Key points covered in this article:

• Winning a firm-fixed-price contract does not guarantee the expected margin. Because the price generally stays fixed, profitability depends on how well the contractor controls direct costs, monitors labor and subcontractor changes, and manages the financial impact of shifting indirect rates throughout contract performance.
• Growth can quietly erode profitability if financial reporting does not keep pace. Rising indirect costs, delayed awards, changing labor assumptions, and underperforming individual projects may not be obvious in consolidated results, which is why contract-level reporting and updated forecasts are essential.
• Management should regularly review each contract’s original budget, actual costs, estimated costs to complete, and projected profit at completion. This helps identify margin erosion early, distinguish normal overruns from potential scope changes or equitable adjustment opportunities, and improve pricing on future bids.

Government contractors spend considerable time developing proposals, evaluating opportunities, and competing for contract awards. Following contract award, attention naturally shifts to performance, staffing, and meeting the customer’s expectations.

However, another question deserves just as much attention: Is the contract producing the profit the company expected when it submitted its proposal?

This is particularly important with firm-fixed-price (FFP) contracts. Under FAR 16.202-1, the contract price generally does not change because the contractor’s costs are higher than anticipated. The contractor must control project expenses, with cost performance ultimately affecting its profitability.

That arrangement creates an opportunity to earn higher margins through efficient performance. It also means that estimates made months or sometimes years before the work is completed can have a lasting effect on profitability.

What makes this challenging is that the factors affecting profit are not always within the individual project manager’s control.

A Profitable Contract Can Look Very Different a Year Later

Consider a government contractor awarded a $2 million FFP contract. Based on its proposal, management expects to incur $1.7 million in costs and earn $300,000 in profit, a 15% margin. The company experiences several changes, and labor costs increase as it competes to retain qualified employees. A subcontractor requires additional resources. Meanwhile, the company has expanded its administrative staff to support anticipated growth, but some of its new contracts have been delayed.

None of these developments is particularly unusual. However, their combined financial effect can be significant.

Suppose direct costs increase by $80,000 and allocated indirect costs increase by another $120,000. Total projected costs are now $1.9 million.

The contract still generates $2 million in revenue, but expected profit has fallen from $300,000 to $100,000.

Management has lost two-thirds of the profit it originally anticipated.

The contractor may still be meeting its contractual obligations and delivering satisfactory performance. From a financial perspective, however, the result is substantially different from what was expected.

This is why contract profitability deserves attention throughout performance, not just when preparing a bid or reviewing year-end financial statements.

Indirect Rates Can Change the Economics of a Contract

One area I believe contractors should pay particular attention to is the relationship between indirect costs and contract profitability.

When developing a proposal, contractors typically estimate the indirect cost rates that will be applied to the project, including fringe, overhead, and G&A. Those rates are based on estimates of the company’s costs and the allocation bases over which they will be distributed.

The difficulty is that neither remains constant.

A company may hire additional accounting, human resources, or contracts administration personnel in anticipation of new awards. It may invest in software, facilities, or other infrastructure. These decisions can be entirely appropriate and necessary to support growth.

But if anticipated revenue or contract activity is delayed, the company may find itself carrying additional indirect costs without the corresponding increase in its allocation bases.

The result is higher indirect rates, which can reduce the profitability of existing FFP contracts.

For example, assume a contract was priced using an overhead rate of 40% applied to a $500,000 allocation base. The estimated overhead cost would be $200,000.

If the actual rate increases to 50%, the allocated overhead becomes $250,000.

That $50,000 difference reduces the contract’s expected profit, even if the project manager has maintained the original direct labor budget.

The underlying issue is not necessarily poor project execution. It may be that the company’s overall cost structure has changed since the contract was priced.

FAR 31.203 provides guidance on indirect cost allocation for contracts that are subject to the applicable federal cost principles. Beyond compliance, contractors should understand whether their indirect cost structures continue to reflect how their businesses operate.

This becomes increasingly important as companies grow, as they enter new markets, or as they take on different types of contracts.

Growth Can Expose Weaknesses in Financial Reporting

I’ve found that one of the more important challenges for growing government contractors is making sure their financial reporting keeps pace with their operations.

A company managing a few contracts may be able to monitor performance using relatively straightforward reports. As the business evolves, management needs more detailed information.

The company may have multiple projects, different labor categories, subcontractors, and indirect cost pools. It may also have a combination of FFP, time-and-materials, and cost-reimbursement contracts.

At that point, looking at overall revenue and profitability is not enough.

A company can be profitable in total while certain contracts are underperforming. Strong results on one project may offset declining margins on another, making the problem less apparent when management reviews only consolidated results.

This is particularly relevant for small businesses experiencing rapid growth. Winning additional contracts is encouraging, but the accounting and reporting processes that supported the company at an earlier stage may not provide the information management now needs.

The question is whether management can determine, on a timely basis, which contracts are performing as expected and which require attention.

That requires more than knowing what has already been spent. It also requires a reasonable estimate of the costs remaining to complete the work.

Labor Costs Require More Than an Annual Budget Review

For many government services contractors, labor represents the largest component of contract costs.

When a proposal is prepared, the contractor estimates the employees, labor categories, compensation levels, and hours necessary to perform the work.

Those assumptions may change during performance.

Recruiting specialized personnel can be more expensive than expected. Employee turnover may require temporary staffing or additional training. Salary increases may exceed the escalation factors included in the original proposal.

If you have a contract that requires five full-time employees and the total compensation increases by say an average $5 per hour, assuming 2080 hours per employee, the additional annual direct labor cost is approximately $52,000.

That amount does not include the potential effect of associated fringe benefits and other applicable indirect costs.

On an FFP contract, these changes can materially affect the expected margin.

Contractors should periodically compare actual labor costs and hours with the assumptions used in their proposals and update their forecasts accordingly.

Waiting until the end of the contract to evaluate these differences limits management’s ability to respond.

Not Every Additional Cost Should Be Absorbed

There is another distinction worth making.

An FFP contract generally places the risk of ordinary cost overruns on the contractor. However, that does not mean every additional cost arising during performance must automatically be absorbed.

Government-directed changes, modifications to the scope of work, and certain other contractual circumstances may provide a basis for an equitable adjustment.

For example, FAR 52.243-1 addresses changes under certain fixed-price contracts. Other clauses may apply depending on the nature of the work and the specific contract.

The important point is that project managers need to recognize when requested work may fall outside the original scope.

If additional work is performed without appropriate authorization, documentation, or timely communication with contracting personnel, recovering those costs may become difficult.

Contract administration and financial management should therefore work together. A scope change is not simply an operational issue; it can have a direct effect on contract profitability.

What Should Management Be Reviewing?

For contractors with a significant FFP portfolio, I would encourage management to review profitability at the individual contract level on a regular basis.

At a minimum, that review should include the original budget, actual costs incurred, estimated costs to complete, and projected profit at completion.

Just as important is understanding the reasons for any significant changes.

If a contract’s anticipated margin declines, management should be able to determine whether the change relates to labor hours, compensation, subcontractor costs, indirect rates, scope changes, or some combination of these factors.

The discussion should also include others beyond the accounting department. Project managers are often aware of staffing challenges, delays, and operational changes before those developments become apparent in the financial results.

Bringing that information together allows management to make better decisions while the work is still in progress.

There is also value in reviewing completed contracts. Comparing actual results with the assumptions used in the original proposal can reveal patterns that should be considered when pricing future opportunities.

Contract Awards Are Important. So Are the Margins Behind Them.

Revenue growth and contract backlog are important measures for government contractors. They reflect the company’s ability to compete and secure future work.

But they do not necessarily indicate whether that growth is financially sustainable.

A contractor may increase revenue while experiencing declining margins. It may expand its workforce and infrastructure in anticipation of new awards, only to find that delays have increased its indirect rates. Or it may discover that its estimating practices have not kept pace with changes in labor costs and business operations.

These are not always compliance problems. Often, they are financial management issues that deserve the same level of attention as contract performance and business development.

FFP contracts can be very profitable when they are priced appropriately and managed effectively. The key is understanding that profitability is not established once, at the time of award. It must be monitored as the work progresses and as the company changes.

For contractors, particularly those experiencing growth, reliable contract-level reporting and a clear understanding of indirect costs can make a meaningful difference.

Ultimately, the measure of a successful contract is not simply that the company won the award and completed the work. It is whether the contract delivered the financial results management expected and whether the lessons learned can improve the next opportunity.

If your organization needs help conducting a fraud risk assessment, reviewing internal controls, or building a comprehensive fraud prevention program, contact PBMares Partner, Neena Shukla. 

If your company is navigating growth, changing indirect rates, or profitability concerns across its contract portfolio, contact PBMares Partner Neena Shukla, Government Contracting Team Leader, for guidance.