Government Contractor CFO's 101 (Part IV) - Economic Forecasting & Modeling I
Economic forecasting and modeling are CFO responsibilities that take on a vital role in the government contracting environment. CFO’s in this market must understand the sometimes arcane cost allowability rules and operate on margins typically thinner than most commercial enterprises. In this case, a skillful CFO can have a positive influence on profitability.
Project Accounting Basics
Knowing where you are helps predict where you’re going. Knowledgeable CFOs are diligent about segregated project costs for each reporting period, year-to-date, and on a cumulative basis. Complicating this process is the government’s application of certain limitations (Indirect rates, cost and fee limits), and incremental funding of contracts.
Indirect structure development
Project costs include their share of indirect costs. The allocation of indirect costs to a project is commonly called your indirect rate structure. FAR Part 31 identifies the parameters and boundaries for developing indirect rate structures. An indirect rate structure can range from a simple single indirect rate system to one having dozens of rates and factors (think big aerospace).
Choosing the appropriate rate structure, using FAR 31 guidance, can be critical for the long term success of your firm. There are many factors to consider in choosing an appropriate indirect rate structure, some of those being:
- Competitive environment and type of business
- Government agencies targeted and contract types
- Mix of commercial and government business
- Size and complexity of the business
- Use of subcontractors
The purpose of a fine-tuned indirect rate structure is to economize costs for those projects that have slim margins due to programmatic or competitive pressures. This is especially important in government contracting since finding this “sweet-spot” can open and maintain a reliable source of income.
Once a suitable indirect rate structure is established, a model for pricing project costs and the allocation of indirect rates can be developed. Pricing models can reliably predict indirect rates and project costs well into the future based on reasonable assumptions of revenue and administrative costs.
A CFO should also understand the price/risk dynamic between fixed price and cost-plus type contracts. Whereas a fixed price research and development contract might present formidable cost and performance risks, a cost-plus widget-making contract might yield little profit. The risk/reward dependency on contract types causes some highly competitive organizations to adopt sophisticated techniques to find an appropriate price point.
For this reason, it may be best, even for large organizations, to have pricing under the control of or at least influenced by the CFO.