(Editor’s Note. Though most of our readings relate to the specialized area of cost, pricing and contracting rules affecting government contractors we also like to keep abreast of general business thinking. Along those lines one of our favorite newsletters we subscribe to is The McKinsey Quarterly, the journal of the notable general management consulting firm McKinsey & Co. where we occasionally address how adoption of sound management practices specifically affect those companies who must comply with government accounting rules. Some of the recent articles, understandably address what companies should be doing in the current financial crisis and economic downturn, which are interesting in their own right, so we thought we would summarize two articles from the perspective of how implementation of their suggestions would affect costing and contracting practices of government contractors.)

Getting prices right in an economic downturn is always a challenge as decreased demand, excess capacity, and greater attention to price conspires to drive down prices. However, in the current environment not only is demand weaker making it harder to maintain prices but significantly more volatile input costs put companies in the middle. What is a business to do? They have to manage profitability of individual customers and transactions more precisely, develop greater insights into their customers’ changing needs and price sensitivities and understand the types of economic factors affecting their own industries as well as their suppliers.

The authors have put forth five tactics aimed at maintaining the best balance possible between sales volume and profit margins. What are these tactics and how do they affect contractors who must compete in the government realm with price and costing rules galore?

1. Watch for sudden shifts in price structure. Companies need to be vigilant in monitoring pricing policies that reduce revenue such as volume discounts, rebates and cash discounts as well as costs to service customers such as freight and sales support expenses. In the current downturn, uncertain costs and declining demand can cause these elements to change dramatically. For example, volatile fuel costs put pressure on delivery costs or declining orders may mean customers are receiving volume discounts they are no longer entitled to. Techniques such as pocket margin waterfalls (i.e. identifying revenue received and subtracting all the deductions from discounts, freight, etc.) should be used that show how much revenue companies keep from their transactions where then companies can adjust their pricing accordingly e.g. adding a fuel surcharge to every order.

Implications. This waterfall analysis would be helpful to analyze government contracts so that when solicitations for new work are issued new terms may be proposed. Favorable terms granted in times where orders were higher may no longer be sustainable. For example delivery scheduling or discount terms may need to be changed. You may want to resist pricing certain items where there is significant price and cost volatility or conversely, aggressively price items where there is less volatility. Also, in this environment where commodity prices can vary widely, you will want to try and negotiate reopener clauses on fixed price contracts.

2. Monitor customer-level profitability. Companies should use transaction-level data to measure the profitability of each customer. By doing so, companies can detect the cost to serve particular customers where, for example, declining order volumes are pushing those customers below desirable profit levels. In most downturns, including this one, many customer groups are becoming simultaneously smaller and more costly to serve. For example, one company found that 20 percent of its customers had fallen below desirable profitability levels forcing it to either raise prices selectively and where possible, lower service costs by decreasing delivery frequency, reducing sales support or fulfilling orders through alternative channels.

Implications. Government contracts and subcontracts, contract line items, and task and delivery orders should be scrutinized for profitability. There is little wonder why we are seeing an increased use of such management tools as activity based costing to more closely analyze the cost drivers that produce expenses to better measure profitability of customers, product/service lines and contracted work. Need to monitor and change overhead rate levels (e.g. decreased facilities utilization, increased contract administration effort) need to be considered more carefully in this environment. The government provides a unique opportunity to adjust terms and prices because prices are often based on cost buildup analyses rather than what the market will bear. As more precision in monitoring profitability occurs you may find the need to either offer less or change the price of certain items offered in the past. Or, if the cost of favorable provisions are included in indirect cost pools you may want to negotiate their reimbursement as direct costs instead.

3. Adjust to changing customer needs. Downturns commonly create changes in customer needs and in the benefits they value when choosing a supplier. The best companies are constantly assessing, through market research and careful listening through daily contacts how economics is changing for their customers so they can react quickly by adjusting prices and benefits accordingly. For example, a resins supplier who had developed a fast curing resin to expedite flow through speed when the economy was strong now developed a less costly resin that cures slower which helps suppliers decrease their costs when product flowtime is less critical under lower demand. While other suppliers are raising prices many customers see the cost advantage of the slower curing resin. As a result, the suppler is able to maintain its profit margins while selling an alterative resin at a lower price.
  
Implications. When more and more customers seek government business to make up for sagging revenues they will often offer lower prices to fill up their excess capacity. Careful assessments of government needs will be more important than ever where in this period of intense price pressure there will be a premium on the ability to lower cost processes or offer lower tech employee resources that will provide government customers adequate quality for their needs at a lower cost. Careful attention to both customer needs and potential competitors’ technologies are critical. Adjusting overhead rates and creative “low-ball” bidding become more important.

4. Monitor your industry’s microeconomics. Radical shifts in costs and demand throw previous market pricing mechanisms into chaos where responding carefully requires a keen understanding of the microeconomic forces at play. For example, a building supply company saw demand plummet with the housing market yet saw costs increase rapidly and had to make a reassessment of his supply, demand and cost dynamics. His analysis led to the conclusion to cut capacity at a plant in an area where decreased supply would not cause a local shortage but lower capacity would mean less price decreases in the area.

Implications. Adjustments of these types will definitely affect overhead rates. For example, capacity (e.g. personnel, facilities, computers) may be reduced and government contractors will need to decide how to treat the resulting excess capacity. If a proposed contract is highly price sensitive these types of costs can be voluntarily deleted from overhead rates while for less price sensitive prices they can remain.

5. Study your suppliers. The volatility in this market requires companies to not only examine the economic factors in their industry but also for their suppliers. For example, a specialty metals firm analyzed the supply, demand and cost factors for one of its main suppliers and after doing so, predicted an industry-wide 15 percent price increase three months before it occurred. Suspecting an unusually high price increase, the company added clauses covering the supplier’s cost increases to its customer contracts, a move that would have been resisted had the price increase been announced. As a result, the move established an industry precedent for passing cost increases through to its customers.

Implications. Under these circumstances the government may become receptive to reopener clauses especially when the likelihood of a substantial price increase is low. There will be the need to line up lower cost subcontractors. Also, contractors will need to bone up on recent FAR changes to how subcontract labor may be charged on prime contracts (e.g. prime contract rates, blended rates, flow-through costs).

Another McKinsey article, “How to Win in a Financial Crisis,” explores opportunities available to savvy companies during a crisis to make strategic gains. Most of the gains discussed revolve around making strategic acquisitions to gain market share, teaming with other companies and making creative financing arrangements. For example, though conventional wisdom suggests that companies should put new investments or potential M&A on hold, experience of highly successful firms during periods of crisis demonstrate the opposite. The authors define three boundaries – regulation, competition and organizational ability to change - that under normal times work toward limiting opportunities but in times of crises shift dramatically to provide enormous opportunities. 

Regulations move. Under normal times regulatory restraints are deeply embedded in the core assumptions of most companies where it is taken for granted that the types of businesses or markets they can enter, types of products and services they can sell and how much market share is possible is set.

However, these constraints are often released or removed during a crisis where mergers or teaming arrangement tending to concentrate businesses are encouraged where once they were prohibited. In addition, regulatory price or profit restraints are reduced to encourage the concentration of industry that was previously discouraged. We have written frequently on considerations and costing issues related to teaming arrangements and acquisitions so we suggest using our word search function to review.

Competition shifts. Times like these (e.g. interest payment defaults, loss of confidence by investors and creditors, supply chain interruptions) can quickly topple established company leaders and open the door to newcomers. Alternatively, small local players hit hard by a crisis may be acquired by larger companies which may tend to be foreign or have more diverse operations. Also creative buyout terms can be used to reduce risk – e.g. buyout payments are conditioned on achieving a set of triggers. Allowability (FAR 31.205-10, 11, 16. 17, 20, 26, 27, 33, 47, 49 and 52), allocation (CAS 403) and FAR legal issues (contract novations, foreign ownership, etc) need to be reviewed to have a good foundation in how numerous corporate changes affect government contracting.

Organization change. Resistance to bold moves in changing corporate culture and operations melt away during crises where shareholders, employees and creditors recognize things must change. Visionary leaders take this opportunity to revamp their company’s power and organization structure, adjust size and generally throw out sacred cows. New organizational changes, compensation and performance bonus plans are created, moves to “best practices” and more precise costing analyses, as mentioned above, become critical to assessing profitability of specific service or product lines as well as contracts. These actions will definitely affect government audit areas including shifts in compensation and changes in bonus plans (FAR 31.205-6) and new organizational changes that may be either internal or external requiring different costing schemes (GCA DIGEST 4Q07). Also more precise costing methods may be adopted which may affect contractor cost and pricing practices which needs to be coordinated with government auditors.

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