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Monday, October 7, 2013

Fair and Reasonable gross profit margins in war vs peace procurement

Supreme Owner Made a Billionaire Feeding U.S. War Machine
Chemical warfare and car bombings are just a few of the hazards working in war-torn countries such as Iraq and Syria. For Supreme Group BV, it’s the cost of doing business. The perilous business, where contractors dodge bullets fired by the Taliban and explosives set by insurgents, has made the company’s majority owner, Stephen Orenstein, a billionaire. Since the start of the war in Afghanistan in 2001, Supreme’s revenue has increased more than 50-fold to $5.5 billion in 2011.

The company’s largest contract -- an exclusive deal to distribute food to U.S. military personnel in Afghanistan -- has been riddled with lawsuits and accusations, including the Department of Defense’s assertion that Supreme overcharged it by $757 million. The U.S. military food contract has paid it $9.1 billion to date, according to data compiled by the DLA.

Orenstein disputes the U.S. overpaid for Supreme’s services. The company said it’s owed an additional $1.8 billion. “The Pentagon used the word overcharging and it’s not justified,” said Orenstein. “We agreed on preliminary rates. They decided to unilaterally apply new rates based on the costs as they see them, and tried to recoup the difference between the two.”

“By keeping the money flowing to Supreme through noncompetitive contract extensions, the Defense Department unwisely and unnecessarily put U.S. taxpayers on the hook”, said U.S. Representative John Tierney, the ranking Democratic member on the House Government Reform & Oversight Subcommittee on National Security, in a statement to Bloomberg News.

Accusations of Supreme overcharging the DLA first surfaced in a March 2011 audit report by then-Pentagon Inspector General Gordon Heddell. According to the report, the DLA overpaid Supreme $124.3 million for transportation and corrugated-packing boxes. In addition, Pentagon personnel had no assurance that billings for another $103 million in boxes were accurate or “even chargeable to the contract,” the report said. The company was also paid about $455 million for airlifting fresh fruits and vegetables from storage areas in the U.A.E. to Afghanistan, without the DLA ensuring the prices were “fair and reasonable,” according to the audit. Supreme was further said to be overpaid $98.4 million from 2005 to 2008 for transportation costs, in part because reimbursement rates “were significantly higher than the rates needed to reimburse the vendor for costs and associated profits,” the report said.

“The discrepancy in the amount Supreme and DLA claim to be owed is based on a contract modification regarding delivery to additional customer locations,” DLA spokeswoman Mimi said in an e-mail. “DLA and Supreme utilized different methodologies to calculate the appropriate price for transportation to these additional locations.”
I won't go into it in any detail, because I'm not qualified to do so, but there are many instances in federal contracting, including the making of contract changes and the awarding of non-competitive contracts, when the government is limited to making payments that are described, if not well defined, by the term "fair and reasonable". See generally FAR Subpart 15.4 and Selling To The Government: What 'Fair And Reasonable Pricing' Means, by Steve Charles, for a beginner's guide to the topic.

The takeaway in this post's context is that the determination of the fair and reasonable price is ultimately the government's, but the government must follow procedural and substantive rules to make that determination; it is thus a contestable determination. And Supreme is well staffed to bring it on. As the article states,
Orenstein confirmed that he and his family control 75 percent of the company. His partner, Michael Gans, holds the rest with his wife. Their first contract provided logistics services to the United Nations peacekeeping operation in Mozambique in 1993. “My strength has always been the execution and procurement, and Michael’s strength is in writing,” said Orenstein. Gans, who is a citizen of Luxembourg and lives in Baech, Switzerland, received a bachelor’s degree in political science from Vassar College in Poughkeepsie, New York, and a law degree from George Washington University in Washington.
GW is the home of the US' foremost procurement law education program.

There is another aspect to this article that I want to bring out:
According to its latest annual report, the company had earnings before interest, taxes, depreciation and amortization of $953 million in 2011 on revenue of $5.5 billion. According to its annual reports, Supreme had net income margins that ranged from 15 percent to 23 percent between 2008 and 2011.

“That’s a fairly large profit margin when it comes to federal government contracts,” said Scott Amey, general counsel for the Washington-based Project on Government Oversight. “Most contractors claim that their profit margins are zero to 5 percent.”

Orenstein confirmed that Supreme’s food distribution fee to the U.S. military in 2010 was “in the range of 18 to 21 percent” and could go as high as 50 percent, according to a transcript of testimony he gave in a 2010 lawsuit. He also testified that it was “very common that the percentage of total revenue, the service fee percentage, exceeded 75 percent,” when the distribution of food and other supplies flown into Afghanistan by airplanes and helicopters accelerated in 2006.

Including almost $1 billion in dividends he has collected since 2008, Orenstein has a fortune valued at least $1.1 billion, according to the Bloomberg Billionaires Index.
Normally, the higher the risk, the greater return that is demanded from market players. Conversely, the lower the risk, the lower the expectation of profits. Regular peacetime government contracting attracts contractors, especially in economically tight times, because governments are more likely to pay than stressed private buyers. The certainty of payment reduces the risk of buyer default, and profits are generally lower. 

But in times of war or disaster, operational risks tend to increase, which increases costs, and the expectation of profits. Even "fair and reasonable" costs may have an inelastic element that justifies higher contract payment, and profit margins. Canny contractors become attracted to war and disaster margins, and can make a motza.

1 comment:

Navdeep Sidhu said...

"Even "fair and reasonable" costs may have an inelastic element that justifies higher contract payment, and profit margins."

Fair point. In war-torn regions "reasonable" doesn't really exist any more, and with that the price and expectation of payment can turn into a roller coaster of what people want versus what they get versus what they really deserve.