Profit Margin for Government Contracts: Key Insights

What profit should you reasonably make on a contract? As a growing or established business, you must carefully calculate your government contract profit. There are many factors to consider and known limits to follow. There is a strategy you must craft, a ceiling you must respect, and self-respect you must uphold. 

That all said, here are the basic tenets of crafting a proposal that both makes you money and shows the agency you’re working with that you’re an honorable, reputable partner.

In This Article:

• Are Government Contracts Profitable?
• FAR Profit Guidelines
• Maximum Percentage of an Award That Can Be Profit
• What is the Weighted Guidelines Method for Determining Profit?
• Factors Included in Your Contract Profit
• Profit Factors in the Weighted Guideline Approach
• Breaking Down the Factors Included in Your Contract Profit
• What is the Average Government Contract Profit?
• Negotiations During the Source Selection Process
• How Prime vs Subcontractor Profit Margins Can Differ
• Do Subcontractor Negotiations Differ from Primes?

Government contracts can indeed be profitable, and contrary to popular belief, it's actually in the government's best interest for contractors to receive fair compensation. Profit serves as a powerful motivator, incentivizing optimal contract performance and ensuring contractors have the necessary resources to deliver effectively.

Businesses shouldn't feel obligated to offer significant discounts when bidding on government contracts. Instead, a more strategic approach is to treat the government as a preferred commercial customer. This means extending the same pricing structures and discounts offered to other valued clients.

For example, if a cybersecurity network software company offers volume discounts to enterprise customers, they should consider extending similar terms to those offered by government agencies. Similarly, a construction firm might provide early payment incentives to private sector clients, which could also be applied to government contracts.

It's important to note that while profit is encouraged, transparency and fairness are required. Government agencies often use tools like Deltek's ProPricer to analyze and negotiate fair and reasonable pricing, ensuring both parties benefit from the arrangement.

Ultimately, successful government contractors understand that profitability and performance go hand in hand.

The Federal Acquisition Regulation (FAR) authors guidelines that illuminate the various factors influencing profit margins in government contracting. By referring to the relevant sections of the FAR, contractors can gain valuable insights into navigating the complexities of profit determination and making informed decisions during the proposal process.

It's good to recognize that estimated costs outlined in a proposal may not always perfectly align with the total actual costs incurred during the execution of a contract. Discrepancies can arise from unforeseen circumstances, project scope changes or market condition fluctuations. The FAR acknowledges this reality and guides contractors in handling such situations. For instance, the regulation may allow certain adjustments to the contract price based on documented cost variations, ensuring that contractors are fairly compensated for their efforts.

For decades there’s been a common misconception that contracting firms must reduce their profit margins when bidding on federal projects. But the FAR actually encourages reasonable profits in hopes of motivating contractors to perform efficiently.

Contracting officers (COs) don’t focus solely on reducing prices by cutting contractor profits. The FAR recognizes that doing so can be counterproductive. In fact, unless a price negotiation is based explicitly on cost analysis, contracting officers aren't even required to scrutinize a company's profit margins.

This creates an opportunity for savvy contractors to bid more competitively while still maintaining healthy profits. For example, a services firm that typically bids 10% profit on commercial work may be able to propose 12-15% on government contracts without raising red flags. Similarly, a product manufacturer could increase margins from 20% to 25% when selling to federal agencies.

Contractors still need to justify their costs and pricing. However, the FAR's profit guidelines provide flexibility to propose rates that appropriately compensate firms for their expertise, innovation and risk. Ultimately, a thorough understanding of FAR profit guidelines is essential for any contractor seeking to succeed in the federal arena.

FAR Unallowable Costs

Unallowable costs represent a unique area of focus for government contractors, as these expenses cannot be billed to or reimbursed by federal agencies. The FAR provides detailed guidance on which costs are considered unallowable, helping contractors navigate this complex landscape.

Some costs are expressly defined as unallowable in the FAR, leaving little room for interpretation. For instance, alcoholic beverages are explicitly prohibited from being charged to government contracts. Other costs may be deemed unallowable based on specific contract terms. A prime example is travel expenses, which could be disallowed if not explicitly authorized in the contract language.

Certain organizational costs also fall into the unallowable category. These might include expenses related to corporate restructuring, mergers and acquisitions or capital-raising activities. Similarly, many patent-related costs, such as those associated with preparing invention disclosures or filing patent applications, are typically unallowable.

The FAR also prohibits compensation schemes tied to corporate securities. For example, bonuses calculated based on stock price fluctuations or dividend payments would generally be considered unallowable.

Beyond these specific categories, the FAR applies a "reasonableness test" to determine cost allowability. This standard asks whether a money-savvy commercial businessperson would incur similar expenses under competitive conditions. Costs that fail this test may be disallowed, even if not explicitly prohibited.

Government contractors must exercise diligence in identifying unallowable costs.

Related articles:

• Allowable Costs: Rules and Strategies for Government Contractors

While profit limitations can seem restrictive, innovative contractors recognize them as guideposts for crafting competitive, compliant proposals. Businesses can strategically determine fair and acceptable profit margins for all parties involved by factoring in these limitations during the early stages of proposal development.

For cost-plus-fixed-fee contracts, the government has established clear boundaries. Experimental, developmental or research work performed under this contract type is capped at a 15% fee based on estimated costs. Architect-engineering contracts, particularly those involving public works or utilities, face a tighter constraint of 6% of the estimated construction cost. This limit encompasses the creation of designs, plans, drawings and specifications. All other cost-plus-fixed-fee contracts are subject to a 10% ceiling on fees relative to estimated costs.

Fixed-price contracts offer more flexibility, with no hard limits on profit margins. However, contracting officers (COs) diligently research market rates to ensure that proposed prices align with industry standards. Successful contractors often target a profit ceiling of 25%, striking a balance between competitiveness and profitability.

Consider a scenario where a technology firm is bidding on a research and development contract for a new defense system.

Using a pricing solution with advanced modeling capabilities, they could explore various fee structures within the 15% maximum, optimizing their proposal to maximize both competitiveness and potential profit. This approach allows contractors to navigate pricing limitations confidently.

The weighted guidelines method is an often misunderstood approach to determining profits.

This methodology aims to incentivize contractors by allowing COs to increase pre-negotiation profit objectives when contractors demonstrate cost-reduction efforts in initial proposal submissions.

The weighted guidelines method incorporates a cost-efficiency factor as its foundation. This factor enables contractors who successfully implement cost-saving measures to potentially earn higher profits. For instance, a contractor using innovative project management techniques to trim expenses might increase their profit margin by a modest percentage.

However, weighted guidelines have a limited scope. They typically apply to negotiated contracts where COs obtain certified cost or pricing data.

Breaking down the percentage of profit for each individual contract dimension can seem daunting, especially since different government agencies assign distinct weights and requirements. It helps to follow these general guidelines:

For those contracts where weighted guidelines are an ideal approach, here are key points that determine profit factors:

Basic Profit Factors 

Weighted guidelines consider several basic profit factors:

• Contract Risk: The degree of cost responsibility and risk assumed by the contractor.
• Contract Type Effort: The technical and management effort required to perform the contract.
• Facilities Capital Employed: The extent of investment into facilities capital required.
• Cost Efficiency: The contractor's cost reduction and cost avoidance efforts.

Additional Profit Factors

Other factors that may be considered include:

• Performance Risk: The contractor's past performance and potential for future performance.
• Subcontracting: The extent and nature of subcontracting proposed.
• Independent Development: Any independent research and development efforts by the contractor.

Weighting of Factors

Each factor is assigned a weight based on its relative importance for the specific contract. The weights are then used to calculate a composite profit objective.

Importance of Technical Merit

The government often emphasizes technical factors over price in best-value procurements. Contractors should prioritize submitting strong technical proposals rather than solely competing on price.

As contractors develop their price points, they must consider how the following elements come into play and affect their profit, for better or worse: 

Contractor Effort

A contractor’s ability to perform effectively depends on each contract's unique context. Working with an agency office of 10 people will entail more routine and repetitive tasks than a contract with Pentagon offices. The latter will require more time, expertise, specialized support, compliance and other types of needs. The stakes will also be higher, and an involved contractor must invest more in trained personnel to successfully manage each job stage. 

Pro Tip: Estimate the amount of time and degree of expertise required to deliver effectively beforehand. This process can help every contractor construct an "effort vs. compensation" baseline before bidding. 

Other Costs

Every contract features unique circumstances, many of which can generate additional costs. Be prepared by factoring in these potential scenarios:

• Agency reputation: If a contractor is working with an agency with a reputation for being particular, even tricky, they will do well to adjust profit calculations for the extra costs that special attention will require.
• Cost risk: Firm-fixed-price contracts are riskier than contracts involving cost reimbursement, so contractors will want to modify their bids accordingly. Make sure to bump up the profit percentage to cover any additional risks.
• Investment: Some contracts require contractors to invest upfront capital to produce and manufacture products. If this is the case, it's smart to include a slight percentage increase in the final price. However, if the agency agrees to send payments frequently and recurringly, contractors are better off refraining from any price hikes. Such an arrangement will help incentivize the government to stick to a set payment schedule and deliver funds faster.
• Quality control: How well does a contractor's business deliver? If they know they're struggling with meeting deadlines, quality control, labor shortages or any number of other constraints, downplay profit percentages to offset these factors.
• Federal socioeconomic programs: Minority-owned businesses or firms still struggling with the aftermath of the COVID-19 pandemic and subsequent labor shortages may be able to add a small profit percentage. In some cases, they can even qualify for specific assistance programs.
• Special situations: The contractor's work on a contract may further develop their firm's intellectual property or new product offerings, allowing them to be monetized in commercial markets. Consider taking a slight profit percentage dip to show good faith if this is the case.

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The average profit margin for government contracts varies by contract size and type and can be influenced by many factors. 

According to the 2024 Deltek Clarity Government Contracting Industry Report, the average profit margin for small businesses is 8%, while medium-sized contractors have an average margin of 20% and larger contractors have an average margin of 24%. 

For cost-plus contracts, where the government reimburses allowable costs plus a fee, profit margins tend to be lower, often around 7-8%. Fixed-price contracts, which put more risk on the contractor, generally allow for higher margins—in the 10-13% range. 

Other contract types also vary in profitability. For example, time-and-materials contracts may yield margins around 9-10%, while firm-fixed-price contracts could reach 12-13% or higher in some cases.

It's important to note that margins can fluctuate based on program phase. Early development work often has tighter margins compared to production—and again, contractors who effectively manage costs and risks may achieve higher profitability.

While these ranges are an excellent general benchmark, individual company margins can vary. Some specialized contractors in high-demand areas like cybersecurity or artificial intelligence (AI) may see margins exceeding industry averages. Conversely, companies facing program challenges or market headwinds could see lower profitability.

Now that we’ve covered how contract profit is determined and the guidelines that drive it, let’s explore how to negotiate the contract.

Negotiating government contracts can be complex, but contractors can secure favorable terms with the right strategies and tools. Here are some key considerations for navigating the process and achieving successful outcomes:

Start High and Negotiate Down

One practical approach is to begin with ceiling and floor prices. Start negotiations at your ceiling price and work your way down but be prepared to walk away if the offer falls below your floor price.

According to one government contractor accounting firm, contractors should aim high. For cost-plus-fixed-fee contracts, they recommend starting negotiations at 30 percent profit. In fact, they've seen contractors win bids with profits ranging from 18 to 25 percent.

Protect Your Profits from Cost Escalations

While aggressive bidding can help secure contracts, it's equally important to safeguard your profit margins against cost increases. One way to do this is by negotiating a material escalation clause. This provision allows for contract price adjustments if certain materials experience rapid price hikes, often covering overhead in addition to the increased material costs.

Day one escalation clauses are the most common type, measuring cost increases relative to the costs on the contract's effective date. To increase the likelihood of including these clauses, be transparent with potential clients. Consider limiting adjustments to highly volatile materials and only when their prices exceed a reasonable percentage. Also, offer to reduce fees if material prices fall significantly.

Ignore TINA at Your Peril

The Truth in Negotiations Act (TINA) is a critical consideration in government contract negotiations. TINA requires contractors to provide cost or pricing data for contracts and subcontracts exceeding $2 million, as well as changes to contracts above that threshold.

Failing to disclose relevant cost or pricing data can lead to defective pricing claims and overpayment recovery by the government. However, there are ways to protect your firm. TINA doesn't apply to contracts under $2 million, those with adequate price competition or prices set by law or regulations. Consider these exceptions and request a TINA waiver from your contracting officer when applicable.

Related articles:

• Government Contract Negotiations: A Guide for Contractors
• Government Contract Pricing: A Starter’s Guide

According to a study submitted to the Air Force Institute of Technology, subcontractors don't typically earn higher median profits compared to their prime contractors. However, subcontractors who demonstrate exceptional expertise in their field can secure higher earnings than both their primes and other subcontractors working on the same contract.

For instance, let's consider a cost-plus-fixed-fee contract, where the contractor receives reimbursement for allowable costs plus a predetermined fixed fee. In this scenario, a highly skilled subcontractor with a niche specialization may be able to negotiate a higher fee due to their unique value proposition and the role they play in the project's success.

On the other hand, in a firm-fixed-price contract, the contractor agrees to deliver the product or service at a set price, regardless of the actual costs incurred. In this case, prime and subcontractors are responsible for managing their expenses to maintain profitability. Subcontractors with a proven track record of efficiency may be able to secure more favorable terms during negotiations.

Subcontractor negotiations in government contracting often follow a different path than those of prime contractors. While both parties, of course, want to lock in favorable terms, subcontractors face unique considerations.

One difference lies in the power dynamic. Prime contractors typically hold more leverage, as they have direct relationships with government agencies. And subcontractors have to navigate negotiations not only with the prime but also indirectly to accommodate the government's requirements. This can lead to a more complex negotiation process, where subcontractors have to balance their own interests with those of the prime and the ultimate client.

Pricing negotiations also tend to differ. Prime contractors often have more flexibility in their pricing structures, as they can adjust their overall bid to the government. Subcontractors, however, may find themselves in a tighter spot. They need to offer competitive rates to the prime while ensuring profitability, which can be challenging when primes push for cost reductions to enhance their bids.

Another crucial aspect is the flow-down of contract terms. Prime contractors must ensure that specific government requirements are passed down to their subcontractors. At this point, subcontractors often negotiate not just on price and scope, but also on compliance with various federal regulations. For instance, a subcontractor might need to adhere to specific cybersecurity standards or reporting requirements, even if not directly contracting with the government.

Risk allocation is another area where negotiations can diverge. Prime contractors often push more risk onto their subcontractors, leading to intense discussions about liability, indemnification and performance guarantees. Subcontractors should always evaluate these terms to avoid taking on disproportionate risk.

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