There is a rate-setting methodology in widespread use in contracts both for solid-waste hauling and for landfill operations that needlessly favors contractors over local governments and, ultimately, over taxpayers. The questionable rate-setting methodology is commonly referred to as an operating ratio (OR).

A typical operating-ratio formula is this one:
[ OR = Allowable Collection Expenses/ Allowable Expenses + Profit ]
 
The median operating ratio included in solid-waste hauling and landfill contracts approximates 90. Although one might believe intuitively that this would equate to a profit rate of 10 percent, calculating the profit with representative numbers, as shown below, reveals that an operating ratio of 90 yields a pre-tax profit on allowable costs of 11.11 percent. This higher-than-anticipated profit margin, however, is insignificant when compared with the other flaws in this rate-setting methodology.
 [90 =  $10,000,000/$10,000,000 + $1,111,111]
  
During World War I, when the federal government first became involved in massive contracts, the cost-plus-a-percentage-of-cost (CPPC) contract seemed a reasonable approach to procuring armaments. The terms of CPPC contracts called for reimbursing contractors for the cost of manufacturing war materials, plus a percentage of those costs.

Astute corporate financial analysts, however, soon discovered that—unlike the traditional market model in which cost savings were equated to higher profits—profits under CPPC contracts for manufacturing war materials were highest when costs were inflated. A contractor that spent $100 million to manufacture a set number of tanks under a CPPC contract with a 10 percent profit margin would earn $10 million in profit.

However, if this contractor, under the same contract, spent $200 million to manufacture the same number of tanks, the profit margin would double to $20 million.

Wartime contracting methods were evaluated following the war, and as a result, future use of the CPPC rate-setting method was banned. Although contractors with CPPC contracts were performing under their contracts with virtually no business risk, they also were rewarded with higher profits when they had experienced cost overruns. Cost-plus-a-percentage-of-cost contracts remain prohibited to this date.^1,2

The operating-ratio approach to rate setting works much like the CPPC contract, in that contractors that exceed their budgets through expenditure of allowable costs are rewarded with higher profits (see Figure 1).
 
 

Figure 1. Calculation of Profit with the Operating-Ratio Method
Examples	Budgeted Allowable Expenses	Actual Allowable Expenses	Operating Ratio	Calculated Profit
Budget Underrun	$10,000,000	$9,000,000	90	$999,900
Performance to Budget	$10,000,000	$10,000,000	90	$1,111,000
Budget Overrun	$10,000,000	$11,000,000	90	$1,222,100

  
Despite the continuing prohibition of CPPC contracts in federal government contracting and despite the clear incentive they offer to contractors to spend lavishly, the operating-ratio feature still is in widespread use for solid-waste hauling and landfill operation contracts.

Further disservice is done to ratepayers, or residents, when some jurisdictions permit the negotiation of landfill operations and the awarding of exclusive waste hauling franchises without benefit of competitive bidding. But, although ratepayers may believe that their interests are protected by the requirement that government agencies select contractors through formal-bidding procedures, there are notable loopholes in some of these formal-bidding requirements.

A state ordinance in California³ specifically excludes landfill operations contracts from the need for competitive bidding. Also in California, conflicting state ordinances exist regarding the need for competitive bidding when awarding franchises for solid-waste hauling. One state ordinance specifically requires competitive bidding when awarding waste hauling franchises,⁴ while another ordinance provides an exception to this requirement when awarding such franchises.⁵

As mentioned earlier in this article, contractors with CPPC or operating-ratio contracts face little or no risk with respect to controlling their expenses. Allowing for higher profit percentages for contractors that face greater risk is a universally accepted practice. Federal contracting has placed a maximum limit of 10 percent profit on cost-plus-a-fixed-fee (CPFF) contracts⁶ because these contracts afford minimal risk to contractors when compared with fixed-price agreements, in which they face possible losses when their costs are not adequately managed.

There are, however, more risks for the contractor with CPFF than with the federally prohibited CPPC contracts. A contractor with a CPFF contract is assured a fixed-dollar amount of profit regardless of the level of spending. This arrangement, although less risk-bearing than the fixed-price method, does provide an incentive to control costs and does not include the CPPC or operating-ratio incentive to spend lavishly.

The contractor that spends less than the budgeted amount earns a percentage of costs, in the form of its fixed fee, over expenditures that exceed the percentage that would have been earned if the expected spending rate had been achieved. On the other hand, the contractor that overruns the expected costs under a CPFF contract earns a fixed fee at a lower percentage of actual costs than anticipated (see Figure 2).
 
 

Figure 2. Calculation of Profit with a Cost-Plus-Fixed-Fee Contract
Examples	Expected Allowable Expenses	Actual Allowable Expenses	Fixed Fee	Profit
Budget Underrun	$10,000,000	$9,000,000	10%	$1,000,000
Performance to Budget	$10,000,000	$10,000,000	10%	$1,000,000
Budget Overrun	$10,000,000	$11,000,000	10%	$1,000,000

  
The ideal solicitation and contracting method both for landfill operations and for solid-waste hauling is to issue competitive solicitations and award a fixed-price contract. Though a monthly flat rate is usual for fixed-price contracts for landfill operations, a price per ton or per customer is normally set on fixed-price contracts for solid-waste hauling.

During the term of this kind of contract, there will most likely be reason to modify the contract, whether it be a fixed-price or cost-reimbursement arrangement. Reasons for such changes could be unexpected violent weather conditions, other emergencies that cause added work, unanticipated bursts in volume, or new regulations. When changes are needed during the term of the agreement, it will likely be necessary to negotiate a revised price for fixed-price contracts or budgeted expenses, and possibly also to revise fee or profit levels for cost-reimbursement contracts.

The needless advantage to the contractor, at the expense of the ratepayer, in performing work under an operating-ratio contract should cause government agencies to treat such contract provisions with extreme caution. Although fixed-price agreements are preferred because this contracting method hands off the maximum risk to the contractor,  it is not always possible to award a fixed-price contract at a reasonable price.

When it is necessary to use a cost-reimbursement contract, the CPPC method, or operating-ratio rate methodology, should be fervently avoided. In contrast, the cost-plus-a-fixed-fee (CPFF) contract shown in Figure 2 does not give the contractor an incentive to spend lavishly. Contractors are reimbursed for their allowable costs, but their fees are based on a fixed percentage of the costs, as estimated at the beginning of the contract. Therefore, cost overruns are not rewarded with higher profits.

Other contract types used in federal contracting, such as cost-plus-incentive-fee (CPIF), and cost-plus-award-fee (CPAF), should also be considered when the government agency awarding the contract is able to develop incentives to encourage the contractor to control costs and/or meet certain operational performance standards. These should be measurable and therefore clearly payable to the contractor for meeting the standards.

The incentives or award-fee factors for CPIF and CPAF contracts normally include cost control. When cost controls are included as an incentive or award-fee factor, then a cost overrun will result in a reduction to the fee percentage determined when the contract was awarded. 5

¹U.S. Code: Title 10, § 2306 (a).
²Federal Acquisition Regulations § 16.102 (c).
³California Public Contract Code § 22002 (d) (5).
⁴California Public Resources Code § 49200 et seq.
⁵California Public Resources Code § 40059.
⁶U.S. Code: Title 10, § 2306 (d).