Good morning,
To follow up on our discussion yesterday about the markups, overhead, and G&A.
In 2017, we had 13.422M in subcontractor revenue we billed as the prime against 12.254M in direct costs for a gross profit of 1.167M or 8.7%.
In 2017 G&A expenses made up 10.97% against the direct costs and associated fringe benefits (allocation method referred to as Total Cost Input (TCI)).
When the G&A costs are allocated against the subcontractor costs the net profit disappears on the subcontracts. The 1.167M drops to a loss of -177k, the 8.7% gross profit is reduced to a loss of -1.32% on the net profit.
The natural question that arises in cost allocation is what happens if we do not allocate the G&A to the subcontractors. This is a common demand from program managers and government contracting officers.
G&A simply cannot disappear, it has to has to go somewhere. The next common method of allocation most contractors often think of is to burden Direct Labor and its associated fringe with the G&A.
While in 2017, using the approved TCI method above that resulted in a financial loss on our use of subcontractors, the same TCI method resulted in a profit on direct labor. We had a 24.69% net income on Direct Labor and associated fringe. There was 4.638M in direct labor revenue against 3.148M in direct labor costs to include fringe for a gross profit of 1.491M. When the G&A is allocated utilizing the TCI method the net profit is 1.145M or 24.69% profit.
At first glance you may wonder why there is a difference in profitability. The difference occurs due to differences in revenue (billing) not costs. We have overall higher billing on our labor costs as compared to our minimal and unprofitable markup on subcontractor costs.
If you shift the G&A from subcontractors to direct labor you get back the 1.167M in profits on the subcontractors but the profit on direct labor vanishes and moves to the negative, a loss of -7.85% is created for negative -364k from the positive 1.145M.
Again, the G&A costs must go somewhere, and the government is perfectly willing to negotiate us into bankruptcy.
Despite the objections from the programs and contract people, Total Cost Input is the regulatory defined de facto method of cost allocation. Changing allocation method does not eliminate costs, it only moves them somewhere else. Again, the costs have to go somewhere.
We use a Value-Added Base, and charge a Subcontract Handling Rate on Total Subcontract Costs (but not G&A). We have salary (its own charge code) and applicable fringe in our numerator and the denominator is Total Subcontract Costs.
I have not included the Subcontract Handling pool in the G&A base. USAID has taken issue with this saying that this exclusion from the G&A base implies that the pool does not benefit from the G&A expenses. Of course, at this point, they are years behind on their audits, we have been doing this same thing for 3 years running and this is the first time anyone has mentioned this, so it will be a mess to undo.
Under a TCI I know that the Subcontract Handling pool should be included in the G&A base, but under a defined Value-Added Base, do we have an argument?
Excellent comment and questions! This is a classical DCAA argument against Value Added although the method is specified in CAS as an acceptable method of allocation. DCAA is required to accept the contractor’s method of allocation unless they assert and demonstrate the method is inequitable to the government. An example would be when all of the government cost contracts were service only (labor) while the commercial work the contractor did included significant subcontractor costs. Here, DCAA could argue the method was inequitable to the government.
Steve
Thank you for your insight. As further clarification, our value-added base has previously been accepted by DCAA, but we had not established use of a Subcontract Handling rate until a Prime award in 2015 (and it hasn’t been through an ICS audit yet). It is the only Prime award in our portfolio. We are primarily a subcontractor on USAID awards, we have no commercial work.
CAS 410 is clear that under Value-Added, base costs for subcontract handling should be excluded from the base for allocation of G&A costs, but what about the pool costs for subcontract handling? Have we been wrong to exclude these as well? Is there any guidance/regulation/precedent either way?
Value Added is defined in the CAS as “Value-added cost input (total cost input less direct material and subcontract costs). Thus, the base would include anything that was not material or subcontractor costs such as associate direct fringe, overhead, and possibly the subcontractor handling pool. Although I am sure the latter is open for debate among DCAA auditors (Please do not make me use the term “fruit of the poisoned tree!).
I always found the challenge for small contractors is defining the pool for the subcontractor handling. Just what goes in there? Many contracting officers have responded to this difficulty by treating the subcontracting handling as a fee instead of a pool.