Combining Cost-Plus and Time & Materials Contracts to Earn Excess Profits: A Case Analysis

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This article presents a case analysis illustrating how government contractors can combine the use of cost-plus and time & materials (T&M) contracts to earn excess profits. The assumptions made in the case analysis are based on work experience at one defense contractor and represent the actual activities that were undertaken by the defense contractor. While the case is presented for a defense contractor, the analysis could be applied to any type of government contract where labor is a primary cost. Public concern over large budget deficits has led Congress to attempt to reduce government spending since eliminating government waste is a major issue. This article illustrates one example of government waste and offers solutions to attempt to solve the problem.

Leitzel argues that Department of Defense (DoD) procurement practice is consistent with the actions of an industry-captured regulator, managing competition among defense contractors for the good of the industry as a whole.' He also argues that asymmetric information, where the contractors and DoD personnel are better informed than outsiders, is the source of many opportunities for defense contractors to be overcompensated. The case analysis presents one method where defense contractors earn excess profits, potentially due to information asymmetries. The article is organized with the following sections: a brief overview of cost-plus and T&M contracts; a description of the process used to earn excess profits on T&M contracts; a case analysis illustrating this process taking note of the implications of the analysis; and finally, potential solutions. Cost-Plus and T&M Contracts

The basic format for a cost-plus contract is that the contractor can bill the government to recover costs plus a designated percentage for profit. The billing is limited to a set level and overruns above the agreed total cannot be billed to the government. Many of the contracts set a limit for specific types of expenditures as well as for the entire contract. Thus, if expenditures for computer usage exceed the agreed upon limit, the excess cannot be billed even if the contract has not been fully billed in other areas. T&M contracts require that companies categorize their employees based upon their education and work experience. Examples of the categories included in the contracts are senior engineer, junior engineer, systems analyst and computer programmer. The categories established for the contract will be based on the type of work to be performed. The T&M contracts specify an hourly rate that can be billed for each of the employee categories. If the rate for a senior engineer is $20 per hour, the contractor bills the government $20 per hour for each employee that meets the requirements for a senior engineer, regardless of how much the employee is actually paid.

In other areas, T&M contracts are essentially the same as cost-plus contracts because limits are set on expenditures for materials, computer charges and supplies. As with the employee categories, the types of billable costs allowed under the contract will depend on the work being performed. Two other items affected by the amount of labor billed are overhead and general and administrative (G&A) costs. Overhead and G&A are billed as a percentage of the labor costs billed. This percentage is established in the bid on the contract. For a cost-plus contract, the amount billed is a percentage of the amount that employees are actually paid. For a T&M contract, the amount billed for overhead and G&A costs is a percentage of the labor costs billed to the government, not a percentage of the amount paid to the employees. Thus, the billing method used in T&M contracts affects the amount billed for labor as well as overhead and G&A costs when compared to cost-plus contracts. The rate billed for each category of employee under a T&M contract is the average hourly salary of all employees in the company meeting the requirements for that category. …


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