TheLectern

By Steve Kelman

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Are contractors taking government to the cleaners?

When I returned home from traveling abroad a few days ago, a pile of annual reports of companies whose shares I own were waiting in a pile of mail. This is company annual report season. There was something in one report I read that caught my eye because of its association with longstanding debates about government contracting.

 The report was from a company called Oceaneering International, a provider of oil exploration equipment. (I actually bought 300 shares of this stock in 1981, over 30 years ago, when a stockbroker said I had no energy stocks in my portfolio and ought to have at least one. Over the 30 years, the value of my investment has gone from $3600 to $62,000 – I wish all my investments had done that well, but that’s another story.)

 It turns out that about 10 percent of Oceaneering’s business – called their Advanced Technologies segment – is with the U.S. government, selling engineering services to the Navy and some special-made equipment to NASA and the Defense Department. (I like the fact that they call this “advanced technologies,” as opposed to their other businesses, which are hardly low-tech. More importantly, I think it is good for government contracting to have successful private firms doing a modest portion of their business with the government, rather than leaving the government market for such services and products to government-unique defense contractors or other government contractors who have no experience competing in the hard commercial world.)

At the end of the report, there is data about the operating income as a percentage of sales for the company’s different businesses.  The bottom line?  Oceaneering’s oil and gas commercial business has an operating income of 22 percent of sales, while its government business’ operating income is 7 percent of sales.
 
If you look at the annual reports of publicly traded companies that have significant commercial and government business, and that report operating income on both groups of businesses – such as many of the IT consulting companies – you will almost always see a similar pattern.  Government business is less profitable in terms of operating income as a percent of sales than commercial business.
 
This fact, of course, gets little attention in debates about government contracting, which often suggest that contractors make huge profits ripping off the government. In fact, a mixture of often intense price competition and cost-based contracts with controls on markups over cost mean that the popular impression in the debate is inaccurate.
 
There is a more subtle way the government might get hurt, to be sure.  If on cost-based contracts there is insufficient attention to cost controls, the number of hours of contractor effort may be higher than really needed, and that will raise overall contractor profits, even though the return on each hour of work may be modest. This is a reason for favoring, when possible, fixed-price contracts or incentive-fee contracts with a cost savings line, or share-in-savings contracting; cost-based service contracting in the commercial world has some of the same problems. But, even if this is a problem, it is not the problem that the popular myths about contractors taking the government to the cleaners suggest.

Posted on Apr 19, 2012 at 9:03 AM


Reader comments

Mon, Apr 30, 2012

While these entries are factual; there is a fundamental error in the comparison. The ~7% return (although the FARS are more detailed than an average) is the margin AFTER the firm has been reimbursed for labor hours, fringe benefits, overhead, allowable property & equipment allocations, janitorial services, administrative burdens specifically due to the government contract,etc. So, the ~7% cannot be compared to other business returns. Look again, pleae. Doing business with the government is complicated and all wish to find ways it could be less cumbersome...it keeps smaller firms from trying to enter. But Lockheed is laughing all the way to the bank as they are "being squeezed by the government" with reduced profit potential. If you'd like to do some worthwhile research, study L-3 COM, especially since 2002. It will water your eyes at how they have grown and expanded their government business basis. Then write your Congressman and ask how its proper that the US Air Force Service Acquisition Executive can walk out of the government's doors and into L-3 Com with there being a conflict of interest. The real issues today are NOT the profit margins allowed. The real issue is how to save Defense acquisition from fraud and corruption.

Fri, Apr 27, 2012 Alan

Is this because (1.)the Government achieves lower rates through competition and transparency (though there is no price competition in engineering), (2.) the Government imposes costly requirements upon its contractors (e.g. subcontracting goals), or (3.) the nature of the work the Government orders is less risky, or (4.) the Government market is more competitive than the private market right now?

Sun, Apr 22, 2012 BOB From Accounting San Diego

Well duh... As a Sr consultant at a BIG-4 firm, I was charged out at $300/hour + all expenses (which weren't cheap) to commercial clients (Visa, Honeywell, Well Fargo) and $125/hour to DoD customers. 100% chargeable in both cases Same consultant, same skill set, so who was corporate really ripping off. Commercial customers know how to manage the consultants on their projects, while most gov't customers do not. Alot of the gov't consultants are actually performing contract employee type efforts. They work offsite and I have witnessed many of them not even working 20 hours per week but billing 40 to the gov't customer. But that is an issue all on its own.

Fri, Apr 20, 2012 Steve Kelman

PHD, thanks for your question. I have looked at Accenture, which fits the pattern -- lower margins in government than commercial business. NG I don't think has much commercial business, ditto SAIC.

Fri, Apr 20, 2012 PHD

Steve maybe you should look at Northrup-Grumman, SAIC, Accenture and a few other major DoD contractors.

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