Guest Blog: Halliburton & Defense Contracting (2/3)

When Robin Burk first proposed this guest blog idea, she wondered if it would be of interest. I did, too, but she had personal experience on both sides of this negotiating table and I thought the topic was important. So we ran Part I - and 39 comments and 3 Trackbacks later, we had our answer. Wow!

This topic has only heated up with the recent news reports re: Haliburton contracts in Iraq. Robin will be getting to that in Part III, but first she needs to complete our readers' "Defense Contracting 101" primer by discussing the concept of "costs" and "profit" as they apply to contracts like this. If you guessed that the rules were a bit different, you'd be right.

Special Report: Halliburton and Defense Contracting (2/3)
by Robin Burk

Well, the topic of defense contracting has been heating up lately, so perhaps this series is timely. On Tuesday Asst. Secretary Paul Wolfowitz announced that only Coalition partners who are 'helping and sacrificing' to rebuild Iraq would be eligible to bid as prime contractors for reconstruction contracts funded by the U. S., although it now appears the bid order solicitations will be held up for review. But what is a 'bid order' anyway?

Meanwhile, a Pentagon investigation has determined that Halliburton overcharged for fuel deliveries in Iraq. Earlier the company defended its prices and claimed it makes only a small profit; the NY Times reports that the overcharge was due to a high price charged by a subcontractor for the fuel rather than to overly high profits for Halliburton itself.

In Part 1 of this series, we identified the rules that govern defense contracting in the US, the process by which competitive contracts are awarded and the key people who are involved in a contract. This installment looks at the way pricing is established for defense contracts, and the types of contracts that can be awarded.

Building the Picture Brick by Brick

Nearly all federal contract pricing starts with cost accounting.

The government isn't particularly interested in the financial profit & loss statements that investors care about. Instead, the price that a contractor can charge is determined from the bottom up. Here's how it works.

Suppose you own a small business that builds brick patios for suburban homes. A new home owner asks you how much you would charge to install a 20' x 30' patio for them. We start with direct expenses:

• You would begin by estimating how many bricks your crew would need, including a few extras in case of breakage. Multiply that by the cost per brick you pay at the supply yard. Do the same for the cement and sand your crew would use. Those are the costs of your materials.

• You're not sure which workers you would send to do the job, but based on prior experience you know a job this size usually takes one senior bricklayer and two junior helpers a total of two days (16 hours) to complete. Senior bricklayers get $25 / hr and helpers get $10, for a total of $720.

• However, you have to pay benefits to your workers, which average 33% of their hourly pay, so the total burdened labor costs are $960.

• You also provide the fleet of trucks used by your crews; let's just say your crew will need one truck and will drive a total of 100 miles to pick up the materials and go to/from the work site. Your accountant might have calculated the real cost / mile of your trucks based on their purchase price, the cost of gas and oil and regular repairs. Or, you might just use the tax deduction rate of 37 cents / mile. In either case, you add this cost to your running total.

• You might also calculate the hourly cost of using any special tools or equipment you provide for your crew by dividing the purchase and maintenance price by the average useful life of the tool.

These costs - labor, materials and related expenses - are what the government calls direct expenses, i.e. they are directly incurred as a result of doing the job. But your little company must incur other costs too, in order to make that backyard patio for your prospective client.

If your crew chief comes into the office to type up an invoice and make 3 copies of the work plans on the copier, his need to use that office equipment creates indirect expenses associated with doing a specific client's work.

Finally, there are general and administrative costs necessary to be in business. For instance, you yourself may need office space, a telephone line, a computer and an office assistant, plus the services of an accountant, in order to run the business. You probably also take a salary from the business to do so. If this job would be 1% of your revenues for the year, then 1% of your total G&A expenses will be considered part of the job's cost..

The federal government, including the Department of Defense, requires companies who bid on a contract to provide a cost justification to back up the financial side of their bid. The bidder must estimate the mix of skills needed to do the job and provide a burdened hourly rate for each labor category. Direct, indirect and G&A expenses are also estimated. For instance, office space costs will be estimated based on the actual location where the job will be performed. The Federal Acquisition Regulations and the Defense FAR Supplement are very detailed and specific about how these costs must be calculated. For instance, marketing and sales costs cannot be included when expenses are calculated. Neither can any proposed profit margin, which is treated separately.

What Profiteth a Man (or a Company)....

Once the total costs of the job are estimated, we enter the thorny realm of profits. The government has to allow contractors to make some profit, if only to cover marketing and sales costs and to return some dividend to shareholders. Otherwise no competent, solvent company would bother to bid.

The allowable profit on a contract can be determined in any of several ways, but the specific way is determined when the contact is awarded.

For instance, the Request for Proposal might ask for a firm, fixed price bid. In this case, bidders reply with a total price for doing the work. If they can accomplish it in less than the estimated hours or with fewer expenses, they pocket more profits; if they overrun, they must cover the losses. This type of contract is only used when the nature and extent of the work is very well known. Otherwise it is too risky for the contractors and for the government - the company doesn't want to take a huge risk and the government doesn't want a company to go bankrupt half-way through the job.

A more common form of pricing is the time and materials or the cost plus award fee contract. In a T&M contract, the government reimburses the contractor for the hours expended, based on the burdened labor rates the company bid for each labor category, plus materials and the allowable indirect and G&A expenses associated with those labor costs. The contract might specify a fixed profit margin, say 4 % or 5%, or it might specify an award fee, i.e. a maximum profit margin that could be earned. In award fee contracts, the Contracting Officer essentially gives the contractor a report card - if the company earns 95 points out of a possible 100, then it gets 95% of the negotiated award fee as profit.

Award fees are written into contracts as a motivation to perform services in a timely and quality way and are appropriate when the contractor can reasonably be expected to determine the quality of work provided, i.e. when there are no outside factors that would have a big impact.

Deja Vu All Over Again

Estimating costs and the time to perform services is an expensive and time-consuming affair for bidders and for the government auditors who verify the bidder's numbers before the contract is awarded. It would save a lot of hassle if the costs could be established on some periodic basis rather than recomputed every time the government wants to have companies provide services or goods, no?

That's what Congress thought, anyway, and so it modified the FAR to allow task order contracts. In this case the government negotiates a contract allowing agencies to task the contractor to do certain kinds of services. Only the specific services listed in the master or 'umbrella' contract may be procured this way and the negotiated labor pricing, G&A rate and profit/award fee apply. A maximum total cost is also specified in the master contract. Agencies who want to use this contractor's services must draft a task order, basically a mini-contract spelling out the tasks to be done, so there is still some overhead required to use a task order contract.  A ceiling is placed on the total amount of work that can be awarded.

A modified approach is for a company to negotiate a set of approved labor categories and costs with the General Services Administration. Once a company has an approved GSA Schedule of rates, it also seeks to be awarded an Indefinite Delivery/Indefinite Quantity contract. This is very similar to the task order contract, but it streamlines the process for an agency that want some well-defined tasks done which don't warrant the 3-6 months that might be needed to get a task order written and through the legal approval process.

We're Getting Closer....

We're beginning to close in on the elusive Halliburton contract in Iraq now. One more step is required, namely to revisit some decisions made during the Clinton administration that resulted in the award of a DoD-wide umbrella contract for logistical and base support services to Kellogg, Brown & Root, a Halliburton subsidiary.

More on that in Part 3 of this special report shortly.