Learn more about accounting for government contractors by reviewing this informative guide on FAR 15.4, which includes a special focus on contract pricing.
Accounting for Government Contractors, An Introduction
In our post on FAR Part 15, we introduced contracting by negotiation in Part 15. A lot of you smart folks probably noticed that we did not include any reference to Subpart 15.4 and its guidance regarding how and when the Government should perform a price or cost analysis during the evaluation of proposal submitted by interested parties. That’s because this aspect of contracting by negotiation is so important that we give it its own entire chapter! FAR 15.4 (“Contract Pricing”) sets forth the policies and procedures for “pricing” negotiated prime contracts (including subcontracts) and contract modifications.
When thinking about accounting for government contractors, some important questions that we should ask when reviewing FAR 15.4 are:
- Is there a difference between “cost” and “price?” and
- How does the Government determine what is “fair and reasonable” when evaluating cost or price?
In oversimplified terms, cost is the money a contractor must pay to perform a contract. For example, if a contractor is constructing a building, it must acquire the materials it needs to build. The money the contractor pays for those materials is part of its contract costs. So is the money the contractor must pay to its employees or subcontractors for their services. In contrast, price is the amount the contractor charges to the Government. To be successful, contractors must make sure that all costs, both direct and indirect factors such as overhead and G&A plus a reasonable profit are included in the selling price.
As a side note, “profit” is not a bad word in government contracting! FAR 15.404-4 clearly states that it is in the Government’s interest to offer a contractor sufficient profit opportunities that are sufficient to stimulate efficient contract performance, attract the best qualified large and small businesses and to maintain a viable industrial base. Profit is a motivator of efficient and effective contract performance. The FAR states that “Negotiations aimed merely at reducing prices by reducing profit, without proper recognition of the function of profit, are not in the government’s interest.” FAR 15.404-4(a)(3). Optimum contract performance is not properly motivated through negotiating extremely low profits, the use of historical averages, or an automatic application of a predetermined percentage to total estimated costs.
Accounting for Government Contractors: Cost and Pricing Data
Contracting officers are generally the ones who determine whether costs and prices are “fair and reasonable.” How do they make that determination? The FAR suggests that they follow the guidance set forth at FAR 15.404.
What in the World is “Cost or Pricing Data?”
This is at least partly and accounting for government contractors question. First of all, we need to know what “cost or pricing data” means. FAR 2.101 tells us that “cost or pricing data” are:
“All facts that, as of the date of price agreement, or, if applicable, an earlier date agreed upon between the parties that is as close as practicable to the date of agreement on price, prudent buyers and sellers would reasonably expect to affect price negotiations significantly.”
The FAR notes that cost or pricing data are not just “SWAGs” or spitball figures based on someone’s judgment; they are verifiable facts. FAR 2.101 also notes that “[cost] or pricing data are more than historical accounting data.” Contractors can’t just toss old accounting ledgers at the Government and expect that to be sufficient. Instead, cost or pricing data includes “all the facts that can be reasonably expected to contribute to the soundness of estimates of future costs and to the validity of determinations of costs already incurred.”
FAR 15.402 tells us that Government contracting officers should only request the disclosure of “certified cost or pricing data” to the extent necessary to establish a “fair and reasonable price.” The pricing guides referenced in the FAR state that the FAR does NOT define the term “fair and reasonable price,” but instead implies two separate tests:
- What is fair?
- What is reasonable?
What Is Fair? Buyers and sellers may have different perceptions on what price is fair.
- Fair to the Buyer. To be fair to the buyer, a price must be either the fair market value of the contract deliverable (if that can be ascertained through price analysis) or the total allowable cost of providing the contract deliverable that would have been incurred by a well-managed, responsible firm using reasonably efficient and economical methods of performance plus a reasonable profit.
- Fair to the Seller. To be fair to the seller, a price must reflect the fair market value of the item/service requested by the Government which takes into account competitive prices in the marketplace which include amounts needed to satisfy the terms and conditions of the contract without losing money.
What Is Reasonable? A reasonable price is a price that a prudent and competent buyer would be willing to pay, given available data on market conditions. Economic forces such as supply, demand, general economic conditions, and competition change constantly. Hence, a price that is reasonable today may not be reasonable tomorrow.
How to Certify Cost or Pricing Data
You’re probably wondering how cost or pricing data is certified. Fortunately, the FAR addresses that well and in detail. In fact, 15.406-2 tells us the exact language that must be submitted to the Government when such a certificate is required. When reading the language, you will note that a contractor must certify that the cost or data provided are current, accurate, and complete as of the date of the final price agreement between the offeror and the Government, or on some earlier date (sometimes called the “handshake date”) upon which the parties have agreed.
Pay close attention to the words “current, accurate, and complete.” The Certificate of Current Cost or Pricing Data will be violated if the contractor has failed to provide last-minute costing information (not current), or has provided inaccurate information, or has chosen not to provide supplier pricing information that it plans to use (not complete).
FAR 15.408 (Table 15-2) contains the format for submitting this data. Offerors submit cost or pricing data to the “cognizant CO.” That just means offerors must submit the data to whichever CO is overseeing this stage of the procurement. (Some agencies have the same CO oversee the entire contracting process, and others have different COs for each contract stage.)
If, after contract award, a CO learns or suspects that a contractor or offeror has submitted defective cost or pricing data, 15.407-1(c) says that the CO should request a certified cost or pricing data audit. The procedures for requesting and conducting such an audit are in 15.407-1(c) through 15.407-1(f).
Evaluating Cost and Price
Contracting officers can evaluate whether contract pricing is fair and reasonable in two ways: by conducting a price analysis or by conducting a cost analysis. We will examine both these methods below.
The Government’s first line of defense in any evaluation/negotiation of a contractor’s proposed price is a price analysis. COs can conduct price analysis in situations that do not require certified cost or pricing data. As you probably suspected, a price analysis looks at whether the price an offeror offers is fair and reasonable, without having to consider the contractor’s underlying costs. 15.404-1(b)(1) puts it this way: “Price analysis is the process of examining and evaluating a proposed price without evaluating its separate cost elements and proposed profit.” There are many ways a CO can conduct a price analysis. The FAR lists seven different ways in 15.404-1(b)(2), but also notes that the list is not exhaustive. You can find additional rules governing price analysis in 15.403-3 and 15.403-5(b)(2).
Sometimes a price analysis cannot be performed. This often occurs when a CO is procuring a completely new product and only received one bid on the solicitation there isn’t enough information in the commercial marketplace or in SAM to determine whether the overall price is fair and reasonable. In that case, a CO should perform a cost analysis instead. 15.404-1(a)(4). COs should also perform a cost analysis when a procurement requires the disclosure of certified cost or pricing data. 15.404-1(a)(3).
FAR 15.404-1(c)(1) defines cost analysis as
“The review and evaluation of any of the separate cost elements and profit or fee in an offeror’s or contractor’s proposal as needed to determine a fair and reasonable price or to determine cost realism, and the application of judgment to determine how well the proposed costs represent what the cost of the contract should be, assuming reasonable economy and efficiency.”
This definition is much more complicated than the price analysis definition, but if we break it down into bite-size chunks, we can understand it better.
- “Review and evaluation” is fairly self-explanatory. A CO looks over the data and then makes a determination based off the review.
- “Any of the separate cost elements” means anything—and we mean anything—the contractor has to buy to fulfill the contract. Cost elements include all direct (e.g., labor, travel, materials, etc.) and indirect costs (e.g., G&A, overheard, etc.). The CO must evaluate each of these costs separately.
- “Profit or fee” is again pretty much what it sounds like. Since profit (or any fee) is included in the final price, a CO should determine that the profit or fee charged is fair and reasonable. While it is not a cost incurred by the contractor, the CO must still evaluate it when performing a cost analysis.
- “In an offeror’s or contractor’s proposal” should be pretty clear to us now, since we discussed proposals at length in Chapter 9! If you need a refresher, go back there and take a peek.
- “To determine a fair and reasonable price” is fairly clear too. If you want to refresh that definition, go back up to the introduction of this chapter.
- “To determine cost realism” is a new term for us. What is cost realism? We’re going to ask for your patience – we’ll talk about that in the next section! For now, think of it literally and you’ll be okay.
- “The application of judgment to determine” refers to the CO’s judgment, not the judgment of some outside source.
- “How well the proposed costs represent what the cost of the contract should be” is a bit of a mouthful. Broadly, it just means that the costs an offeror is offering should match the costs that a regular person (or agency) would normally pay for something.
- “Assuming reasonable economy and efficiency” is a very accountancy term. Basically, it just means that a CO is directed to evaluate what a contract “should” cost based on current market trends, without fluffing prices or padding hours or gross inefficiencies.
So how does a CO perform a cost analysis? 15.404-1(c)(2) lists six ways a CO could perform a cost analysis. As with price analysis, the list is not exhaustive.
Accounting for Government Contractors: Cost Realism and Other Issues of Cost Analysis
FAR 15.404-1(d)(1) defines cost realism as “the process of independently reviewing and evaluating specific elements of each offeror’s proposed cost estimate to determine whether the estimated proposed cost elements are realistic for the work to be performed; reflect a clear understanding of the requirements; and are consistent with the unique methods of performance and materials described in the offeror’s technical proposal.” This is another long definition, but with what we’ve learned so far, you should be able to get it down if you read it a few times. Cost realism is not always a part of cost analysis; in fact, generally, it is only supposed to be used in certain circumstances.
Thank you for joining the Public Contracting Institute for this discussion of accounting for government contractors. If it was helpful, consider joining on of our excellent classes on accounting for government contractors.