Small Business Government Contractors Cautiously Optimistic in the Face of Challenging Market Conditions

We released the 2023 Deltek Clarity Government Contracting Industry Report, which is now in its 14th year. For this year’s report, we surveyed 700 respondents across 11 primary industries — including information technology, professional services, and Department of Defense contracting — to gauge their overall confidence in the government contracting sector and determine their priorities and challenges.

Across the board, government contractors — small, medium and large — remain confident in the industry's strength over the next 12 months, with confidence increasing 1.6% from last year’s report. This is continuing an upward trend of the past several years, and the overall confidence score — 144 out of 200 — is the highest we’ve seen since the pandemic started.

Despite the uptick in confidence, the government contracting sector is not without its challenges and those challenges don’t impact all contractors the same way. Small businesses were shown to be more vulnerable, not having the resources of larger businesses, they may struggle in the competition for funding, talent and resources.

To overcome these challenges, many contractors reported looking inward at ways to reduce costs and bolster the strength of their own businesses by creating efficiencies and optimizing processes they have some control over.

3 Market Conditions Impacting the Government Contracting Industry

According to our research, 37% of small business contractors saw growth in 2022, and 64% anticipate favorable results this year in 2023. However, when measured against the 49% revenue growth reported among contractors of all sizes, it’s clear that while small businesses fared well, they didn’t see as significant of a performance improvement as their larger counterparts. The main drivers of this discrepancy include suboptimal economic conditions, more competition among small businesses and difficulty winning business for new contractors who don’t have lengthy performance histories. That competition is heating up in part due to category management and the consolidation of federal contracts into preferred contract vehicles. These consolidations may skew funding outlooks by showing that the overall funding going to small businesses is rising but in actuality, the number of contract awards and vendors is declining. Compounding the issue of fierce competition are additional external factors outside each contractor’s control, like supply chain issues and red-hot inflation.

Additionally, small business government contractors also reported struggling with profitability. The Clarity Report found that smaller contractors have, on average, 8% profit margins while larger and medium-sized contractors have 24% and 20% margins, respectively. In large part, these differences are attributed to rising labor costs, inflation and compliance expenses. Often lacking deep pockets, small businesses simply can’t absorb these kinds of costs while protecting their margins.

To overcome these challenges, small business government contractors are focusing on three key areas: strategic teaming initiatives, new capture strategies and business development.

1. Strategic Teaming Initiatives

In today’s challenging market, teaming with competent partners has never been more important. Due to a confluence of factors — including the impending requirement for CMMC 2.0 compliance, diversity, equity, and inclusion (DE&I) initiatives, supply chain issues and increased mergers and acquisitions (M&A) activity — small businesses need to reevaluate their partnerships to bolster the path forward.

An example of a mutually beneficially teaming strategy might be when a smaller company partners with a large contractor on a small business set-aside opportunity. By joining forces, a small businesses benefits from the mature processes, technologies and past performance a larger business brings to the table. The larger business, in-turn, benefits from being able to perform work on a contract they wouldn’t normally be eligible for. Whether partnering with large businesses or another small business, contractors with complementary skill sets may have a higher win probability working together because it bolsters the credibility and reputation of each business. This can also lead to repeat business down the road with the government’s preference for working with contractors that have a proven track record.

2. New Capture Strategies

Additionally, it’s important for small business government contractors to develop new capture strategies to stay competitive, increase their win rates and secure government contracts effectively. As an example, your chances of winning business increase when you understand opportunity requirements early in the government procurement cycle. If the first time your business is hearing about an opportunity is when the RFP is released, it’s very likely that you’ll be at a disadvantage against contractors who have been diligently working with the government to shape those requirements months or even years before the RFP was released.

Teaming up with new partners can also help here. A contractor never knows when a new partnership can present the perfect opportunity to expand their portfolio into other government agencies that might need their products and services.

3. Business Development

Eighty-five percent of small business government contractors expect their win rates to increase over the next 12 months. Despite this optimism, they still site challenges, including a lack of face-to-face opportunities with decision makers and limited business development (BD) resources.

These challenges are not keeping companies from expecting BD investments to increase.

A strong majority (61%) reported expecting increases with almost none (1%) predicting a decrease. There are a variety of different strategies companies are taking with investment in their BD function including improving sales processes, better opportunity identification and a focus on developing more competitive bids.

Similarly, contractors are spending time identifying and analyzing the key performance indicators (KPIs) they measure and track. By studying metrics like bid and proposal costs, win rates on recompetes, win rates on new bids, revenue growth forecasts and target pipeline-to-win ratios, contractors can build an increasingly effective operation.

The survey also found that many contractors are looking to diversify their revenue streams outside of government with top performers being twice as likely to explore new markets in the private sector as their most important initiative. Since capture and business development are both expensive, they are evaluating opportunities with the goal of zeroing in on fewer, more valuable opportunities instead of spreading out resources across many opportunities.

Audit and Compliance Challenges

This year contractors reported facing twice as many government audits in 2022 as they did in 2021; half of these audits were financial in nature, and the rest were related to cybersecurity or other governmental compliance issues. The cost of compliance ranked as one of the top four costs impacting businesses in 2022, and this is further evident with contractors spending between 41 and 160 hours per year preparing for these audits. Small businesses are particularly impacted by compliance costs and may not even be aware of their necessity until they are in the midst of their first DCAA audit.

As such, it comes as no surprise that compliance is an ever-present challenge for contractors, and smaller ones in particular. Not only do contractors need to comply with CMMC 2.0 and the cybersecurity executive order, there are DE&I requirements, small business contracting regulations, supply chain issues and climate resilience and sustainability initiatives to consider, too.

To address these concerns, small business government contractors listed reengineering business processes, hiring better talent, investing in systems and regulatory training, assigning dedicated resources to tasks, obtaining systems validation, conducting internal audits, investing in new technology and moving to the cloud, as their top strategies.

Chart from 2023 Clarity Study Finance section on Initiatives to Address Audit Challenges

Human Capital Management Challenges

To win the war for talent, many small business contractors are figuring out what they can do to attract better talent. In today’s difficult economic climate, many are struggling to offer competitive compensation, and they’re also having a hard time finding good candidates and matching them to positions. To solve this, contractors are trying to become better at passive recruitment, as well as keeping top talent engaged and retained.

To this end, many contractors are implementing or optimizing career development programs. They’re also adopting hybrid work models, giving employees the ability to work from home and the office, to meet their expectations. Additionally, government contractors are investing in human capital management technologies, implementing reward and recognition programs, prioritizing mentor-mentee relationships and investing in DE&I initiatives.

Learn More About the State of Small Business Government Contracting

After a few difficult years, the government contracting industry has financially recovered from the pandemic. To increase profitability even more, smart contractors are reengineering business processes to ensure they’re operating as efficiently as they can be.

But at the same time, small business contractors face a number of challenges — particularly when it comes to competing for talent, managing compliance requirements, navigating supply chain issues and combating inflation.

By tackling these challenges head-on and controlling what they can internally, small business contractors can increase their competitiveness, build better organizations and ultimately win more business.