(Editor’s Note. In the past we received praise for a couple of articles we wrote that linked good management practices with compliance issues. As we did in the past, we selected an interesting article written by McKinsey consultants in the July 2009 issue of the McKinsey Quarterly called “What Next? Questions for CFOs.” The article addresses actions needed as the recession fades and recovery seems to be more likely. So as government contractors implement the types of advice offered here, what type of compliance issues are they likely to encounter?)

The credit crisis and shocks to the economy have put chief financial officers at the front lines to implement measures to help companies survive. Now that an eventual recovery is beginning to be in sight, the CFO’s tasks become more complex because the future is still uncertain and credit is still tight yet there may be some great opportunities.

1. What shape will the recovery take? Though the worst seems to be over much uncertainty remains about the nature and pace of the recovery. There are no assurances where other McKinsey studies see the very real possibilities for either significant inflation due to large deficits being incurred now or alternatively a long recovery with the likelihood of more recessions. Companies need to project, for example, the possibility of wage and price inflation due to heavy deficits, high unemployment and lower international trade.

Compliance implications. Such significant uncertainty calls for frequent monitoring of indirect rates (altering projections as needed and updating projections with actual data) so as to forecast annual estimates of rates at least, quarterly, if not monthly. For pricing purposes, careful considerations of uncertainties need to be taken into account without running afoul of unallowable contingency costs. Creative use of alternative categories of labor (e.g. full time, variable, temp, subcontract) with flexible pricing possibilities will generate lots of audit scrutiny.

2. Have you restructured enough?. A weak economy makes it easier to implement unpopular operations changes and to make divestitures. Companies may have more leverage over their suppliers, unions and regulators who may be more cooperative where employees understand the need for change. Also, there should be a short list of acquisitions to take advantage of good deals before the recovery is apparent, driving up acquisition prices.

Compliance Implications. Restructing activities will likely increase. A hot audit area will probably be identifying “external” restructuring activities to ensure contractors are carefully accumulating and reporting such costs, including associated costs. Contractors also need to be mindful of the distinction between unallowable external restructuring (related to acquisitions, divestments and financing) costs and allowable “internal” restructuring efforts (related to bring about economies and efficiencies). Restructuring activities also create new company structures resulting in new business units with potentially different pricing opportunities and home office allocations of costs. Indirect rate structures also need to be evaluated.

3. Is your supply chain sufficiently flexible? Whereas 2008 led to questions about what would happen if the downturn was worse than expected, in 2009 it is worth considering what happens if the surprise comes on the upside. Can they respond without bringing back high costs or cutting quality?

Compliance Implications. In a period of change, the government is looking to see whether pricing proposals adequately reflect changing economics. Auditors are expected to be particularly sensitive to making sure low estimates of business growth in the recent past do not result in unreasonable low estimates of business and hence excessively high indirect rates (i.e. lower base costs generate higher rates).

4. Should you restart conversations with potential alliance partners? Whereas there was a big increase in interest to seek out strategic partnerships to go after government business much of this activity was put on hold last year. This year, as long as the underlying logic is still sound, many partners may be closing deals. Moreover, many businesses may have been hurt during the downturn and become competitively disadvantaged so joint ventures may be more attractive than ever.

Compliance Implications. Contractors need to dust off their knowledge of particular cost and pricing rules as they relate to joint ventures and strategic business units (see our article in the 3Q08 issue of the DIGEST if such activity is planned.) For example, whether a separate segment or a new joint venture entity is preferable needs to be decided and how the choice will affect indirect rates charged to contracts. Also special attention needs to be paid to IR&D/B&P, intercompany transfers, rental and legal costs

5. Can you sell your recovery plan to investors? Whether it be meetings within (strategy) or outside parties (investors, bankers) communications will likely proliferate.

Compliance Implications. Where do allowable business meetings become unallowable entertainment events? When do unallowable brochures become allowable communications with investors and meetings with the public? When do insignificant internal efforts not requiring monitoring of hours become significant requiring identification of internal costs related to unallowable activities?

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