Budget Cuts Are Coming—Managing Your Costs By Wayne Clark, CPA Federal Strategies Group LLC Background Funding cuts to federal agencies and programs will make fewer dollars available to contractors. Many of the large federal contractors reduced their indirect costs in anticipation of performing the same work at a reduced price. All contractors need to prepare for a more competitive environment that favors the low bidder. To succeed in this environment, a small business must place more emphasis on managing costs. How does a government contractor manage costs? A government contractor’s primary performance metric is the indirect rates. A simple indirect rate structure includes fringe, overhead and general & administrative (G&A) rates. To simplify the process, these rates are combined into a single rate applied to direct labor called the wrap rate or multiplier. For example, a common multiplier calculation for a contractor with only direct labor is (1+fringe rate)*(1+overhead rate)*(1+G&A rate). Always validate the multiplier by applying the multiplier to direct labor in the P&L and then compare this value to the sum of direct labor and allowable indirect costs in the P&L. How does a contractor manage its indirect rates? The contractor prepares a budget for the upcoming accounting year. The budget includes revenues, costs, profit and indirect rate calculations. The contractor will likely meet or exceed its profit goal for the year if actual indirect rates are equal to or less than budgeted indirect rates. Are budgeted and provisional indirect rates the same? Provisional indirect rates are indirect rates approved by your cognizant federal agency. Provisional indirect rates are the maximum indirect rates that can be used in bids or used in billing cost reimbursable type contracts. Ideally provisional indirect rates include some estimates for unexpected cost increases such as healthcare premiums. Provisional indirect rates, in general, should exceed budgeted year-end indirect rates. What strategies should I use to hit my indirect rate targets? A common strategy is to accrue monthly discretionary expenses that include bonuses and 401(k) matches. These amounts are paid after year end and are tied to actual performance. Reductions in accruals can offset unanticipated cost increases or lost revenue. What strategies should I use to manage my direct costs? In general, direct labor is the largest direct cost for many contractors. Some contractors reduce salaried employee’s direct hourly rate by defining the work week as more than 40 hours. Apply pressure to consultants and subcontractors to reduce their billing rates. Also consider reducing the mark up applied to non-labor direct costs. What other steps can I take to control my costs? Do not incur additional indirect costs in anticipation of future growth. Additional indirect costs should lag behind company growth. Always consider the impact to indirect rates when incurring long-term indirect costs such as hiring additional indirect employees. I have to spend money on business development Use business development dollars wisely. In general, your odds of success increase when you limit the proposal activity to opportunities where you are positioned to win. Focus on submitting high-quality proposals for these opportunities. A good business development staff is essential to revenue growth. Re-evaluate the business developer’s compensation mix of salary and performance bonuses. How do I evaluate my cost control during the year? Once you have finalized the annual budget, copy the file and name it Forecast. The Forecast is updated monthly by replacing the budget amounts with actual revenues and expenses. The Forecast indirect rates for the year are then updated and compared to the expected year-end indirect rates. Forecast indirect rates that exceed the budgeted year-end indirect rates are an indication to management that cost-cutting actions may be necessary. The use of a Forecast is a critical management tool. Summary The contracting world is changing. Contractors are chasing fewer and fewer federal dollars. The ability to manage costs and to be price competitive will become more and more important over the next several years. Small businesses need to place more emphasis on managing costs. The primary cost management tools are annual budgets and forecasts that are updated on a monthly or quarterly basis. The updated forecasts provide strong indications to management as to whether or not actual year-end revenues, profits and indirect rates will fall within management goals. Wayne Clark, CPA, is a Senior Manager with Federal Strategies Group LLC. He provides government contract and management consulting, M&A advisory, forensic accounting and expert testimony to the government contracting industry. He can be reached at WayneC@FedStrat.com.