Comments on Proposed Changes to Profit Policy (DFARS Case	 
2000-D018) (20-NOV-01, GAO-02-227R).				 
								 
In July 2000, the Department of Defense published a proposed	 
revision of its guidelines for developing profit objectives used 
in contract negotiations. The existing profit policy guidelines  
consist of: (1) investment in facilities and equipment, (2)	 
performance risk, and (3) contract type risk. For each profit	 
factor, the contracting officer determines an appropriate value  
and applies it against a specified base to develop the profit	 
objectives. The proposed revision to would make the following	 
changes to the profit guidelines: (1) inclusion of a fourth	 
element--cost efficiency, which would allow the contracting	 
officer to reward cost reduction efforts; (2) elimination of	 
profit on investment in buildings and a reduction in the amount  
of profit derived from equipment investment; (3) the amount of	 
profit based on performance risk would be increased; and (4)	 
general and administrative expenses would be included in the cost
base used for computing profit for performance risk, contract	 
type risk, and cost efficiency. The decrease in profit for	 
investment in facilities would be offset by the increased profit 
derived from performance risk and the inclusion of general and	 
administrative expenses.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-227R					        
    ACCNO:   A02490						        
  TITLE:     Comments on Proposed Changes to Profit Policy (DFARS Case
2000-D018)							 
     DATE:   11/20/2001 
  SUBJECT:   Contract negotiations				 
	     Profits						 
	     Policy evaluation					 

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GAO-02-227R
     
GAO- 02- 227R DOD Profit Policy

United States General Accounting Office Washington, DC 20548

November 20, 2001 Defense Acquisition Regulations Council Department of
Defense

Re: Comments on Proposed Changes to Profit Policy (DFARS Case 2000- D018) On
July 24, 2000, the Department of Defense (DOD) published a proposed revision
of its guidelines for developing profit objectives used in contract
negotiations. After reviewing comments on the proposed rule, DOD published,
on September 21, 2001, a revised proposal. This letter provides our comments
on the September 21 proposal.

The existing profit policy guidelines consist of three factors: (1)
investment in facilities and equipment (called ?facilities capital
employed?), (2) performance risk, and (3) contract type risk. For each
profit factor, the contracting officer determines an appropriate value and
applies this value against a specified base to develop the profit objectives
for a contract. For example, the normal value for contract type risk on a
firm, fixed- priced contract (with progress payments) is 3 percent, while
the normal value for facilities (buildings) is 15 percent. The base for
facilities capital employed is the investment that the contractor has made
in buildings and equipment. For performance risk and contract type risk, the
base is the estimated costs of performing the contract, excluding general
and administrative expenses.

The proposed revision to profit policy would make the following changes in
the profit guidelines:

! A fourth element- cost efficiency- would be added. The cost efficiency
factor would allow the contracting officer to add up to 4 percent in profit
to reward cost reduction efforts.

! Profit on investment in buildings would be eliminated and the amount of
profit derived from investment in equipment reduced.

! The amount of profit based on performance risk would be increased.

! General and administrative expenses would be included in the cost base.
This base is used in computing profit for performance risk, contract type
risk, and cost efficiency.

The decrease in profit for investment in facilities would be offset by the
increased profit derived from performance risk and the inclusion of general
and administrative expenses. According to the Federal Register notice, these
changes are not intended to increase or decrease average profit objectives.
The cost efficiency factor represents an additional amount of profit than is
available under the existing profit guidelines.

GAO- 02- 227R DOD Profit Policy Page 2 These changes represent a significant
restructuring of DOD profit policy. The

importance of contractor investment in facilities and equipment would
decline significantly and a new profit factor- cost efficiency- would be
added. According to DOD, the current profit structure rewards contractors
for investment in facilities at a time when the defense industry has excess
capacity and under- utilized facilities, acting as a disincentive to the
further rationalization of the defense industry.

In implementing the cost efficiency factor, we believe that DOD should
consider developing metrics to aid in assessing cost efficiency gains. For
example, examining loaded labor hours (i. e., cost per labor hour, including
all direct and indirect costs) along with productivity measures could
provide a basis for assessing contractor cost efficiencies over time. Such
metrics could also be used to compare relative costs from one contractor to
another for similar types of work. Measures of the cost efficiencies of
contractors would help the Department determine whether the purpose of the
proposed regulatory change is being achieved.

We appreciate your consideration of our comments. If you have questions or
would like to discuss our comments further, please call me at (202) 512-
4841.

Sincerely yours, William T. Woods Acting Director Acquisition and Sourcing
Management

(120103)
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