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Guide to Contract Pricing

Cost and Price Analysis for Contractors, Subcontractors, and Government Agencies

Management Concepts Press

Basic Pricing Policy and Concepts

The government policy is to contract for its products and services at fair and reasonable prices. No matter how the problem is approached, the decision comes down to a matter of good personal judgment on whether or not a particular asking price is fair and reasonable. We have to consider a broad range of factors that exist when the purchase is made.

The problem faced by government contracting people in deciding whether or not a price is reasonable is in many ways like that of an individual making purchases for his or her own private purposes at the local department store or supermarket. We all know that we usually have to pay more for high quality articles than we do for ordinary articles. We realize we are likely to pay more if we make emergency purchases, such as getting the furnace repaired after normal business hours or stopping at the local convenience market so we will not be delayed by a long line at the supermarket. We know that we may have to pay more for name brand items, such as an IBM personal computer rather than a no-name clone, and that an electric "water pic" will cost more than a conventional toothbrush.

PRICING RESTRAINTS IN GOVERNMENT CONTRACTING

Government contracting people encounter some restraints not faced by private individuals when trying to reach a decision on a reasonable price to pay.

Use of Public Funds

The government employee is spending public funds rather than his own money. If we, in our private lives, choose to spend $50,000 for an automobile, we are the ones who bear the expense and no one else is affected. However, the government employee is held responsible for use of good judgment so that excessive prices are not paid.

Promote Full and Open Competition

Federal Acquisition Regulation (FAR) 11.002(a) provides that agencies

1. Specify needs using market research in a manner designed to —

i. Promote full and open competition with due regard to the nature of the supplies or services to be acquired; and

ii. Only include restrictive provisions or conditions to the extent necessary to satisfy the minimum needs of the agency or as authorized by law.

2. To the maximum extent practicable, ensure acquisition officials —

i. State requirements with respect to an acquisition of supplies or services in terms of —

A. Functions to be performed;

B. Performance required; or

C. Essential physical characteristics;

ii. Define requirements in terms that enable and encourage offerors of commercial items and nondevelopmental items an opportunity to fill such requirements;

iii. Provide offerors of commercial and nondevelopmental items an opportunity to compete in acquisition to fill such requirements;

iv. Require prime contractors and subcontractors at all tiers under the agency contracts to incorporate commercial items or nondevelopmental items as components of items supplied to the agency; and

v. Modify requirements in appropriate cases to ensure that the requirements can be met by commercial items or, to the extent that commercial items suitable to meet the agency's needs are not available, nondevelopmental items.

Full and open competition, when referring to a contract action, means that all responsible sources are allowed an opportunity to compete (FAR 2.101(a)). Note also that the FAR citation above encourages the use of commercial items and nondevelopmental items to encourage maximum competition. Government contracting officers do not have the luxury of buying from one or even a very few sources, based on good business relations in the past. They cannot restrict their sources to suppliers who are already known for quality products and on-time delivery. The government does not have product or supplier loyalty. They must extend the opportunity to compete to all responsible sources. This approach is in marked contrast to that of private individuals and businesses who may well return to the known vendors repeatedly, rather than take a chance on some vendor with whom they have no experience.

PRICING ADVANTAGES IN GOVERNMENT CONTRACTING

Government buyers have some significant advantages in getting fair and reasonable prices. Some of these advantages are mentioned below.

The Government Is the Only Buyer

For certain commodities such as spacecraft and weapons systems, Uncle Sam is the only buyer. In these cases, the government has a strong negotiating position on pricing because the seller cannot turn to other consumers who are willing to pay a higher price.

High Volume Purchases

Private suppliers like to deal with high-volume buyers and are inclined to give better prices to such buyers. Government agencies typically deal in fairly large quantities, as much or more than individual buyers in the private sector. The government's simplified acquisition activity (i.e., individual orders less than $100,000 each) alone is a major revenue source, particularly to small businesses near federal installations. This major revenue source for private businesses helps the government in securing reasonable prices for the products and services that it buys. The benefits are even greater when heavy competition exists to get government business.

The Government Pays Its Debts

Large volume buyers who are also good credit risks tend to get better prices because the seller runs less risk of taking a financial loss. It is taken for granted that the government pays its legal obligations. The Anti-Deficiency Act requires that government agencies have money to pay for contract work before signing the contract. It is not necessarily certain that the private sector buyer actually has all the funds required to pay for a buy "up front." That commercial buyer may itself have to pass on the goods or services to another buyer and obtain payment before it has the money to meets all its own bills. The problem of cash flow is a very real concern to all businesses, large or small, and it takes cash in hand to pay bills. A government agency, on the other hand, has the money needed to pay its bills from the outset; otherwise it cannot contract to buy products or services. If the government decides not to buy after the contract is placed, the contractor is protected against financial loss without having to resort to expensive legal actions. Contractors do not need to "up their prices a shade" because their government customers may not pay.

Prompt Payment of Bills

The Prompt Payment Act is another factor that helps the government, already known for paying its legal debts, to get more reasonable prices. In almost all cases, the government contractor is very certain to be paid somewhere around 30 days after submission of a proper invoice. A fairly common practice among firms in the private sector is to alleviate their cash flow problems by paying suppliers late. This practice provides a way to have the use of money interest-free for a longer time. Such firms may even deliberately lose discounts. It may be better to delay paying the full amount, even though interest is added, than be short of cash to pay more pressing obligations such as payroll. In the worst cases, private firms may wait as long as possible to pay their bills and then take the offered discount long since expired. Such firms are depending on the fact that, as a practical matter, the most the supplier can do is refuse to sell to them again, and lose business in the process.

Most Favored Customer Treatment

The government is often in a good position to obtain "most favored customer" treatment from vendors because of its high-dollar value buying practices. It is common practice in the commercial sector for suppliers to grant special price concessions to customers who are favored because they buy in very large quantities, or pay very rapidly or provide other benefits to the supplier. The government is very often in the position of being able to buy large quantities with the promise of rapid payment and can successfully use that leverage to obtain price concessions not available to ordinary buyers. FAR 13.303-2(b) requires that after determining Blanket Purchase Agreements (BPA) would be advantageous, contracting officers shall:

Consider suppliers whose past performance has shown them to be dependable, who offer quality supplies or services at consistently lower prices, and who have provided numerous purchases at or below the simplified acquisition threshold. (Emphasis added.)

It is important to understand that no supplier is forced to give the government "most favored customer" treatment; no one forces the supplier to deal with the government in the first place. The requirement merely says that the supplier must give that pricing advantage to the government if it desires to enter into a BPA. The supplier knows that a BPA (a type of charge account) will very likely result in some government purchases.

Cost and Pricing Data

Under some conditions (covered in more detail in Chapter 5) the government may receive cost and pricing data from offerors prior to selecting one of them for an actual contract. These cost and pricing data give the government detailed information about how the offeror developed the asking price in its proposal. Government examination of that information is a major help in judging the reasonableness of the offeror's price proposal. The Truth in Negotiations Act (PL 87-653) provides the legal basis for obtaining this information under prescribed conditions. Private companies and individuals do not have this advantage as a legal right in private contracting.

WHAT IS A FAIR AND REASONABLE PRICE?

A fair and reasonable price is different things to different people. The buyer tends to think on the low side, and the seller tends to think on the high side. The seller wants to make as much money as possible and the buyer wants to save as much as possible.

Although the FAR talks about payment of fair and reasonable prices, it does not define the term. The reason the term goes undefined is that whether or not a price is reasonable depends on great many factors, and it simply is not possible to define the term in a few words. However, you will see as we progress through this text that (1) the government prefers market-based pricing over cost-based pricing to judge fair and reasonable price, and (2) cost-based pricing is appropriate only when the forces of the marketplace cannot judge fair and reasonable price. The determination depends heavily on good personal judgment and experience, no matter how the problem is approached. One purpose of this text is to help you understand how to approach the problem.

It is a good idea to look at five means normally identified to establish a fair and reasonable price. Four of the means are market-based, and one is cost- based.

Market-Based Prices

Competitive Offers — Prices arrived at through this means are:

• In response to solicitations encouraging competing offers;

• Prepared with no effort by the buyer to suppress a known source;

• Submitted by multiple responsible offerors who can satisfy the buyer's requirements with priced offers responsive to the solicitation's expressed requirements; and

• Submitted by offerors who are competing independently for a contract to be awarded to the responsible offeror submitting the lowest evaluated price.

Sellers proposing prices that are too high risk seeing the business go to a competitor. The forces of the market push each offeror to propose a fair and reasonable price.

Established Catalog Price — Prices established by this means are:

• Published by the seller in a regularly maintained catalog or price list;

• Available for inspection by potential buyers; and

• State current prices, including discounts and other price-related terms, for offered goods and services.

The published catalog or price list is the seller's message that:

• They are willing to offer goods and services at the prices published;

• ll competing offerees may either accept the prices as published by placing an order, or decline the prices as published by refraining from placing an order; and

• Market forces make it disadvantageous to use their income producing capacity to sell goods and services at lower prices than those published.

The seller is in effect saying, "other customers are willing to meet our price. We plan to continue servicing them with these prices that they find satisfactory. Therefore, it is not to our advantage to offer a lower paying customer (like you) the benefits of our income producing capacity." The forces of the market push the buyer to accept a fair and reasonable price.

Established Market Price — Can be substantiated from sources independent of the seller; and are current sales prices established in the normal course of trade between buyers and sellers free to bargain in the market place.

The seller believes and is able to show to their satisfaction (and if necessary, to the customer's satisfaction) that their proposed price for comparable goods and services is either better than or equal to prevailing prices for comparable goods and services in the marketplace.

The seller is in effect saying, "other customers are willing to meet our price. We are confident that current and potential customers will be satisfied to pay these prices. Therefore, it is not to our advantage to offer a lower paying customer (like you) the benefits of our productive capacity." The forces of the market encourage the buyer to accept a fair and reasonable price.

Established by Law or Regulation — Prices are established by legislative or regulatory authority usually to protect buyers, punish buyers (for example, a fine or penalty), or to achieve some socioeconomic goal.

In these cases, the seller is able to demonstrate that (1) other authorities have established a ceiling or floor on their prices; and (2) all customers are consistently impacted by the established prices.

The seller is saying in effect, "other authorities regulate our prices. We are blameless. Presumably the regulating authorities have judged the price to be fair and reasonable under the circumstances." Regulatory forces in the market encourage (or force) the buyer to accept a fair and reasonable price.

The four means above rely on the marketplace to determine a fair and reasonable price. However, when there are no competing sources or the competing sources are ineffective, the marketplace cannot be relied upon to produce a fair and reasonable price. In those cases, cost-based pricing serves as a surrogate to the market in determining a fair and reasonable price.

Cost-Based Prices

When the buyer cannot rely on the competitive forces of the market economy, it will often make extraordinary efforts to judge a fair and reasonable price. If the order is significant, the buyer may encourage or even demand that the seller prepare a detailed cost and price breakdown showing the composition and basis or estimate of the total cost by: Direct Cost; Indirect Cost; Profit; and Total Price. The cost and pricing data submitted is analyzed, and serves as a basis to negotiate a fair and reasonable price.

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Excerpted from Guide to Contract Pricing by John Edward Murphy. Copyright © 2009 Management Concepts, Inc.. Excerpted by permission of Management Concepts Press.
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