July 25, 2024
Generated by AI and edited by Paul Calabrese, Principal
Government contractors who also serve commercial clients are uniquely positioned to leverage diverse opportunities while navigating complex regulatory environments. This dual engagement offers significant benefits but also requires careful management of compliance and operational strategies. Understanding the dynamics and strategic considerations of this business model provides valuable insights for contractors aiming to maximize their potential in both sectors.
Advantages of Government Contractors with Commercial Clients
Diversified Revenue Streams: Contractors serving both government and commercial clients benefit from diversified revenue streams, reducing dependency on a single sector. Government work provides stability during economic downturns that impact the availability of commercial work. Furthermore, the government generally pays on time and the only write-downs are unallowable expenses. On the other hand, commercial endeavors are more profitable with a much higher market-based fee. They also do not impose an administrative burden because there are no regulatory limitations and reporting is not required. A downside for commercial projects is that they carry a greater risk of non-payment leading to bad debt expense.
Innovation and Cross-Pollination: Commercial markets often drive rapid innovation and new technologies. Contractors exposed to commercial projects can bring innovative solutions and best practices to government contracts, enhancing the efficiency and effectiveness of public sector projects. On the other hand, the government sector provides unique access to cutting-edge technology such as space exploration (innovations developed from NASA), military applications such as the internet, medical research, or access to “protected” populations requiring specialized assistance.
Enhanced Market Competitiveness: A dual client base broadens a company’s expertise, making it more competitive. The ability to meet varied client requirements and deliver high-quality outcomes in different environments enhances a contractor’s marketability and reputation. The contractor’s long-term sustainable is further enhanced by providing the same capabilities to both the commercial and government sectors.
Improved Resilience and Flexibility: Balancing government and commercial contracts fosters resilience and flexibility. While government projects involve longer cycles and strict regulations, commercial projects may offer quicker turnarounds and more agility. This balance can enhance a contractor’s ability to adapt to different project demands and timelines.
DCAA’s Perspective on Dual-Focused Businesses
The Defense Contract Audit Agency (DCAA) plays a pivotal role in ensuring that government contractors adhere to financial regulations and maintain integrity in cost allocation. From the DCAA’s perspective, contractors with commercial clients must navigate several key areas:
- Compliance and Internal Controls: The DCAA requires contractors to maintain rigorous internal controls to ensure proper use of government funds. This includes clear separation of costs among all projects, whether they be government or commercial to prevent misallocation of Federal funds.
- Cost Allocation and Pricing: The DCAA scrutinizes cost allocation practices to ensure that expenses related to commercial clients are not charged to government contracts. Accurate cost segregation and transparent accounting systems are crucial to meeting these standards. DCAA’s biggest concern is a situation where the contractor has a mix of government cost-reimbursable work with government fixed priced, time and material contracts, and commercial efforts. The contractor must establish controls to avoid potentially mischarging fixed price contracts in a loss position to cost reimbursable contracts that have available federal funds.
- Audits and Financial Reviews: Regular DCAA audits and financial reviews ensure compliance with federal regulations. Contractors must demonstrate adherence to these regulations through thorough documentation and financial management practices. Typical audits and reviews include:
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- Incurred cost to settle final indirect rates
- Proposal audits to determine the accuracy of projected direct and indirect expenses
- Accounting system reviews
- Periodic reviews of public vouchers
- Close-out of cost reimbursable contracts
- Compliance with the Cost Accounting Standards (CAS)
- CAS Disclosure Statement (D/S) reviews to determine the adequacy of the CAS D/S
- Defective pricing to determine if fixed price contract cost or pricing data was overstated and not disclosed to the government on the date of the agreement on price.
Risk of DCAA audit
As we consider DCAA’s role with contractors that have commercial work, and the various types of audits they perform, the table below provides a matrix of the chances of receiving a DCAA audit.
| Level of Audit Risk | Dept. of Defense Contracts? | Cost Reimbursable Contract? | Subcontractor? |
|---|---|---|---|
| Highest | Yes | Yes | No – Prime |
| Medium | No | Yes | No – Prime |
| Low to None | No | No | Yes |
Impact on Government Contractors with Commercial Divisions
| Regulatory Compliance | Balancing compliance with stringent government regulations while pursuing commercial opportunities is a significant challenge. Contractors must implement robust internal controls that include compliance mechanisms to manage these dual requirements without stifling commercial innovation. |
| Cost Segregation | Meticulously tracking and allocating costs between government and commercial projects through project cost reporting is complex but essential. Specialized accounting systems and thorough training for financial personnel are necessary to ensure compliance. Direct costs are assigned to contracts whereas indirect costs are converted to multi-tier indirect rates that provide a measure of administrative expense loaded on direct project cost. |
| Resource Allocation | Contractors must allocate their workforce, technology, and capital effectively to meet the demands of both sectors without compromising quality or delivery timelines. |
| Cultural and Operational Differences | The cultural and operational differences between government and commercial clients can pose challenges. Government projects often require strict adherence to formal processes and detailed documentation, while commercial clients may prioritize speed and innovation. The most significant governmental requirement is tracking time and effort so utilizing accounting software to capture total time reporting is mandatory. Balancing these expectations requires adaptable business practices. |
Benefits of Consolidated G&A
A consolidated General and Administrative (G&A) expense structure offers several advantages for government contractors with commercial clients. The government’s expectation is that contractors will utilize a single or “consolidated” G&A for both governmental and private projects because it provides for cost efficiency, simplified compliance, and improved decision-making.
When to Consider a More Complex Business Structure
Government contractors with substantial and growing commercial operations should consider a more complex business structure when:
Scale and Complexity Increase: As the scale and complexity of commercial operations grow, managing compliance and resource allocation within a single structure becomes challenging. A separate business unit or subsidiary for commercial activities can provide better focus and control. This often occurs when a large commercial enterprise purchases a small government contractor. To avoid “the tail wagging the dog,” the smaller government contract entity is placed in a subsidiary to “fence in” the myriad of specialized compliance and niche accounting requirements not applicable to the larger commercial parent entity. Typically, the parent company removes the administrative functions from the subsidiary and provides corporate support functions from the parent to the subsidiary in the form of home office allocations. Using the principles of Cost Accounting Standard 403, certain home office functions are allocated to the subsidiary. It is important to understand that everything allocated to the subsidiary is subject to audit. To avoid governmental review, the parent company may not allocate parts of the executive staff due to their high compensation and other benefits.
Market Demands Diverge: When the demands and operational strategies of government and commercial clients diverge significantly, a more complex structure allows for tailored approaches to each market, ensuring that both sectors receive the appropriate level of attention and resources.
Structuring for Sale
If a government contractor plans to sell their business within the next few years, they should structure their business to maximize value and attractiveness to potential buyers including:
- Separate Business Units: Establishing separate divisions for government and commercial operations can provide clarity and transparency to potential buyers. This separation highlights the strengths and profitability of each division, making the business more attractive. In this scenario, each division might have a separate overhead representing a different line of business. However, there would still be a single G&A.
- Streamlined Operations: Ensuring streamlined and efficient operations, with robust internal controls and compliance mechanisms, increases the business’s appeal. Potential buyers will value a well-organized and compliant operation with minimized risks.
- Comprehensive Financial Records: Maintaining detailed and accurate historical financial records for both government and commercial activities is crucial. Clear documentation of cost allocation, compliance, and profitability will enhance the credibility and value of the business during the sale process. Investments in more specialized accounting systems that integrate automated accounts payable and electronic timekeeping make the purchase more attractive.
- Annual Audits: Consider yearly financial statement audits performed by an independent public accounting firm that provide assurance as to the accuracy of yearly, internal financial reports. The yearly audited reports are helpful to determine the businesses value for sale.
- Assist with Due Diligence: The purchasing entity must have a “due diligence review” of the company for sale. One of the key areas to review is prior DCAA audits or other governmental oversight reviews to understand the amount of risk of non-compliance with the government regulations and detect any outstanding legal or punitive judgements that add to the purchaser’s liabilities.
- An ESG Program: A defined ESG program with reporting on greenhouse gas direct and indirect emissions, including mitigation efforts, should be publicly available on the seller’s website. Diversity, Equity, and Inclusion (DEI) policies are also attractive to a younger generation of buyers who are pledging a commitment to the environment and social equality.
- Cybersecurity Policy and Procedures: Developing compliance to and ongoing assessment of the purchaser’s cybersecurity capabilities will increase interest in the buy.
Conclusion
Government contractors with commercial clients enjoy significant advantages, including diversified revenue streams, enhanced innovation, and improved market competitiveness. However, they must navigate complex regulatory requirements and operational challenges. From the DCAA’s perspective, maintaining stringent compliance and transparent cost allocation is essential. A consolidated G&A structure can offer cost efficiency and simplified compliance, while a more complex business structure may be necessary as the scale and complexity of operations grow. For contractors planning to sell, separating business lines, and maintaining comprehensive financial records will enhance their market value and attractiveness to potential buyers.
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