Defense Contractor Financial Management presented to EPMC by Dr. Tony Perino

How might I best use my contractor’s financial motivations and constraints to help my program succeed?

Which is more important: Cash Flow, Profit or Profitability?

Cash Flow vs. Profit 0 0 PROGRAM LIFE CYCLE DOLLARS Cumulative Net Income Cumulative net Cash Flow Development Phase Production Phase

Profit vs. Profitability

Profitability is an indicator of financial health

INTERRELATIONSHIP OF PROFITABILITY MEASURES Dupont Formula Extended Dupont Formula Return on Assets Financial Leverage** Return on Stockholder's Equity X= Net Income Total Assets Total Assets Stockholder's Equity Net Income Stockholder's Equity ( ( ( ( ( ( Return on Sales* Total Asset Turnover Return on Assets X= Net Income Sales Sales Total Assets Net Income Total Assets ( ( ( ( ( ( *Return on Sales is also called Net Profit Margin *** This financial leverage ratio is sometimes called the equity multiplier

PROFITABILITY INCOME STATEMENT SALES TOTAL COST COST OF SALES SELLING EXP ADMIN EXP ASSET S BALANCE SHEET ROA% CASH RECEIV- ABLES INVENTORY PLANT & EQUIP PAYABLES & ACCRUALS NOTES & BONDS COMMON STOCK RETAINED EARNINGS CREDITORS OWNERS ROE% NET INCOME ROS%

So……? Which is more important: Cash Flow, Profit or Profitability?

OK, Next Topic!

Post-Cold War Industrial Base Policy Concerns about the health of the aerospace and defense industrial base became increasingly evident during the 1990s and even more so after 9/11. Two major changes in DoD policy during this time frame: Profit Policy Contract Financing Policy

Shift in DoD Profit Policy Purpose is to reduce facilities investment as a factor in establishing profit objectives on negotiated contracts The goal is to reward technical innovation and cost reduction efforts The weighted guidelines profit factors used by govt. contracting officers were changed

WGL DD Form 1547 Change (1)Change (2) Change (3)

Significant Changes (1) Technology incentive range (7 – 11%) available under Technical Risk Factors Applies to contract performance that –Fundamentally changes existing product or system characteristics –Increases technical performance, improves reliability, or reduces cost

Significant Changes (2) Adds G & A to the cost base for all profit factors This allows company spending on IR&D to be included in the base thereby increasing profit levels Reduces FCCM impact on profit objective by eliminating land and buildings and lowering the equipment factor.

Significant Changes (3) Adds a new cost efficiency factor –Increases profit potential by up to 4% of total cost base. –Contractor must demonstrate cost reduction efforts that benefit the pending contract. –Govt. KO has maximum flexibility in determining how to evaluate the benefit and in selecting the assigned value (0% - 4%)

Technical Evaluation Factors (Adequately Assess Contractor Risk) Technology being applied or developed by the contractor Technical complexity Program maturity Performance specifications and tolerances Delivery schedule Extent of warranty or guarantee

Cost Efficiency Evaluation Factors (Adequately Assess Benefit to Program) Participation in Single Process Initiative improvements Actual cost reductions achieved on prior contracts Reduction or elimination of excess or idle facilities Cost reduction initiatives

Cost Efficiency Evaluation Factors (Adequately Assess Benefit to Program) Adoption of process improvements to reduce costs Subcontractor cost reduction efforts Effective incorporation of commercial items and processes Investment in new facilities when such investment contributes to better asset utilization or improved productivity

Profit Policy Summary DoD uses WGL to encourage and reward contractor economic behavior by providing earnings commensurate with risk, investment and technology employed Significant WGL changes –Addition of new Technology Incentive Range –Adds G&A to cost base –Increases Performance Risk ranges –Decreases Facilities Capital profit –Adds Cost Efficiency Factor

Weighted Guideline Application Examples (Refer to Handout) Government: Contractor: Minimum Markup Rate 7.0% =Return on Sales 1.7% Normal Markup Rate 15.8% =Return on Sales 6.2% Maximum Markup Rate 24.8% =Return on Sales 10.1%

And Now – For Our Last Topic

Contract Financing Policy Facilitate Access to Leading Edge Technology Available in the Commercial Sector

Government Sources of Contract Financing For Commercial Items (if industry norm): Advanced Payments (FAR ) (before work starts) Interim Payments (FAR )(during performance) For Non-Commercial Items: Advanced Payments [C+/FP](FAR 32.4)(before work starts) Interim Payments [C+](FAR )(based on cost incurred) Progress Payments [FP] (FAR 32.5)(based on cost incurred) Performance Based Payments [FP] (FAR 32.10)(event driven)

Advantages of Performance Based Payments Enhanced technical and schedule focus Reducing cost of administration Reinforcing the role of program managers and integrated team members Linking payments to performance

Progress Payments vs Performance Based Payments

Progress Payment Example Month #1 Cost Incurred50,000$ Prog. Pmt. Rate80% Prog. Pmt. Amt.40,000$ Cum Cost Incurred50,000$ Cum. Prog. Pmts.40,000$ Delivery CLIN Price Liquidation Rate Liquidation Amt. Cash Due Unliq. Prog. Pmts. Cum. Cash Flow Progress Pmts.40,000$ DD 250 Pmts. Total40,000$

Progress Payment Example Month #1Month #2 Cost Incurred50,000$ 500,000$ Prog. Pmt. Rate80% Prog. Pmt. Amt.40,000$ 400,000$ Cum Cost Incurred50,000$ 550,000$ Cum. Prog. Pmts.40,000$ 440,000$ Delivery CLIN Price Liquidation Rate Liquidation Amt. Cash Due Unliq. Prog. Pmts. Cum. Cash Flow Progress Pmts.40,000$ 440,000$ DD 250 Pmts. Total40,000$ 440,000$

Progress Payment Example

Contract Financing Progress Payments Vs. Performance Based Payments Refer to Handout