Are contractors taking government to the cleaners?

When I returned home from traveling abroad a few days ago, a pile of annual reports of companies whose shares I own were waiting in a pile of mail. This is company annual report season. There was something in one report I read that caught my eye because of its association with longstanding debates about government contracting.

 The report was from a company called Oceaneering International, a provider of oil exploration equipment. (I actually bought 300 shares of this stock in 1981, over 30 years ago, when a stockbroker said I had no energy stocks in my portfolio and ought to have at least one. Over the 30 years, the value of my investment has gone from $3600 to $62,000 – I wish all my investments had done that well, but that’s another story.)

 It turns out that about 10 percent of Oceaneering’s business – called their Advanced Technologies segment – is with the U.S. government, selling engineering services to the Navy and some special-made equipment to NASA and the Defense Department. (I like the fact that they call this “advanced technologies,” as opposed to their other businesses, which are hardly low-tech. More importantly, I think it is good for government contracting to have successful private firms doing a modest portion of their business with the government, rather than leaving the government market for such services and products to government-unique defense contractors or other government contractors who have no experience competing in the hard commercial world.)

At the end of the report, there is data about the operating income as a percentage of sales for the company’s different businesses.  The bottom line?  Oceaneering’s oil and gas commercial business has an operating income of 22 percent of sales, while its government business’ operating income is 7 percent of sales.
 
If you look at the annual reports of publicly traded companies that have significant commercial and government business, and that report operating income on both groups of businesses – such as many of the IT consulting companies – you will almost always see a similar pattern.  Government business is less profitable in terms of operating income as a percent of sales than commercial business.
 
This fact, of course, gets little attention in debates about government contracting, which often suggest that contractors make huge profits ripping off the government. In fact, a mixture of often intense price competition and cost-based contracts with controls on markups over cost mean that the popular impression in the debate is inaccurate.
 
There is a more subtle way the government might get hurt, to be sure.  If on cost-based contracts there is insufficient attention to cost controls, the number of hours of contractor effort may be higher than really needed, and that will raise overall contractor profits, even though the return on each hour of work may be modest. This is a reason for favoring, when possible, fixed-price contracts or incentive-fee contracts with a cost savings line, or share-in-savings contracting; cost-based service contracting in the commercial world has some of the same problems. But, even if this is a problem, it is not the problem that the popular myths about contractors taking the government to the cleaners suggest.