In both our consulting practices and inquiries from subscribers we have often been asked questions related to whether it makes sense to “low ball” proposals – that is propose prices that do not recover full costs of a project.  We have encountered considerable resistance from the financial side of contractors’ houses for bidding on work that the CEO has earmarked as critical to winning, insisting they would loose their shirts.  Though we will focus on the economic value of bidding on the project, there are, of course, numerous pros and cons that may outweigh the economic benefits or costs.  Examples of benefits of bidding on less profitable work may include (1) getting your foot in the door for future work – either expectations of follow-on work or getting exposure to government agencies not previously worked with (2) obtaining important experience – technological, learning to do business with the government, seeding abilities in other parts of the business that are transferable to other government or commercial work (3) keeping employees working.  Cons can be equally compelling such as (1) low economic value can promote lower quality or service levels that might result in adverse past performance ratings or (2) provide less than optimal use of valuable resources that are difficult to replace such as personnel and equipment.   

Government accounting, not to mention accounting in general, encourages the perspective of total cost accounting.  Since revenue (price) on cost-based contracts are  based upon actual incurred costs, there is the tendency to examine the desirability of a contract by comparing revenue versus all-in costs.  However, cost accounting texts also address other ways of costing contracts (e.g. marginal contribution) that may be relevant. 

In a recent case study we encountered the Contractor’s company-wide overhead rate was 150% and its G&A rate was 24%, a bit on the high side of the normal range experienced by professional services firms.  In competition for a $50 million contract, Contractor’s prior bid was 60% higher than the company that was awarded the contract.  The winning bidder was characterized as a “body shop” – little permanent staff of professionals with minimal overhead costs who hire personnel only when a contract is won – and they have learned that during contract performance, the government was not pleased with their performance and would be happy to find someone else.  Through various legal channels, Contractor determined that the incumbent would likely bid an all in-rate of a certain amount and to equal that proposed price, Contractor would need to bid overhead rates of 50% and G&A of 15%.  The CEO and project managers did not want to take any chances of proposing too high a price so they decided they would bid these rates by providing significant “management cost reductions” from their actual projected costs and would be willing to cap their rates to assure the government reasonable costs.  

We discussed this issue with some of Contractor’s financial personnel who were understandably concerned the company would “loose its shirt” if they bid these rates and were stuck with capped rates if they won.  In discussing the matter with Contractor, an analogy from one of our old accounting instructors came to mind that provided an interesting framework to consider the problem.

Picture a funnel with a spout off the side and the bottom of the funnel going into a big bucket.  Revenue dollars flow into the top of the funnel and some dollars go out of the side funnel.  These dollars represent payment for direct costs - labor, ODCs, etc.  The remaining dollars flow into the big bucket which represent all the other costs like overhead and G&A.  When the bucket is filled with dollars (overhead and G&A expenses paid for) the excess overflow is the firm’s profit.  So, if the bucket is full, any additional dollars that exceed the direct dollars out can be considered profit.  Though a relatively high percentage of dollars would flow out the side spout under the new contract to cover the direct labor and ODCs, still some dollars would flow into the bucket. 

If the bucket is full when the contract is in place and the contract would not generate significant additional overhead or G&A costs, then even the low proposed rates would generate considerable profits since most if not all dollars flowing into the bucket would be excess and hence profit.  Even if the bucket was not full, then the residual dollars would help fill it up.  Of course, this would be a fool-hearty pricing strategy for all contracts (the bucket never gets enough dollars to cover expenses let alone generate profit).  It would even be fool-hearty for the new contract if it is expected to generate significant indirect costs which would enlarge the bucket resulting in less or no overflow at all.  But for some marginal contracts this low-bid pricing can be a good strategy. 

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