Remaining Profitable in a High Inflation Environment

Inflation isn’t likely to get under control anytime soon. Consensus is building that until the Fed takes real action – like raising interest rates above the rate of inflation and ending quantitative easing – high inflation will persist. According to a recent Bloomberg survey of 72 economists, average hourly earnings are expected to increase 5.6% into Q2 of 2023.

How is Inflation Impacting Government Contractors?

Companies in our market face unique pressures where contracts are completed in years not months, value is denominated in the hundreds of millions instead of hundreds of thousands, and the government customer works with uncertain budget cycles instead of quarterly earnings beats. In this article, we’ll look at the high inflation environment through the eyes of government contractors and discuss the steps companies can take to reduce the impact of inflation on their business.

Are there actions government contractors can take to remain profitable despite inflation? The key to building resilience in the face of inflation is to be nimble and creative with how you reduce costs. If you’re a small business, that might mean that owners take a more active role in business development, capture, or operations, to backfill a resource who left instead of immediately hiring to fill that role.

Gunnison Consulting Group, a mid-tier IT services firm in Fairfax, VA, jumped at the opportunity to reduce their overhead. According to Dave Uehlinger, CFO at Gunnison Consulting Group, “As a company in high growth mode, cutting overhead is a balancing act between investing in growth and managing other expenses. We have opted to let our lease expire and go virtual for next year or more as an offset to the rising salary costs.”

Large businesses have more options to cut costs given their scale. On CACI’s Q1FY2022 Earnings Call, John Mengucci, President & CEO of CACI described how they’re reducing their overhead costs: “Frankly, we put our shared service center in place in Oklahoma City. Great processes there using automation everywhere we can. So that gives us another lever for efficiency and cost management.”

Strategies to Remain Profitable in a High Inflation Environment

Here are some strategies that companies of all sizes can take to remain profitable in a high inflationary environment:

• 1099s instead of W2s? Is the work seasonal or does it ebb and flow throughout the year based on government procurement activity? If so, it may be more profitable to hire consultants to take on those responsibilities as needed instead of having full time employees year-round.
• Geographical Expansion. Do your employees have to be in high-cost locations like the D.C. Metro Area, or can they be in lower cost areas like Oklahoma or Florida? Gunnison Consulting Group grew their geographical footprint to reduce costs this way. According to Dave Uehlinger, CFO at Gunnison Consulting Group, “We have expanded our reach geographically. Two years ago we were in five states, and today we are in over 20 states. This allows us to find more affordable talent in lower cost of living geographies.”
• Execute Contract Mods and Update Rates When Possible. Depending on your contract language, you may be able to increase hourly rates more than the escalation clause allows. Most escalation rates are 2-3% a year, and inflation is currently running at 8.5%, so who knows what your actual cost will be in a few years. Contracts with a smaller base period and more options years should be looked upon more favorably since you may be able to update rates beyond the escalation clause each option year. If you have a good relationship with your customer, then they should understand the need to increase your rates. According to Kevin M. Phillips, Chairman, President & CEO of ManTech [11/2/2021 Q3 2021 Earnings Call], “Look, when we have high demand for the right talent…and wage inflation, if it does start increasing above an amount that can’t be built in or is already built into escalation that we can manage between each program, we often go to customers and there’s flexibility in going through those discussions because of the need for the talent.”
• Green the Workforce on Existing T&M and FFP Projects. In this scenario a company initially staffs a contract with the required key personnel at the proposed bill rate. Then at some point during the period of performance, the company transitions those individuals off the project while bringing in other personnel that meet the minimum labor category requirements at the same bill rate but with a lower cost.
• Pursue More Cost Plus Work. Inflation? What inflation! On cost plus contracts, the government eats all the inflation cost. According to John Mengucci, President & CEO of CACI [10/28/2021 Q1 2022 Earnings Call], “60% of our revenue was cost plus, so higher wages get passed along to our customer, that’s not a glib comment saying I’m happy about pushing additional costs, but that’s what the marketplace requires…” The downside about cost plus contracts is that they require significant internal infrastructure and accounting processes for a company to be able to bid them, so for some companies it might not be worth the investment and management.
• Reducing Employee Turnover. This might sound counterintuitive as many companies often consider layoffs to reduce costs instead of keeping their employees. However, The Work Institute estimates the cost of employee turnover to range from 33% up to 200% of the departing employee’s salary. For employees who are critical to the success and future growth of the company, the turnover cost is on the high end of this range. Don’t think that you need to shower your current employees with additional benefits and compensation to get them to stay either. According to The Work Institute’s 2020 Retention Report which uses data from over 233,000 employees from 2010 through 2019, the top 3 categories for employees leaving in 2019 were Career Development (19.6%), Work-Life Balance (12.4%), and Manager Behavior (11.8%). These are all preventable things that shouldn’t increase the cost of doing business.
• Training Delivery Staff. Instead of going external and trying to hire that expensive seasoned executive to join your leadership team, are there any internal delivery staff who you see as potential leaders? Transitioning a delivery person to an internal role like business development, capture, or operations and mentoring them to grow that role in-house can be much more affordable than bringing on an external hire who demands a higher compensation. You won’t have the immediate results of hiring an experienced executive, but you also won’t have the immediate cost!
• Reorg. Before inflation hits your business too hard, think about reorganizing and reviewing your internal processes to make sure that you are maximizing the productivity of your overhead staff. While most companies think that reorgs should happen as a cost cutting measure when times are tough, we think you should consider a reorg when business is going great. Despite having consecutive record years, we recently did a reorg at Red Team. Not only did we change some people’s roles, but we also reevaluated some of our core processes. The end result? We are now able to respond to client needs faster, our employees are in roles that better align with their career objectives, and new processes and tools were implemented with some automation to operate more quickly and efficiently.

Inflation-Proof Your Business

According to Aaron Raddock, Partner & National Leader, Government Contracts at BDO USA, LLP, “Though the strategy will necessarily vary by company, customer and contract, there is a heightened sensitivity right now within the government to the impact inflation is having on its supply base of federal contractors. For example, in March, GSA issued it’s letter regarding a ‘Temporary Moratorium on Enforcement of Certain Limitations Contained in Certain GSA Economic Price Adjustment (EPA) Contract Clauses’, relaxing its policies on when contractors can increase their prices on Federal Supply Schedule contracts. This sentiment is not isolated to GSA and the FAR has long recognized that government contractors are not expected to operate at a loss. Evaluating the impact of inflation on your current contracts, your contractual rights to an increase, and having the right conversations with your customers are necessities for many of our clients in this environment.”

Like everything in government contracting, dealing with inflation ultimately comes down to your relationships. If you have good relationships with your employees, it will be easier to keep them engaged and motivated even if you have to implement some not-so-pleasant cost cutting measures. If you have very strong relationships with your customers and they want you to do the work, then you may be able to restructure your contracts to remain profitable. Executing option years at higher hourly rates, doing contract mods to adjust for inflation, and implementing cost-cutting measures are all easier when your customer wants you to continue doing the work. If your work is essential to the agency’s mission – even better!

Hopefully you found some of these tips useful. Now it’s time to pick up your cost cutting sword and join the inflation fight!

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