The State of the Government Contractor Industry - Grant Thornton LLP

The State of the Government
Contractor Industry: 2010
White paper 2010

Contents
01 2010 market outlook:
Predicting the unpredictable
05 A look at Grant Thornton’s
15th Annual Government
Contractor Industry Survey

The State of the Government Contractor Industry: 2010
2010 market outlook: Predicting the
unpredictable
For many government contractors, business is booming – at
least in comparison to the rest of the economy. Unlike most
of the commercial sectors that suffered from major business
disruption, financial losses and employee cutbacks in 2009, the
government contracting industry experienced steady growth,
boasting a 12 percent increase over the preceding year. Although
continued progress in the sector is expected over the next two
years, the pace of growth will likely slow, as several potential
challenges come to the forefront – including the difficult fiscal
environment and insourcing. In addition, new compliance and
ethics requirements issued by the Defense Contract Audit
Agency (DCAA) and a variety of proposed policy changes will
also continue to impact the market.
Presumably, contractors will feel some of the effects of the
major budgetary constraints now being placed on their clients,
with almost all agency budgets currently flat and expected
to remain so for the foreseeable future. As a result, budget
prioritization and strategic allocation of funds and resources
will play an enhanced role in new project initiatives for most
government bodies. In addition, program reviews are also taking
precedence as departments consider what they can live without
and where they can save money. Lastly, the appropriations
process and its anticipated hurdles could have a further numbing
effect on agencies, restricting their ability to launch new
initiatives pending the passage of a full, new appropriation.
The fiscal picture
With a tidal shift in the makeup of the federal budget, including
an anticipated public debt of $20 trillion by 2019, significant
changes inevitably loom on the horizon for government
contractors and their clients. Fiscal pressures are becoming
far more acute than in recent years, as mandatory spending
continues to dominate the budget for most programs – including
Medicaid, Medicare and Social Security – and with interest
on debt growing dramatically as a portion of mandatory
spending, rising from 11 percent today to 20 percent by 2019.
Furthermore, as a proportion of the federal deficit, interest on
debt will rise from 12 percent today to 85 percent by 2019. It
goes without saying that such a deficit reversal poses an almost
unprecedented fiscal challenge to the government and its
departments – with the resolution of this challenge remaining far
from clear.
1

It is important to note that while most civilian agencies are
slated for flat or reduced spending, in reality, the budgetary
freeze only applies to about one third of the discretionary
budget. For example, the proposed FY11 budget requests more
money for national security than projected just six months
ago, with the Department of Defense’s (DoD) base budget
increasing 4.4 percent this year and 3 percent per year thereafter.
Furthermore, DoD will receive $160 billion this year (and has
requested the same amount next year) for overseas contingency
operations. However, current projections show a decrease in
contingency funding by two thirds as of FY12 – a target believed
by many to be overly optimistic. Add to this the costs of base
realignment and closure, as well as DoD health care ($45 billion
a year and growing) and it becomes clear that despite its apparent
budget stability, the DoD remains under enormous financial
strain.
Insourcing
Insourcing has also become an important area of focus for
government contractors in regard to business development and
strategy, as well as employee retention. Currently, the DoD is
leading the insourcing charge thanks in large part to the Secretary
of Defense’s Workforce Initiative, which plans to hire 35,000
new employees in FY10 and FY11. The goal of this initiative is
to strategically build skill sets in-house while also reducing the
number of contracted positions used to perform these critical
functions to 26 percent of the workforce (from 39 percent in
FY08). Nearly half of these new positions are expected to be
filled by contractors currently performing this work.
Aggressive budgetary assumptions are tied to these
insourcing goals, with an expected $40,000 to $44,000 savings
per insourced employee for approximately 17,000 to 22,000
positions, raising significant questions—and attracting growing
congressional interest—as to how this target was determined and
whether it truly includes the total cost to the taxpayer. Further,
based on information from the DoD, the majority of positions
already identified for insourcing are not within the realm of
critical skills targeted by the Secretary, but are fairly routine
commercial mid- to lower-level positions, making the DoD’s
analysis even more questionable.
To their credit, civilian agencies have been more measured
in their insourcing endeavors, better following the Office
of Management and Budget’s guidance to take into account
competition, cost/performance analyses and hierarchy of
workforce positions and needs in their insourcing reporting and
implementation efforts. An example of this is the Department
of Homeland Security, which is currently undergoing efficiency
reviews across the board and focusing on internal skills that are
needed in order to develop a management core. In addition, the
State/USAID is increasing its focus on workforce development,
while the Department of Health and Human Services is
developing a component-level insourcing plan.
As to be expected, with the expansion of insourcing has also
come increased public scrutiny as to the recruitment process of
these new employees, as varying parties begin to examine the
integrity of business relationships and role of “merit system”
hiring in this process. Unfortunately, employee poaching by the
government for insourced positions has the potential to make
a huge impact on the smaller services firms, raising discussions
around the development of a mutual, non-compete hiring
initiative.
Compliance and ethics programs
Beginning with the War on Terror and Hurricane Katrina,
the government procurement process as of late has undergone
significant scrutiny, resulting in several new guidelines for
government contractors in their compliance and ethics programs.
Spearheaded by the Federal Acquisition Regulation (FAR)
Council, these requirements first became effective in December
2007 through the Contractor Code of Business Ethics and
Conduct clause at FAR 52.203-13 and are applicable to all
contracts of $5 million or more with a performance period of
120 days or more. Under these new compliance regulations,
government contractors are required to have the following in
place:
1. A code of business ethics and conduct within 30 days of
contract award, making the code available to each employee
engaged in performance of the contract.
2. A business ethics awareness program and internal control
system within 90 days of contract award. This requirement
does not apply to small business companies and contracts for
the acquisition of a commercial item.
3. Reasonable steps for communicating the contractor’s
standards and procedures and other aspects of the
contractor’s business ethics and awareness and compliance
program and internal control system, conducting effective
training programs and also disseminating information
appropriate to an individual’s respective roles and
responsibilities.
This new clause also requires that government contractors
now establish standards and procedures to facilitate timely
discovery of improper conduct in connection with government
contracts, as well as ensure that corrective measures are promptly
instituted and carried out should a problem exist. With this in
mind, the Contractor Code of Business Ethics and Conduct
clause at FAR 52.203-13 includes seven minimum standards that
the contractor’s internal control system must meet:
1. Assign responsibility at a sufficiently high level and with
adequate resources to assure effectiveness of the business
ethics awareness and compliance program and internal
control system.
2

2. Reasonable efforts not to include an individual as a principal
who has engaged in conduct in conflict with the company’s
code of business ethics and conduct.
3. Periodic reviews of company business practices, procedures,
policies and internal controls for compliance with the
contractor’s code of business ethics and conduct.
4. An internal reporting mechanism, such as a hotline, which
allows for anonymity or confidentiality, by which employees
may report suspected instances of improper conduct.
5. Disciplinary action for improper conduct or for failing to
take reasonable steps to prevent or detect improper conduct.
6. Timely disclosure in writing to the Office of Inspector
General and the Contracting Officer whenever the company
has credible evidence that a principal, employee, agent or
subcontractor has violated Federal law involving fraud,
conflict of interest, bribery, gratuities or the False Claims Act.
7. Full cooperation with any government agencies responsible
for audits, investigations or corrective actions.
These new regulations place considerable risks on
government contractors, particularly in regard to their internal
control systems, not only requiring internal or external audits
of the compliance system, but also requiring the company to
make formal disclosure to the government whenever there is
credible evidence that a violation has occurred. As a result, it is
imperative for government contractors that all audits required
for the internal control system are performed by auditors with
expert knowledge of federal procurement rules and regulations.
Furthermore, all internal or external audits of the compliance
system should include sufficient audit steps to identify the cause
of the perceived compliance issue and appropriate remedies.
New developments at the DCAA
Regrettably, many of the issues that fueled the creation of
these new compliance standards resulted from audit reports
of the DCAA that either mischaracterized the facts or were
misinterpreted by parties attempting to politicize routine
government contracting issues. Consequently, the DCAA
finds itself the subject of increased political scrutiny and is now
implementing changes in its approach to audits.
The DCAA’s troubles began on July 22, 2008, when the
Government Accountability Office (GAO) issued a report to
Congress concluding that, after reviewing certain audit files,
the DCAA had failed to comply with the Generally Accepted
Government Audit Standards, including:
1. Documentation in the work paper files did not support the
audit opinion.
2. DCAA supervisors dropped findings and changed audit
opinions without adequate evidence for the changes.
3. Sufficient work was not performed to support the audit
opinions.
The GAO also stated that, in their opinion, the DCAA was
too lenient on contractors and questioned whether the DCAA
had sufficient independence from the contractors they were
auditing. The GAO concluded that the DCAA’s failures were
the result of a management and agency culture that focused on
a production-oriented mission and paid inadequate attention to
performing quality audits.
3

In response to the GAO’s report, the DCAA issued a flurry
of new policies and procedures, which included the following:
1. Significant deficiencies/material weaknesses and audit
opinions on internal control systems: The DCAA would
no longer issue reports stating that systems are inadequate
in part, with the new policy being that if any significant
deficiency or material weakness was noted, the report would
include the opinion that the system is inadequate. The
new guidance also stated that the DCAA would no longer
include recommendations to improve the system in the
audit report and that it was not necessary to demonstrate
actual questioned costs to report a significant deficiency/
material weakness, but rather only that there is a possibility
of questioned costs.
2. Reporting suspected contractor fraud and other
contractor irregularities: The working level auditor
is authorized to make the fraud referral directly to the
cognizant investigators without prior discussion with
or approval by the DCAA Branch Manager or Resident
Auditor.
3. Reporting significant/sensitive unsatisfactory conditions
related to actions of government officials: The DCAA is
authorized to report a Contracting Officer directly to the
Inspector General when a Contracting Officer ignores an
audit recommendation and negotiates costs or profit that the
DCAA considers unreasonable and excessive.
4. Audits of the contractor code of business ethics and
conduct: Auditors must perform procedures to address
the requirements of the new compliance regulations during
audits of a contractor’s control environment and accounting
system controls. The audit program requires that the DCAA
obtain and review copies of the contractor’s internal/external
audit reports performed as part of the internal control
system.
The road ahead
For government contractors, these changes are just the
beginning, with several additional procurement policies set to
make their debut very soon, including regulations regarding
personal conflicts of interests, new definitions for inherently
governmental, closely associated and critical positions, and the
Defense Federal Acquisition Regulation’s proposed standard
that if a contractor fails a systems audit, for even the most minor
of reasons, the DoD will withhold a percentage of its payments
until the problem is rectified.
Needless to say, the government contracting industry is
clearly in a state of change and uncertainly – posing potential
risks, as well as opportunities – to those businesses operating
in this arena. Companies seeking to secure their place in this
competitive marketplace must take heed, thinking strategically
and acting proactively to ultimately ensure that they are
operating as efficiently and effectively as possible.
As a follow-up to its initial findings, the GAO issued
a highly-critical report on Sept. 23, 2009, summarizing its
examination of several DCAA offices and concluding that major
problems existed throughout the DCAA. Shortly thereafter,
the DCAA Director was terminated and transferred to another
position within the DoD.
4

The State of the Government Contractor Industry: 2010
A look at Grant Thornton’s 15th
Annual Government Contractor
Industry Survey
The Grant Thornton 15th Annual Government Contractor
Industry Survey provides perspective on how the government
contracting industry has evolved over the past year, through
the collection and analysis of responses from a cross section
of small, medium and large companies that consider the
federal government to be a significant customer. Providing a
comprehensive view of the industry as a whole, the survey aims
to provide benchmarking data and identify key trends regarding
the day-to-day business operations, as well as the future
challenges and opportunities facing government contractors.
Revenue trend from federal contracts
While much of the commercial business sector deteriorated in
2009, the government contracting industry remained strong,
with 50 percent of respondents reporting increased revenue from
federal government contracts, 30 percent reporting no significant
change in revenue and only 20 percent experiencing reduced
revenue – a trend in keeping with the past four surveys.
Revenue trend from federal business
Increased 50%
Decreased 20%
No change 30%
Revenue from cost reimbursable contracts
The government’s shift in direction from efficient, commercial
practices to a more micromanaged, audit and investigation
environment is evidenced by survey responses regarding revenue
by contract type. According to respondents, 46 percent of
their revenue was from cost reimbursable work, continuing
an upward trend noted in recent years’ surveys. The jump in
cost reimbursable contracts was first noted in the 12th Annual
Survey when it jumped to 39 percent – up 11 percent from the
year before. In the ensuing three years, the percentage of revenue
from cost reimbursable contracts continued to rise to 46 percent
in this year’s survey.
It is impossible to equate the high use of cost reimbursable
contracts with the notion that the government is attempting
to use more commercial processes to streamline federal
procurement, as time and material contracting is the primary
method used in the commercial business sector to acquire
professional services.
Management and support headcount as a percentage of
total headcount
For government contractors, the percentage of management and
support No change staff to total headcount is typically a key component of
price competitiveness. This year’s survey shows that, on average,
Decreased
management and support functions comprise 14.6 percent of
total Increased headcount. This is a modest decrease from the 16 percent
shown in last year’s survey and a slight increase from the 13.8
percent shown two years ago.
5

Profit rate (before interest and taxes) as a percentage of
revenue
One common misconception regarding the government
contracting industry is that it is a high-profit business.
Unfortunately, this notion could not be further from the truth.
Surveyed companies provided financial information on gross
profit before interest and taxes as a percentage of gross revenue,
with 45 percent showing either no profit or profit rates between
1 and 5 percent compared to 37 percent in last year’s survey. In
addition, 85 percent had either no profit or profit rates between
1 and 10 percent compared to 76 percent in last year’s survey.
The number of surveyed companies with profit rates above 10
percent shrank from 24 percent last year to 15 percent this year.
Profit rate before interest and taxes
15 th
Annual Survey
Annual Survey
1 -- 5% profit rate
6 -- 10% profit rate
11 -- 15% profit rate
>15% profit rate
No profit
31%
32%
40%
39%
12%
10%
3%
14%
14%
5%
14 th 44%
Procedures for identifying out-of-scope work
Out-of-scope work can come from either directed or
constructive changes, both of which entitle the contractor
to an equitable adjustment in contract price and schedule. In
general, directed changes are easy to identify as they arise from
government issued contract modifications and, in such cases,
there is no argument whether the contract has been altered.
Constructive changes, on the other hand, are more difficult to
determine, as they can only be identified by a contractor that has
effective procedures in place to monitor contract performance
against the contract statement of work.
Often, equitable adjustment requests for constructive
changes have been resisted by the government arguing that
the contract has not changed. However, based on the survey
responses received, it appears that many respondents have
improved their procedures for identifying out-of-scope work,
with 44 percent identifying their procedures as very effective and
39 percent calling their procedures somewhat effective. These
findings are an improvement from last year’s survey.
Effectiveness at identifying out-of-scope work
15 th
14 th
Annual Survey
Annual Survey
Very effective
Somewhat effective
Not effective
35%
39%
45%
17%
20%
6

Government requests for out-of-scope work without contract
modification
Surveyed companies were also asked to provide the frequency
of government requests for out-of-scope work without
contract modification, with 78 percent stating that government
customers frequently or occasionally ask for out-of-scope work
without providing a contract modification. This information
is troubling, as government regulations are very clear that only
the Contracting Officer has the authority to change the contract
and such changes should occur through contract modification or
other formal authorization.
Furthermore, surveyed companies were also asked to provide
the response they typically provide when the government
requests out-of-scope work without issuing a contract
modification, with 81 percent either always performing the
work or sometimes performing the work. It is clear from these
findings that the necessity to please the customer is a prime
requirement for keeping contracts, and that certain government
officials are taking full advantage of this fact despite government
procurement regulations.
Labor multipliers
Used as a means of pricing work, a labor multiplier is derived
by dividing the total loaded labor price by the bare cost of
labor. For example, assume a direct labor employee is paid $10
per hour. Further, assume that after applying fringe benefits,
overhead, G&A and fee, the $10 in labor is marked up to $23.
The labor multiplier would then be 2.3 ($23/$10). The labor
multipliers in this year’s survey are somewhat lower than last
year, with the multiplier for on-site direct labor falling from 2.4
to 2.1 and for off-site labor from 2.0 to 1.8 – possibly resulting
from an increase in competition in the marketplace.
Government requests for out-of-scope work without
contract modification
Frequently 16%
Occasionally 62%
Never 22%
Response to government requests for out-of-scope work
without contract modification
Always perform 15%
Refuse to perform 19%
Sometimes perform/refuse 66%
Average labor multiplier through fee
15 th Annual 14 th Annual
Labor type Survey Multiplier Survey Multiplier
On-site direct labor 2 . 1 2 . 4
Off-site direct labor 1.8 2.0
7

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About this white paper
This white paper summarizes discussions held at
the Grant Thornton LLP Government Contractor
Roundtable on Tuesday, March 9, 2010. Audience
members included chief executive officers, chief
financial officers and other key decision-makers
with government contracting firms. Stan Soloway,
President and Chief Executive Officer of the
Professional Services Council, and Norm Duquette,
Grant Thornton LLP Government Contractor
Specialist, discussed major issues facing the
government contracting marketplace, as well as the
results of the 15th Annual Government Contractor
Industry Survey.
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