under "Amount Employed" base amounts for each facilities capital employed area are provided by Item 7 of the previously completed DD Form 1861-Contract Facilities Capital Cost of Money. These amounts are multiplied by their respective assigned values to arrive at the profit/fee objective.

Item 30 concludes the final profit/fee objective. This figure is determined by summing all profit/fee objectives calculated for Performance Risk, Contract Type Risk/Working Capital, and Facilities Capital. This figure can be used as part of the pre-negotiation position.

Differences between DOT 4220 and DD 1547

Similar to DOT Form 4220, DD Form 1547 requires that both a weight and level of risk be assigned to each contract factor for the purpose of determining an appropriate profit/fee objective. However, there are several differences between the two procedures that should be highlighted and which could play a role in the decision of which procedure to use. The following factors, which have been incorporated into DD Form 1547, vary from DOT Form 4220:

• Integration of contract financing with contract type risk assessment.
• Decreased emphasis on contract cost and redirection of performance risk assessment to technical, management, and cost rather than the individual elements of cost.
• Elimination of separate profit/fee policies for manufacturing, research and development, and service contracts.
• Increased and redistribution of the proportion of prenegotiation profit/fee objective to be based on facilities capital in order to encourage and reward aggressive capital investment in facilities that benefit DoD or the agency employing this newer procedure.
• Removal of contractor General and Administrative (G&A) expense from the profit/fee base.

DD Form 1547 recognizes that contractors incur significant amounts of interest expense under fixed-price contracts and cannot be directly compensated by the Government. (Contract financing policies classify a contractor�s interest expense as an unallowable cost.) To reduce this burden on contractors, the Government utilizes progress payments and the working capital adjustment section of DD Form 1547. Progress payments made to the contractor are a vehicle used by the Government to significantly reduce a contractor�s expenses related to financing working capital for a contract. With decreased "out-of-pocket" financing, the contractor will have less interest expense to absorb. If any costs remain to be financed by a contractor after the progress payments have been made, the ensuing interest expense will be recognized in the contract profit/fee. Interest is taken into account in the weighted guidelines by means of the working capital adjustment line. This adjustment is directly related to the amount of working capital provided by the contractor, the duration of the contract, and the current interest rate. Working capital increases with these factors. As this profit/fee component increases, so will the bottom line profit/fee objective.

For example, a contractor which provides 20% of the required working capital for a given contract will receive more compensation (in terms of higher profit/fee) than the contractor which provides only 10% of the required working capital for the same contract, assuming all conditions/costs are the same. See Case Study 12-1. (Note: Study uses DD Form 1547).

CASE STUDY 12-1. Contractor Provided Financing

The same analysis applies to contract duration and interest rate differences as well. For example, a contract of greater duration or negotiated during a period with a higher interest rate will receive a higher profit/fee percentage than the contract with lesser duration and negotiated at a time with a lower interest rate. See Case Study 12-2.

CASE STUDY -2. CONTRACT DURATION AND INTEREST RATE DIFFERENCES

DOT Form 4220 integrates profit/fee and contract financing policies in principle but not in practice. There is no structural linkage between progress payments provided and the remaining financing needed by the contractor. Furthermore, there is no specific link between the contractor�s risk and the contract length.

Contract Costs and Performance Risk

Another difference in the two weighted guidelines forms is the decreased emphasis on contract costs and the redirection of performance risk assessment to technical, management, and cost rather than the individual elements of cost. DOT Form 4220 involves 18 separate calculations among its respective risk factors. Each cost category receives a risk allocation and resultant contribution toward overall profit/fee. Furthermore, each assessment of risk must include observance of the correct risk range for the respective contract type. DD Form 1547 minimizes the number of calculations by reducing the number of cost categories which reduces the available weights to be considered and limits the impact that the individual cost element has on the profit/fee determination. Other related changes introduce technical, management, and cost control factors to weight assignments for performance risk.

DD Form 1547 eliminates separate profit/fee policies for manufacturing, research and development, and service contracts. While the purpose for separate profit/fee policies in DOT Form 4220 is to increase profit/fee for manufacturing (capital intensive) contracts, the criteria for categorizing a contract type is not well defined. As a result, identification of the type of effort allows for a research and development contract to be computed under the manufacturing column of the DOT form. If a contracting officer classifies the contract as research and development or services, the DOT form does not provide consideration for facilities investment. Without recognition for capital employed during the work effort, contractors are not rewarded for productivity improvements. With the absence of facilities investment as a profit/fee factor, contractors may be discouraged from increasing assets to improve productive methods. Contracting officers compensate for this reaction by using the manufacturing column of DOT Form 4220 for contracts which would ordinarily be categorized as research and development or services.

The purpose of the newer policy implemented on DD Form 1547 is to treat all contract efforts the same. This is accomplished by employing a single column approach, as opposed to the DOT version which uses designated columns for each contract type. It merges the previous three columns of the DOT form for the purposes of avoiding conflicts in contract type identification. Each risk factor on DD Form 1547 provides alternative weights dependent on the nature of the type of effort. Therefore, the differences in financial investment between contract types can be appreciated and all contract efforts can be treated the same.

Facilities Capital Cost of Money

The two versions of weighted guidelines analysis differ in the emphasis placed on facilities capital. A proportion of prenegotiation profit/fee objective was redistributed to facilities capital to encourage and reward aggressive capital investment in facilities which benefit DoD. DOT Form 4220 combines the general categories of land, buildings, and equipment. Without differentiation among these fixed assets, investment in any asset will provide for the same result in profit/fee determination. The contractor is not incentivized to invest in one area more than the other because all have the same effect. To provide incentive toward investment in fixed assets with cost-reduction potential, DD Form 1547 discriminates among the three categories. This reformed approach increases weight on investments in cost-reducing equipment. With this additional weight, profit/fee potential in these fixed asset investments should act as an incentive for future investment. Meanwhile, lower weights in investments less appealing to the Government, should provide contractors with less profit/fee. This reform results in a more defined decision making process for facility investment geared toward overall future cost-reduction.

Contractor G&A Expense

The final area of reform in weighted guideline analysis considers the role of G&A expense. G&A expenses support all activities of an organization, while perhaps only contributing a minor benefit toward the contract effort. In DOT Form 4220, G&A expense is assigned a specific weight as part of determining profit/fee. In DD Form 1547, however, G&A does not have a direct impact on profit/fee. It is still a component of the total Government cost objective, but it has been removed from the cost base used in determining the profit/fee objective. With G&A no longer a significant consideration in calculating profit/fee, this reform provides the contractor with incentive to better manage these expenses. Please note, however, that while G&A is not used in DoD�s weighted guidelines� measurement base, the overall profit/fee percentage is usually expressed as a percentage of total cost, which does include G&A and does not include cost of money.

Summary

Structured approaches for determining profit/fee provide a consistent format for analyzing the risk factors and for establishing cost objectives for negotiations associated with contracting efforts. A structured approach is an efficient source of documentation for a contracting officer during negotiations. The Weighted Guidelines method, the most commonly used structured approach in federal contracting, has been recommended to provide guidelines for analyzing profit/fee. This method of evaluating risks inherent within a contract assigns weights to the various factors that are determinants of the risks involved with the effort. Alternate approaches for determining profit/fee may be used if they are deemed more appropriate for determining the proper profit/fee objective.

Various factors are examined to determine their degree of risk. The complexity of the work and the level of cost responsibility assumed by the contractor are analyzed for their degree of risk. Contract type is a major determinant in the cost risk assumed by the contractor as firm-fixed-price contracts inherently carry a higher degree of risk for the contractor.

Profit/fee is a valuable tool for offering incentives to contractors. The potential reward of profit/fee can be responsible for stimulating more efficient contract performance. Profit/fee can help to attract the best capabilities of qualified business concerns.