Grant Thornton's 2015 Government Contractor Survey

Grant Thornton's 2015 Government Contractor Survey

Contents 1 Introduction 2 Executive Summary 4 Company Profile 10 Workforce Trends 12 Cost Accounting 18 Proposals 22 Project Management and Contract Administration 30 Compliance Programs and Business Systems 34 Dealing with DCAA and Contracting Officers 40 Executive Compensation 43 Mergers and Acquisitions and Other Business Strategies 46 Recent Developments at DCAA 50 Sponsors

Introduction Grant Thornton LLP is pleased to provide the 2015 Government Contractor Industry Survey as part of our continued thought leadership within the government contractor community a community we have proudly served for three decades. Our survey provides a comprehensive look at the industry as a whole. It also includes detailed information on the day-today business of a government contractor including a wealth of information on updates to government regulations and changes in the policies, priorities, and approaches of government auditors and contracting officers. Finally, the survey addresses mergers and acquisitions and other business strategies that could benefit the owners of companies involved in government contracting. The survey is designed to cover sensitive areas that can directly affect the revenue and profitability of a government contractor and to help companies remain competitive in the marketplace. We also offer suggestions on how to deal with contractual and financial issues that may arise during performance of government contracts. Whether you are an established government contractor or a business considering entering this market, we hope you will find the information in this survey to be useful in managing your business now and planning for its future. We pride ourselves on being a firm of thought leaders who provide personalized attention and the highest quality of service. Our goal is to ensure this survey continues to evolve and to provide those interested in government contracting with the most precise and useful information possible. We welcome any suggestions for specific topics to cover in next year s survey. Please contact me directly at rich.lafleur@us.gt.com with your suggestions. A special thanks goes to my fellow partner, Kerry Hall, for his leadership in driving this survey process as well as the production of the survey in many of the year s past. We are fortunate to be supported by several generous sponsors who share our passion for this industry: BB&T Capital Markets Cresa Holland & Knight LLP Professional Services Council (PSC) Pleasant Valley Business Solutions (PVBS) Stout Risius Ross, Inc. SunTrust Banks, Inc. Richard P. LaFleur Partner in Charge, Markets, Industries and Clients Government Contracts Practice Leader Atlantic Coast Market Territory 1 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 1

Executive Summary Grant Thornton s periodic survey of government contractors presents a wealth of financial and nonfinancial information provided by companies located across the country. The government contractors that participated are small, medium and large companies and include both privately owned as well as publicly held companies. We also included in our survey new developments in government contracting in order to assist the reader in staying current with the seemingly ever-changing priorities and processes followed by government personnel who interact with government contractors. We sincerely appreciate the participation of the many companies that contributed to our survey. Revenue from government contracts During the past year, revenue from government contracts grew for 42% of survey participants, while 37% reported reduced revenue. The remaining 21% reported no significant change in revenue from their government work. The percentage of companies experiencing reductions is at the high end of the trends that we have noted over the many years we have published this survey. The reductions this year are the inevitable consequence of altered government spending priorities as well as sequestration; this will almost certainly be resolved in the next year or two. Profit rates Profit rates remain dismal in the government contracting industry. In the current survey, 52% of respondents reported either no profit or low profit in the range of 1-5% of revenue. This compares to 60% from the 2013 survey and 37% reported in the 2012 survey. Trend in number of full-time employees The number of full-time employees increased at 59% of the surveyed companies, while 15% report decreases, and the remaining 26% reported no significant change. In the 18th annual survey, 42% reported increases, 32% decreases, and 26% no significant change. Trends in indirect cost rates Indirect rates increased at 26% of the surveyed companies and decreased at 42%, with the remaining 32% reporting no significant change. In the 2013 survey, increases in rates were reported by 42% of respondents, 17% reported decreases, and 41% reported no significant change. Impact of revised maximum executive compensation on indirect cost rates The maximum allowable executive compensation for contracts awarded between December 31, 2011 and June 23, 2014 is $952,308. For all contracts awarded on or after June 24, 2014, the compensation limit is $487,000. These different limitations will require a contractor to compute two sets of indirect rates which will be applied based on the award date of individual contracts. Accounting for uncompensated overtime Seventy-five percent of surveyed companies account for uncompensated overtime by computing a diluted hourly rate (compression method) to allocate labor costs to cost objectives. The remaining 25% apply a standard hourly rate (standard 2 Grant Thornton's 2015 Government Contractor Survey Survey

variance method) to the hours reported and record the variance between labor distributed and payroll paid as a credit to overhead. In a cost-reimbursable environment, the use of the compression method can result in free work to the government customer and contribute to lower profits for the contractor. Proposal win rates Surveyed companies reported a 35% win rate on proposals submitted in a competitive environment. The win rate increased significantly to 75% when the company was the incumbent on the previous contract. Funding notices on cost reimbursable and T&M contracts Surveyed companies were asked to rate the effectiveness of their procedures for providing required advanced funding notices in a timely manner. Ninety-two percent of respondents reported their procedures are either very effective or somewhat effective; this is up from 86% reported in our last survey. Identifying claims for out-of-scope work Surveyed companies rated the effectiveness of their internal procedures for identifying out-of-scope work. Seventy-seven percent of respondents rated their procedures to be either very effective or somewhat effective which is consistent with the 82% reported in our last survey. Government requests for out-of-scope work without a contract modification Seventy-eight percent of surveyed companies report that government officials either frequently or occasionally request they perform out-of-scope work without a contract modification. Such requests are not consistent with the government s own procurement regulations and, given their frequency, have significantly corrupted the procurement process. Relationship with DCAA auditor A very large percentage of surveyed companies (43%) have a low opinion of the Defense Contract Audit Agency s (DCAA s) work product and the quality of its conclusions and believe the DCAA audit conclusions are arbitrary and not appropriately referenced to procurement regulations. This compares to 53% in our last survey. Further, 33% find DCAA to be inflexible and not responsive to contractor rebuttals. Relationship with the contracting officer Surveyed companies have an even lower regard for contracting officers than they do for DCAA. Forty-nine percent of surveyed companies report that contracting officer positions are arbitrary and supported with appropriate regulatory reference, and 45% find their contracting officer to be inflexible and not reasonably receptive to contractor rebuttals. M&A activity Fifty-six percent of surveyed companies expect the environment for M&A activity to improve over the next 12 months while 35% expect no change. During the past year, 69% of surveyed companies that considered M&A walked away from a prospective deal because of issues identified during due diligence. DCAA's role in the procurement process DCAA s role in the procurement process has been significantly reduced because of government concerns with DCAA s perceived inability to issue quality audit reports in a timely manner. DCAA s responsibilities have been reduced to such a degree that one can easily foresee the possibility that DCAA may soon officially lose its independent status within the procurement system and be put under the direct management control of contracting officers. Cost effectiveness of compliance regulations We asked surveyed companies whether or not they considered the compliance requirements for business ethics to be reasonable and cost-effective. The majority of respondents (63%) believe they are excessive and not cost-effective which compares to the 59% reported in our last survey. The compliance regulations are about to become more costly and more burdensome to contractors if new regulations proposed by the Department of Labor on May 28, 2015 are incorporated into the FAR. 3 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 3

Company Profile Grant Thornton s 2015 Government Contractor Survey is based on information provided by companies that do business with the federal government as a primary customer. We distributed questionnaires and received responses from participating companies between March and June of 2015. Financial statistics in the survey typically relate to fiscal year 2014 and were treated in the survey as belonging to the current year. We analyzed all of the data provided by respondents to be certain it was statistically valid and representative of the companies that responded to the survey. Data is presented in the survey as a whole or by company size when appropriate. In many instances, we also provide data from prior surveys in order to identify trends from survey to survey. In addition, we include a narrative for each topic and in several instances, offer suggestions on effective practices for cost accounting and contract administration for government contracts. Size of the business Surveyed companies provided their annual revenue by revenue range, and the results are summarized in Figure 1. Each of the revenue ranges shown are well-populated which demonstrates that the survey data represents an excellent cross-section of the government contractor industry. Revenue by market The revenue by market is shown in Figure 2. The percentage of revenue from contracts with federal agencies remains very high at 74% which illustrates that companies participating in the survey see the government as a primary customer. This year s rate of 74% compares with 84% in the 2013 survey, 93% from the 2012 survey, 94% from the 2011 survey, and 91% from the 2010 survey. Fig 1. Annual revenue >$150 million $51-150 million $11-50 million $0-10 million 15% 33% 36% 16% Fig 2. Revenue by market We also asked whether the surveyed companies were classified as small businesses using the size standards published by the Small Business Administration (SBA). Fifty-two percent of the surveyed companies report they are a small business which is similar to the percentages noted in the past four surveys. Defense Other federal State and local Commercial 40% 34% 8% 18% 4 Grant Thornton's 2015 Government Contractor Survey Survey

Revenue trend from federal business The revenue trend from federal business is illustrated in Figure 3 for the current survey along with the results from the prior four surveys which are presented for comparison. In the current survey, 37% reported decreased revenue from federal business while 42% experienced increased revenue from government contracts. Fig 3. Revenue trend from federal business 2015 survey 2013 survey 2012 survey Increased 2011 survey 2010 survey 42% 36% 55% This is the second consecutive survey where the number of companies experiencing decreased revenue from government contracts is very close to the number of companies experiencing increased revenue. This is no surprise and indeed is the predictable consequence of altered spending priorities as well as sequestration caused by the inability of politicians from both parties to efficiently manage the country s financial affairs. While procurement by certain civilian agencies can withstand the uncertainties associated with sequestration, it seems clear that procurements for national defense need a steady path from year to year given the need to maintain a modern and well-equipped military in a dangerous world. The government could save a great deal of money by instituting a streamlined procurement process but there are few signs indicating that the government is prepared to make significant changes in the procurement process. Revenue source We asked surveyed companies to provide the percentage of revenue from services, products, and pass-through transactions. On average, professional services generated 66% of revenue, product sales were the source for 18% of revenue, while the remaining 16% came from pass-through transactions. Decreased No change 37% 38% 29% 22% 20% 21% 26% 21% 23% 30% Revenue trend from the GSA or other multiple-award IDIQ contracts Approximately 20 years ago, the government greatly increased the use of indefinite delivery/indefinite quantity (IDIQ) contracts as part of a major effort to streamline the procurement process. Previously, the only major IDIQ contracts were the Federal Supply Schedule contracts which were directed and managed by the General Services Administration (GSA). IDIQ contracts typically include full terms and conditions, product or service offerings, negotiated unit prices, and a nominal minimum ordering requirement. An IDIQ contract is generally awarded to multiple contractors who are then allowed to compete for task orders or delivery orders issued by the government for goods and services. Some task or delivery orders may be set aside for small business competitors, while others are unrestricted and available to all companies holding the IDIQ contracts. IDIQ contracts usually remain in place for several years and are intended to cover those products and services where the government anticipates recurring requirements. Companies that do not have the IDIQ contract are 5 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 5

effectively barred from competing for work as a prime contractor for task orders or delivery orders. We have noted in the past that companies often bid deeply discounted pricing as part of their initial proposal for the IDIQ contract. Since the contract itself is simply an ordering vehicle with additional competition required for actual work, we believe it is normally advisable for companies to bid higher prices in the proposal for the initial IDIQ contract with the knowledge that the company has the option to discount those prices in a competition for highly desirable real work under delivery orders or task orders. In our experience, one size fits all is not a formula for success in government contracting. Fig 4. Revenue trends from GSA contracts or other IDIQ contracts Increasing Decreasing No significant change 45% 14% 41% Fig 5. Revenue by contract type We asked companies to provide information on the overall trend in revenue from IDIQ contracts and the results are shown in Figure 4. This year, 45% of respondents report increases in revenue from such contracts while 14% report decreases. The remaining 41% report no significant change. Revenue by contract type Surveyed companies provided a breakdown of revenue by contract type and the results are shown in Figure 5. We ve also provided information from the past five surveys for comparative purposes. The revenue by contract type has changed somewhat from that reported in recent surveys. Compared to the results from the 2013 Survey, the revenue from firm fixed price (FFP) contracts has increased from 20% to 33%, cost-reimbursable contracts have declined from 40% to 34% and T&M contracts have declined from 40% to 33%. There is a major disconnect between government policy and government practice when it comes to selecting a contract type. Part 16 of the Federal Acquisition Regulation (FAR) expresses a clear preference for FFP contracts and imposes specific requirements that must be met before a cost-reimbursable or Time and materials (T&M) contract can be issued. In spite of the clear regulatory preference for FFP, that contract type still represents barely one-third of the total revenue surveyed companies earn from government contracts. 2015 survey 2013 survey 2012 survey Cost-reimbursable Time and materials Firm fixed price 2011 survey 2010 survey 2009 survey 34% 40% 45% 40% 46% 45% 33% 40% 35% 40% 34% 35% 33% 20% 20% 20% 20% 20% 6 Grant Thornton's 2015 Government Contractor Survey

FAR Part 16 also makes clear that T&M is the least favored contract type and such awards require specific determinations by the contracting officer that no other contract type is suitable. The contracting officer s determination must be reviewed and approved by the head of the contracting activity if the total contract term, including option years, exceeds three years. We believe that in the next Congressional examination of necessary improvements to the procurement system, the regulations on contract type should be re-evaluated mandating a preference for FFP where the deliverable is clearly defined and a preference for T&M for the acquisition of professional services where the requirement is less clearly defined. In our opinion, cost reimbursable contracting should be minimized or eliminated since that is the one unique contracting type used by the government that is rarely used in commercial markets for the acquisition of goods and services. Eliminating cost reimbursable contracting would also save the government many billions of dollars annually currently being spent by contractors, DCAA, and contracting officers related to cost submissions and the costs to audit and billions more funding cost overruns on cost reimbursable contracts. Source of revenue growth over the next 18 months We asked respondents to predict the source of revenue growth over the next 18 months. The results are summarized in Figure 6, along with comparative data from the last four surveys. Fig 6. Sources of anticipated revenue growth 2015 survey 2013 survey 2012 survey Prime contracts for federal business Subcontracts for federal business State and local 69% 49% 55% 26% 69% 57% 34% 56% 61% 20% 19% 15% 12% 23% 2011 survey 2010 survey The findings from the five surveys show the effect of the uncertainties involved in federal contracting that many of the respondents face. Although the situations obviously differ from company to company, the data summarized in Figure 6 shows that for many small to medium sized companies, it is challenging to lack visibility as to where the business the company depends on for its survival will come from year to year. Political impacts from factors such as sequestration and lowered priorities for defense and space exploration also create major business uncertainties. It seems axiomatic that it would be preferable and far more cost-effective if the government could adopt certain national priorities that would survive the ever-changing political whims of elected officials. Commercial 31% 32% 25% 19% 26% 7 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 7

Profit rates before interest We asked companies to provide their profit rates before interest and taxes as a percentage of revenue and the results are shown in Figure 7. We have also included the results from the five prior surveys for comparison purposes. Profits continue to plunge when compared to profits reported in earlier surveys. The profit rates in Figure 7 are calculated before interest and taxes and therefore do not reflect the total cost of doing business. For companies that make a profit or finance their working capital, the profit rates are significantly lower than the already low profit rates shown in Figure 7. The very low profit rates realized by contractors combined with the insignificant savings from government audits discussed later in the survey strongly suggest that an overhaul of the procurement system could save many billions of dollars currently being wasted conducting audits of low-risk cost submissions. Even if the government sees a need to maintain an audit agency in support of contracting officers, it should be clear that the risk assessments should be redesigned to focus on situations where the risk of procurement issues is evident from premium profit rates. Fig 7. Profit rates before interest and taxes 2015 survey 2011 survey 2013 survey 2010 survey 2012 survey 2009 survey No profit 7% 4% 6% 10% 14% 5% 1-5% profit rate 45% 56% 31% 40% 31% 32% 6-10% profit rate 39% 31% 37% 35% 40% 39% 11-15% profit rate 7% 5% 18% 9% 12% 10% >15% profit rate 2% 4% 8% 6% 3% 14% 8 Grant Thornton's 2015 Government Contractor Survey

Facility costs Surveyed companies provided facilities cost as a percentage of revenue and the results are shown in Figure 8. We are aware that several privately held government contractors lease facilities from other organizations that are at least partially owned by the same executives that own the government contracting entity. The rental cost principle in FAR Part 31 limits the amount of rent that can be charged between organizations under common control to the normal cost of ownership such as depreciation, taxes, insurance, facilities capital cost of money, and maintenance. We have observed several instances where a contractor unnecessarily limited rental costs by misinterpreting what constitutes common control or by not claiming all of the costs properly includable in the accounting records for the real estate entities when computing cost of ownership. Fig 8. Facilities cost as a percentage of revenue 69% 24% 4% 2% 1% 1-5% 6-10% 11-15% 16-20% >20% 9 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 9

Workforce Trends Approximately 66% of the companies participating in this year s survey provide professional services to their clients. This is often a highly competitive business market that puts a premium on a company s ability to recruit and retain skilled and motivated employees who perform as required by the contract. Trend in number of full-time employees We requested that companies provide information on the trend in the number of full-time employees at the company. The responses are summarized in Figure 9 and show that the number of employees is increasing at 59% of the companies, decreasing at 15% of the companies and no significant change at the remaining 26%. These statistics are an improvement over the findings from the last survey in which only 42% reported the number of employees was increasing. Turnover rates We asked surveyed companies to provide employee turnover rates as a percentage of full-time employees and the results are shown in Figure 10. Turnover rates in the 0-5% range are reported by 30% of the respondents, while 26% report turnover in the 6-10% range. Of the remainder, 27% report turnover rates in the 11-15% range and 17% report turnover greater than 15%. The median turnover rate for all respondents is 9%. These high turnover rates are at least partially the result of the government s changing spending priorities and sequestration which has resulted in government programs being cancelled or delayed. We asked surveyed companies to provide the impact of sequestration on their full-time workforce and 25% reported that the impact was major and resulted in a reduction in staff while the remainder reported that the impact was minor or non-existent with no impact on the number of full-time employees. Fig 9. Trend in number of full-time employees Increasing Decreasing No significant change 59% 15% 26% Fig 10. Turnover rates 30% 26% 27% 17% 0-5% 6-10% 11-15% >15% 10 Grant Thornton's 2015 Government Contractor Survey Survey

Wage increases We asked companies to provide the average wage increase percentage for full-time employees during the past year. The responses ranged from no increases to 9%, with the median response of 2%. The median wage increase is slightly lower than those reported in recent surveys. Health insurance benefits Surveyed companies provided their health benefits costs as a percentage of labor costs and the results are shown in Figure 11. Also shown are the results from the prior five surveys, provided for comparative purposes. Companies health insurance costs are a function of several variables including benefits offered, percentage of health insurance costs paid by the company, percentage paid by the employee, and other factors. The information in Figure 11 shows the median health insurance cost as a percentage of labor for this year s survey is in the 7.1-8% range, compared to 9.1-10% reported in the last survey. We also asked companies to describe the impact of the Affordable Care Act (ACA) on health care costs at the company and we received some interesting responses. Approximately 46% of respondents reported that health care costs increased significantly while approximately 54% of the companies reported no significant change in health care costs. Additionally, 33% of the respondents increased the employee share of health plan costs and 10% reduced benefits for the employee s family. 401(k) plans We asked companies whether the company percentage contributions to the 401(k) plan had changed in the past year. Only 15% reported changes to the 401(k) match while the remaining 85% reported no change in the percentage match to the employee s 401(k) plan. Of those that changed the match, 9% reduced the match while 6% reported increases. Paid absences Surveyed companies were asked whether paid absences for an employee s vacation and sick time were accrued separately or as a combined benefit. The majority (70%) responded that paid absences are accrued as a combined benefit. Fig 11. Health insurance as a percentage of labor costs <4% 4.1>5% 5.1-6% 6.1-7% 7.1-8% 17% 6% 14% 16% 10% 9% 12% 5% 10% 8% 9% 7% 4% 11% 8% 15% 12% 13% 7% 13% 9% 11% 14% 16% 13% 9% 13% 9% 17% 10% 8.1-9% 9.1-10% >10% 9% 5% 7% 11% 4% 4% 7% 12% 8% 4% 8% 15% 31% 39% 31% 26% 26% 26% 2015 survey 2013 survey 2012 survey 2011 survey 2010 survey 2009 survey 11 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 11

Cost Accounting A company s cost accounting practices are often critical factors in the competitiveness and profitability of the company. Government regulations on cost accounting practices are conceptual and provide a great deal of discretion in selecting specific cost accounting practices that are most effective in the various markets where the company operates. Once a company has implemented its cost accounting practices, they must be consistently applied. In some situations, changes to cost accounting practices must be reviewed and approved by a contracting officer or government auditor before the changes can be implemented. Fringe benefit rates Many government contractors offering professional services to their clients account for fringe benefits in a separate burden pool which is allocated to projects and other indirect cost pools as a rate applied to total labor costs. The fringe benefits pool generally includes costs for payroll taxes, paid time off, health insurance, retirement plans and other employee benefits. Some contractors include employee bonuses in the fringe benefits pool, while others charge benefits to other indirect cost pools or as a direct cost to projects. Bonuses can have a significant impact on indirect cost rates in situations where bonuses are large. We asked companies to provide their fringe benefits rates and to indicate whether the fringe benefit pool includes or excludes bonuses. The responses are shown in Table 1 along with the results from the five prior surveys which are presented for comparison. The median fringe benefits rate without bonuses in the pool is 36% while the median rate including bonuses in the pool is 1% higher at 37%. The median fringe benefits rates in this survey are very close to those reported in prior surveys. As discussed in the Workforce Trends section of this survey, it appears that many contractors are maintaining their fringe benefits rates at historical levels by requiring that employees pay a larger portion of increased health insurance costs. Labor overhead rates Firms that offer professional services to government agencies usually maintain indirect cost pools to accumulate the costs of indirect charges for management and support time, as well as other indirect expenses associated with the direct charging personnel who perform the work described in the contract statement of work. These indirect cost pools are usually referred to as labor overhead and are generally allocated to contracts by a rate applied to direct labor costs. Some government contractors include the fringe benefits associated with the direct labor costs in the allocation base rather than in the labor overhead pool. While moving fringe benefits associated with direct labor from the numerator to the denominator yields a lower calculated overhead rate, the sum total of the costs for direct labor, fringe benefits and labor overhead remains the same under either method. Table 1: Fringe benefits rates as a percentage of total labor Benefit inclusion type 2015 Survey 2013 Survey 2012 Survey 2011 Survey 2010 Survey Fringe benefits including bonuses 37% 36.4% 34% 35.5% 35% 35% 2009 Survey Fringe benefits excluding bonuses 36% 34.5% 32% 33% 33% 33.8% 12 Grant Thornton's 2015 Government Contractor Survey Survey

Surveyed companies provided their actual labor overhead rates for their primary pools and the results are shown in Table 2 along with the results from the five prior surveys which are included for comparative purposes. Separate rates are shown for on-site (company site) and off-site (customer site) overhead. On-site rates are generally considerably higher than off-site rates, because the on-site overhead pool includes the facility-related expenses incurred by the company to house the employee, while no such expenses are incurred or allocated to the labor costs of direct charging personnel who work at the customer site. The rates in Table 2 are also separated by allocation base, showing rates for companies that include fringe benefits in the allocation base separate from those companies that include fringe benefits in the labor overhead pool. Surveyed companies also provided information relative to the logic behind separate overhead pools where multiple overhead rates are maintained in the cost structure. The results are shown in Figure 12. Physical location is the primary discriminator between overhead pools for contractors that maintain multiple labor overhead pools. The survey also found that only 24% of respondents established separate overhead pools by customer. This approach generally results in commercial work subsidizing government work since it is beyond dispute that government contracts impose far greater administrative and reporting burdens on companies than do contracts with commercial clients for nongovernment work. It might be advantageous for government contractors to revisit this approach, particularly in situations where the company has a strong competitive advantage in the government market in which it operates. When advising clients on indirect cost rate structures, we recommend that to the maximum extent possible, the company should establish an indirect cost rate structure that results in separate rates that are competitive and profitable in each of the government contracting and commercial markets in which the company pursues work. This approach can be implemented within a single legal entity and does not require separate legal entities by market. A one-size-fits-all approach to indirect cost allocations is generally not the most advantageous approach to allocating costs, particularly in situations where a company is striving to attract new business and grow in markets that are very price sensitive. The regulations in the FAR and cost accounting standards (CAS) are very flexible in regard to allocating indirect costs, with a wide range of acceptable methods. A well-thought-out cost structure is very important for all government contractors including not-for-profit organizations that frequently seek funding from government and non-government sources who have entirely separate rules and regulations relative to budgeting and billing. Figure 12: Logic behind multiple overhead rates Location 53% Function 15% Customer 24% Product vs. services 8% Table 2: Overhead rates by site and allocation base Overhead type 2015 Survey 2013 Survey 2012 Survey 2011 Survey 2010 Survey On-site direct labor 77% 84% 80% 65% 69% 84% On-site direct labor plus fringes 36% 43% 48% 38% 48% 51% Off-site direct labor 49% 38% 48% 42% 47% 45% Off-site direct labor plus fringes 20% 21% 23% 19% 18% 17% 2009 Survey 13 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 13

G&A rates The cost structures of most government contractors include a general and administrative (G&A) expense pool. G&A typically includes the cost of headquarters functions such as executive management, accounting, legal, contract administration, human resources, and sales and marketing. G&A also typically includes the company-funded portion of independent research and development (IR&D) and bid and proposal (B&P) costs. The G&A pool is usually allocated to projects at a rate applied to total cost input (TCI) or value added cost input (VACI) although other methods are authorized in CAS 410 where neither TCI nor VACI would yield equitable results. TCI is the sum of total costs excluding G&A expenses, while VACI is total costs excluding G&A, direct materials, and direct subcontracts. Surveyed companies provided their actual G&A rates and allocation bases and the results are shown in Table 3 along with the results from the previous five surveys. The G&A rates from this year s survey are generally consistent with those from prior years. Material handling and subcontract administration rates Many government contractors that allocate G&A on a VACI base also establish a material handling/subcontract administration pool. The objective is to apply an indirect cost rate to the costs for direct materials and direct subcontracts which is lower than the full G&A rate applied to other costs in the VACI base. The material handling/subcontract administration pool typically includes the costs of the company s procurement function, the costs of warehousing the items when the company is procuring inventory and minimal charges for contract administration, legal and program management as appropriate. For the current survey, 29% of respondents report they included material handling/subcontract administration rates in their cost structure and provided their rates which are shown in Table 4. We also included the results from the prior five surveys for comparison purposes. By design, the rates have been consistently low for all years. Further, the rates have not varied significantly from survey to survey. Some companies find it difficult to maintain competitive G&A rates in some of the markets in which they compete for new business which is more price-sensitive than the company s existing business. Government regulations very clearly prescribe that the G&A pool should be minimized and costs should be allocated through other means, such as direct costs or overhead, to the maximum extent possible. The regulations also encourage special allocations where appropriate as discussed later in this section of the survey. Table 3: G&A rates by allocation base Allocation base 2015 Survey 2013 Survey 2012 Survey 2011 Survey 2010 Survey Total cost input 13% 12% 13.5% 13% 13% 11% Value-added cost input 17% 15.4% 15.4% 15.5% 15% 15% 2009 Survey Table 4: Material handling and subcontract administration rates Cost type 2015 Survey 2013 Survey 2012 Survey 2011 Survey 2010 Survey Material handling rate 3% 3% 2.7% 2.2% 3% 3% Subcontract administration rate 3% 3.4% 2.5% 2.2% 4% 4% 2009 Survey 14 Grant Thornton's 2015 Government Contractor Survey

Special allocations Special allocations of indirect costs are authorized in FAR Part 31 and CAS when the use of the normal established cost accounting practices would result in an inequitable allocation of indirect costs. Special allocations are often used to burden large and unusual pass-through transactions for items such as equipment, materials, subcontracts, or special facilities. They may also be appropriate in short-term projects in remote areas with few reporting requirements where the term and location of the contract work do not permit the amount of G&A management and administrative oversight that is applied to a contractor s normal business. We asked companies whether they used special allocations to burden unusual transactions and only 9% responded affirmatively. See Figure 13 for the responses for this year and the prior five surveys. Contractors frequently encounter situations where reduced allocations are necessary for both competitive reasons and to assure equitable allocation of costs. In such situations, we almost always advise clients to use special allocations rather than changing the allocation base from TCI to VACI. Changing the indirect cost rate structure in anticipation of a possible future award will distort the cost and revenue flow to existing contracts which should be avoided. Changing the rate structure can also create serious funding issues for contractors with significant revenue from cost-reimbursable contracts. Fig 13. Special allocations 9% 10% 7% 18% 8% 8% 2015 survey 2013 survey 2012 survey 2011 survey 2010 survey 2009 survey The concept of special allocations in FAR Part 31 and CAS is also consistent with a government policy put in place in October 2009 which limits indirect costs on large pass-through transactions where the contractor s value added is limited. The Limitation on Pass-Through Charges clause at FAR 52.215-23 specifies that the indirect cost burden on large pass-through transactions is limited to the amount of value added by those indirect cost functions. In our view, that clause is conceptually identical to the special allocation provisions in FAR Part 31 and CAS. However, a word of caution is in order. DCAA has applied what we can only describe as tortured reasoning and have concluded that the excessive pass-through costs not compensable as a result of FAR 52.215-23 must still be charged to the contract and absorbed by the contractor. DCAA s position is described in Section 7-2127 of the DCAA Audit Manual. DCAA s position that a cost that does not benefit a contract must nonetheless be charged to that same contract appears to be inequitable, inconsistent with the entire concept of equitable allocation of indirect costs, and is unsustainable. We strongly encourage contractors to include a clear description of a special allocation when one is used in a cost proposal. That will put the issue squarely before the contracting officer when the proposal is being evaluated. Assuming the contract is awarded, the contractor will then have a documented basis to demonstrate that the special allocation was accepted by the contracting officer in the contract award. This type of additional protection may become important in the event that DCAA attempts to apply the ill-conceived guidance from DCAA Audit Manual 7-2127 in future audits. There are other alternatives that serve the same purpose as special allocations, and they should be considered as necessary. These alternatives include contract-specific burden pools or establishing a separate business segment with its own cost structure for any contract with staffing needs, performance requirements or cost patterns that differ from the contractor s existing business. 15 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 15

Trends in indirect cost rates Surveyed companies were asked to provide information on the trend of indirect cost rates at their company and the results are summarized in Figure 14. Rates are increasing at 26% of the companies and decreasing at 42%. In the last survey, 42% of respondents reported increasing rates while only 17% reported decreasing rates. We will continue to monitor this closely in future surveys. Impact of revised executive compensation limits on indirect cost rates The government recently changed the statutory cap on executive compensation in such a way that will require contractors to apply different indirect rates to different contracts based on the award date of the contract. For all contracts that were awarded on or after December 31, 2011 but before June 24, 2014, the statutory cap is $952,308. For all contracts awarded on or after June 24, 2014, the statutory cap is reduced to $487,000. These significantly different cost limitations depending on the award date of the contract means that indirect rate submissions for provisional billing rates and final rates will necessitate separate rate computations for each statutory cap with the separate rates applied based on the award dates of each contract. These dual rate submissions will be required as long as contracts awarded on or before June 23, 2014 are still active. Many services contracts extend for a five-year term so it s possible that dual-rate submissions will be necessary through 2019. Figure 14: Trends in indirect cost rates Increasing 26% Decreasing 42% No significant change 32% Uncompensated overtime Uncompensated overtime refers to hours worked in excess of the standard work week by exempt personnel who are not paid for the overtime hours. The timekeeping and cost accounting practices applied to uncompensated overtime can have a major impact on revenue, profitability, and competitiveness. Surveyed companies were asked whether exempt personnel who charge time directly to contracts work uncompensated overtime; 63% reported in the affirmative. This is slightly higher than the 60% reported in our last survey. For those companies reporting significant uncompensated overtime, we requested information on their timekeeping practices. Eighty-two percent of the companies that reported uncompensated overtime record total time worked rather than limiting hours reported to the standard work week. We advise professional services firms with significant uncompensated overtime to record total time worked. The failure to record total time worked could have a very negative impact on revenue and profitability and might also create a risk that the government could withhold approval of the cost accounting system. Beyond recording total time worked, the cost accounting practices adopted for uncompensated overtime should also be carefully considered to assure that the practices themselves do not harm revenue or profitability. Government regulations in this regard are very permissive and identify two acceptable accounting no change methods, which can be broadly described as the compression method and the standard variance method. decreasing Under the compression method, the company computes an increasing effective hourly rate by dividing the salary paid by the hours worked, and then charges projects at that effective hourly rate. In a cost reimbursable environment, the only party that benefits is the government that reaps the benefit of free work and the party that suffers is the contractor who works extra hours at no charge to the customer. This is illustrated by the following example: A direct labor employee is paid $1,000 per week, which is an average of $25 per hour for a standard 40-16 Grant Thornton's 2015 Government Contractor Survey

hour work week. In the first week, the employee works 20 hours on project A and 20 hours on project B. Each project is charged $500 (20 hours @ $25). In the next week, the employee works 50 hours for the same $1,000 salary. The effective (compressed) hourly rate is $20 ($1,000/50). The employee works 25 hours on project A and 25 hours on project B. Each project is charged $500 (25 hours @ $20). The impact of the compression method is that the employee worked an additional 10 hours for the client in the second week and did not generate any revenue for the company for the extra 10 hours worked. Occasionally, we have encountered situations where the government customer will not pay the company for hours worked by company employees without compensation. Except in very rare circumstances, there is no valid contractual basis for such a position and the government s resistance to payment for services received can be easily overcome. Fig 15. Recording uncompensated overtime The generosity in the compression method is absent in the standard variance method, and the client is billed a full hourly rate for each hour worked. At the beginning of each year, a standard rate is established for each direct-charging employee. Total time is recorded in the timekeeping system throughout the year, and total time reported is charged at the standard rate. The variance between the labor charged to projects and burden pools at standard and the actual salary paid is credited to overhead. In a cost reimbursable environment, the advantages to the standard variance method over the compression method are evident. Under the standard variance method, there is a full labor charge to projects for all hours worked and there are no free hours. Further, the credit to overhead and the increased direct labor base can benefit the company from both a competitiveness perspective and a profitability perspective to the extent that lower overhead equates to increased profitability on fixed price and T&M contracts. The standard variance method can also create the opportunity for discretionary spending in overhead as deemed necessary or desirable by company executives. Surveyed companies provided information on the accounting method being used for uncompensated overtime and the results are shown in Figure 15 along with the results from the prior five surveys. The vast majority of the companies continue to use the compression method. Because that method can be so detrimental to revenue, profitability, and competitiveness, we suggest that those companies with a significant amount of cost reimbursable business re-evaluate their accounting approach to uncompensated overtime. 2015 survey 2013 survey 2012 survey Compression method Standard variance method 2011 survey 2010 survey 2009 survey 75% 78% 72% 76% 80% 84% 25% 22% 28% 24% 20% 16% 17 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 17

Proposals Fig 16. B&P costs as a percentage of revenue <1% 15% 14% Government procurement regulations require that contracting officers promote and provide for full and open competition in soliciting offers and awarding government contracts. There are several very broad exceptions to this requirement including (a) only one responsible source and no other supplies or services will satisfy agency requirements; (b) unusual and compelling urgency; (c) industrial mobilization; (d) engineering, developmental, or research capability; (e) expert services for a current or anticipated litigation or dispute; (f) international agreements; (g) authorized or required by statute; (h) national security; or (i) public interest. 1.1>2% 16% 18% 35% 52% 41% 47% 52% 40% Bid and proposal costs as a percentage of revenue Surveyed companies provided statistics showing B&P costs as a percentage of revenue and the results are shown in Figure 16 along with the results of the previous four surveys. The results from the current survey appear to show a sharp movement to the low end of the scale compared to the results from the previous survey. It s likely that the delays in procurements caused by sequestration are a primary cause in the dip in B&P costs during the past year. On the general topic of B&P costs, CAS 420 makes clear that only personnel who charge directly to externally funded projects should charge directly to B&P projects. Applying that regulation, accounting or business development staff that do not charge directly to externally funded projects should not charge time directly to B&P projects. 2.1-3% 3.1-4% 4.1-5% 16% 13% 9% 8% 9% 6% 9% 10% 9% 4% 9% 2% 7% 3% 2015 survey 2013 survey 2012 survey 2011 survey 2010 survey 10% 2% >5% 21% 11% 10% 2% 18 Grant Thornton's 2015 Government Contractor Survey Survey

Proposal win rate Surveyed companies provided information about their proposal win rates when pursuing non-sole-sourced government contracts. The results are shown in Figure 17 along with the win rates from the five previous surveys which are provided for comparison. The median win rate this year is 35% which is in line with the win rates reported in prior surveys. We also asked for win rates when the respondent was the incumbent on the previous contract. In this situation, the win rate increases significantly from 35% to 75%. This statistic verifies the reasonable expectation that a proven well-performing incumbent should have a significant competitive advantage over nonincumbents when competing for continuing work. We have encountered situations where the incumbent maintained an excellent performance record and yet received a significantly lower technical rating than non-incumbents. It is difficult to rationalize such incongruity unless one stops to consider that the government expects the presumably less qualified incumbent to hand over all of its key employees to the supposedly more qualified company that won the competition. This practice of simply handing over employees from one company to another after a source selection is one of the oddities that make government contracting practices far different from normal commercial business practices. It is little wonder that bid protests are an integral part of government contracting. Proposal win rate when bidding as a special business unit It is fairly common in the government contracting industry for companies to establish special business units such as joint ventures or limited liability corporations to pursue specific government contracts. Frequently, the motivation to establish such units is based on the belief that the current cost structures in the existing business units are not price competitive to win the new business. Depending on the extent of the price competitiveness concern, the special business unit may be populated with employees from member companies or new hires or not populated and simply receive a reduced management and support (G&A) charge from the member companies. When price competitiveness is the primary motivation, we often advise clients that they can achieve the same result by establishing a new lower-cost operating segment with its own cost structure within the existing legal entity. Government procurement regulations give broad discretion to contractors regarding organizational matters. This approach saves the time and expense associated with the creation of a new legal entity such as a joint venture or limited liability corporation, which may or may not win the contract for which it was created to perform. Surveyed companies provided their proposal win rates when they bid as a special business unit and the results are shown in Figure 18. The win rate is 64% which is significantly higher than the reported in the previous survey. Fig 17. Proposal win rates 35% 30% 30% 36% 30% 30% 2015 survey 2013 survey 2012 survey 2011 survey 2010 survey 2009 survey Fig 18. Proposal win rates when bidding as a special business unit 2015 survey 2013 survey 2012 survey 64% 43% 19 Grant Thornton's 2015 Government Contractor Survey Grant Thornton's 2015 Government Contractor Survey 19