Consistency, consensus needed on industry profits.

• Author: Farrell, Lawrence, Jr.
• Position: President's Perspective - Defense contracts

At a time when defense programs are under growing pressure to control costs and increase efficiency, it is important for the industry to be attuned not only to customers' needs but also to the way government officials view contractors' profits.

Although there is a widespread perception that defense contracts yield healthy profits, in reality, the way government officials view profits can be drastically different from the way industry measures that profit.

First, let's review the basics. Firm fixed-price profit levels can be whatever the awarded contract cost structure calls for. By law, a typical "cost-plus," fixed fee research-and-development contract caps industry profits at 15 percent of the cost of the project. Some are limited to 10 percent.

But no matter how the profit margin is determined, industry and government see the margin differently. In one example cited by Jack Cash, a professor of business management at the Defense Acquisition University, a project with costs estimated at $9 million might come with a $1.35 million profit fee, or 15 percent. The same contract, as described by industry accountants, only shows a profit margin of 6.53 percent, rather than 15 percent. The difference is attributed to unallowable costs the industry must pay (such as interest on loans, advertising and bad debt expense) and income taxes. These take a huge bite out of the profit margin.

Government officials generally don't see profit the way it's looked at in the commercial world, Cash points out. "The average person working in a program office doesn't see it." While the policy is structured to pay a reasonable profit, the perception in government circles is that contractors are making far more than what they are.

Under new policy guidance issued by the Defense Department less than two years ago, contracting officers are being asked to change the way they negotiate profits with industry, and are emphasizing areas that traditionally did not factor into contractor profits.

Unlike previous practices, the government no longer rewards contractors for investing in facilities or equipment. As a matter of fact, the government wants to discourage industry from spending money on facilities, mid wants, instead, to increase the focus on technical innovation and efficiency, notes Cash. In the past, he says, it used to be that the government wanted to motivate contractors to invest in manufacturing plants and buildings.

The new method for determining fair profits...