ACQ 315 Understanding Industry

Transcription

1 ACQ 315 Understanding Industry Pre-Course Reading May 24, 2013 Version 1

2 CONTENTS CHAPTER 1: Understanding Industry An Overview... 3 CHAPTER 2: Cash Flows... 4 Cash Inflows... 4 Cash Outflows... 4 Cash Flow Cycle... 5 CHAPTER 3: Financial Reporting... 7 Balance Sheet... 8 Income Statement Chapter 4: Cost Accumulation and Allocation Indirect Cost Management Direct vs. Indirect Costs Accounting for Indirect Costs Pool and Base Considerations Indirect Cost Analysis and Management Types of Indirect Cost Pools Types of Indirect Cost in Each Pool Page 2

3 CHAPTER 1: UNDERSTANDING INDUSTRY AN OVERVIEW Excerpt from Understanding Industry, a paper prepared by Vicky Armbruster, December 2010 Defense acquisition professionals must build winning teams of civilian and uniformed Government personnel, prime contractors, subcontractors, and vendors to deliver needed capability to the warfighter on time and at an affordable cost. The Government elements of these teams represent widely diverse organizations (such as program management, finance, research, engineering, test, logistics, Office of the Secretary of Defense, and service and Congressional staff), themselves charged with ensuring effective, efficient, and appropriate use of the public money allocated to the program. The industry team members also represent similarly diverse organizations and, as publicly traded companies, are answerable to laws and regulations beyond those on contract. Industry s key concerns are customer satisfaction, meeting contract requirements, and maximizing shareholder value. Companies are not solely guided by profit motive. They are in business because they belong there it is their niche and they provide an essential leg of the acquisition triangle (requiring organizations, acquisition command, and industry). Both Government and industry do their best to respond to their investors ultimate priorities. For the Government, it is the proper use of taxpayer dollars in managing acquisition projects to support military capabilities. For industry, it is protecting shareholder value through responsible execution of their contract workloads. Both Government and industry are concerned about taking care of their stakeholders (requirer, warfighter, shareholder, buying command, testing organization, employees), and both recognize that success leads to more business and more responsibility in the future. In both cases, the major investor is the American public. Each party to the contract will find their path to program success is far less difficult when they learn to recognize each other s true workload and the differing pressures from their respective environments. For example, at the execution level (PM to PM), the Government/industry leaders are focused on the program baseline metrics (schedules, cost, and technical parameters) and peripherally aware that the industry partner needs to be successful long enough to stay in business. It is best, however, to be aware of the tensions at the executive level which drive our PMs at times to behave differently. When the Government PM understands that statutory requirements on public companies aimed at protecting investors as well as the corporations urgent need to make their numbers the metrics that measure company success (i.e., profit, backlog, return on sales, and return on invested capital) it will be easier to respect these needs at negotiation and during program execution. And, when the industry PM understands the regulatory, budgetary, planning, oversight, and Government auditing workloads, it will be easier to proactively assist in establishing clear, concise, and current information sources to readily answer these needs with less disruption to work in progress. Both Government and industry share a strong commitment to mission success for the ultimate customer (the warfighter). Sharing a common path to mission success depends upon first achieving an understanding between the Government and industry on what their responsibilities are and where the differences lie in how they satisfy their stakeholders. Page 3

4 The following material is an excerpt from the BCF 205 course textbook. CHAPTER 2: CASH FLOWS A business is a system of cash flows inflows and outflows. The long-term objective of a business is to have cash inflows from customers exceed cash outflows for expenses. Cash has time value and is not free to a business. A business must earn its cost of capital (i.e., the cost associated with attracting owners and lenders to invest cash in the business). CASH INFLOWS There are three sources of cash inflows: 1. Owners Owners (e.g., stockholders in a corporation) contribute cash to start or expand a business. The cash is used to purchase assets or pay expenses incident to creating a product or products that customers will buy. 2. Lenders Lenders provide cash on a temporary basis to finance such assets as inventories and equipment or to meet current cash needs like payrolls and accounts payable. Almost all businesses use some form of short-term borrowing (i.e., debt) for temporary financing. Long-term debt is used for long-term financing requirements such as equipment, buildings, and land. 3. Customers Nothing happens in a business unless there is a sale or the promise of a sale. All activity in a business is focused on generating cash inflows from customers to replace cash outflows from business expenses. For a business to be viable in the long term, cash inflows from customers must exceed cash outflows for expenses by at least the cost of capital. CASH OUTFLOWS There are four categories of cash outflows: 1. Operating Expenses Cash is used to pay day-to-day expenses for everything from the production shop to the executive offices. These expenses tend to be repetitive payroll to be met every week or every two weeks, utilities to be paid each month, and suppliers on regular payment schedules. 2. Investments Page 4

5 In order to manufacture products, provide inventories of materials or goods, or create services for sale to the customer, a business invests cash in assets. Current assets are cash, accounts receivable, and inventories. Fixed assets are equipment, buildings, and land. 3. Financing Activities A financing activity is any action that obtains or returns cash to an owner, lender, or creditor. Owners contribute capital (i.e., cash) by purchasing stock. Creditors provide materials, utilities, or services in exchange for a deferred cash payment. Lenders (e.g., banks, mortgage companies, pension funds, etc.) rent cash to a business for the short or long term in exchange for interest payments. Profits kept in the company (retained earnings) become part of owner s equity and are an important source of financing for business growth. Profits not retained are passed to stockholders as dividends. 4. Government Cash payments must be made for taxes, such as Social Security (FICA), unemployment (FUTA), property, income and many others. CASH FLOW CYCLE The system of business cash flows is a six-step process. STEP 1: Cash is accumulated to form or expand a business. Cash inflows from owners and lenders form the initial capital of the business. The first cash inflows come from owners, since lenders generally want to see a vested owner interest before they will participate. STEP 2: Cash is converted to tangible assets. Cash is useful only for buying assets, paying expenses, or dividends. It is the assets that produce the goods or services that attract customers. Current assets are cash, accounts receivable, and inventory. Fixed assets are equipment, buildings, and land. Except for cash, each of these assets is acquired or created to attract customer revenues. STEP 3: Assets are consumed to produce a product or service. Assets such as inventories of raw material, equipment, and buildings are combined with utilities, wages, and salaries to produce a product or service for sale to the customer. Manufacturers combine raw material, wages, and machine time to create finished goods. Merchandisers purchase finished goods for retail sale. Service providers acquire the essential technical skills and equipment to meet customer needs. STEP 4: The product is sold to customers. Sales revenues from customers the result of delivery of a product or service are the most important events to a business. Page 5

6 STEP 5: The customer pays cash to the business enterprise. The customer pays cash for the product or service. The cash payment represents a return of the cost of all the assets consumed, expenses incurred, and any profit. Any cash payment that does not at least return costs incurred results in a loss to the business. STEP 6: The business enterprise decides what to do with the cash. Cash received from the customer is used for one or more of the following: Pay current expenses such as wages, utilities, creditors, etc. Pay interest on or return borrowed cash to lenders. Acquire new or replacement assets. Distribute profit to owners or return owner investment. Page 6

7 CHAPTER 3: FINANCIAL REPORTING Publicly owned companies prepare annual reports to describe the financial activities and condition of the company to interested parties including investors, creditors, and the Securities and Exchange Commission (SEC). There are four basic financial report formats presented in an annual report. They are generally referred to as: Balance Sheet Income Statement Statement of Cash Flows Statement of Retained Earnings Basic Financial Report Formats The Balance Sheet displays the financial structure of the company at a point in time. It describes in monetary terms the assets owned by the company and the claims against those assets by the creditors and owners. The Income Statement displays the results of the business activities of the company for the accounting period. This form presents the "bottom line" profit or loss for the period. The Statement of Cash Flows provides information on cash receipts and cash payments with cash flows classified according to operating, investing, and financing activities of the company. The Retained Earnings Statement reconciles the retained earnings account from the current year's balance sheet to the retained earnings account on the prior year s balance sheet. This reconciliation includes adjustments for income and dividends during the period. Figure 1: Basic Financial Report Formats The four reports listed above provide the basic information reported to the public. The reports are prepared in accordance with "Generally Accepted Accounting Principles," which are rooted in the ten accounting concepts listed in Figure 2: Generally Accepted Accounting Principles. Money Measurement Entity Going Concern Cost Dual Aspect Realization Matching Conservatism Consistency Materiality Generally Accepted Accounting Principles Accounting records show only facts that can be expressed in monetary terms. Accounts are kept for business entities as distinguished from the persons associated with those entities. Accounting assumes that a business will continue indefinitely. Assets are entered on the accounting records at the amount paid to acquire them. Assets = Equities Revenue is recognized when goods or services are delivered and in an amount that is reasonably certain to be realized. Costs are matched against the revenues of a period. Provide for all losses; anticipate no profits. The same method should be used for a given type of transaction from one period to the next. Disregard trivial matters; disclose all important matters. Figure 2: Generally Accepted Accounting Principles Page 7

8 BALANCE SHEET One of the primary formats for displaying financial information about a company is the balance sheet. The balance sheet expresses the financial condition of the firm at a point in time as assets and equities. Assets are things of value owned by the firm. Equities are claims against those assets by creditors (liabilities) and owners (stockholders' equity). In viewing the following balance sheet format, be aware that: A balance sheet is valid only for a fixed point in time. In other words, it is a snapshot of financial condition. A balance sheet expresses aspects of a firm's current condition which can be expressed in monetary terms. It does not, for example, tell about the number or quality of personnel, the firm's reputation, or market share. A balance sheet usually shows assets at the cost paid for them. They may be written down if there is evidence that the true value is less than the amount shown on the books. A balance sheet must always balance. This means that the total value of all assets equals the total value of the liabilities and stockholders' equities. The left side of the balance sheet shows the assets (things of value) owned by the company. Assets can also be viewed as the investments of the company. The left side of the balance sheet can be broken down into three categories: 1. Current assets: Cash and those assets expected to be converted to cash during the next year 2. Fixed assets: Plant and equipment 3. Other assets: Intangible assets which do not fit into the current or fixed categories The right-hand side of the balance sheet (liabilities and stockholders' equity) shows the sources of financing which provided the company with the ability to invest in assets. The right-hand side of the balance sheet lists nothing of value (i.e., no assets). The right-hand side shows the claims against the assets by the owners and creditors based on their relative contribution to the financing. This concept that the right-hand side of the balance sheet shows simply the sources of financing is perhaps one of the most difficult for students new to accounting. Page 8

9 Figure 3: Sample Balance Sheet Page 9

10 INCOME STATEMENT The income statement is one of the basic elements of an organization's financial reporting system and displays what is commonly referred to as "the bottom line." The income statement, balance sheet, statement of cash flows, and statement of retained earnings describe the total financial position of the company. The income statement is a monetary representation of the revenues and related expenses for a particular accounting period. While the balance sheet is considered a snapshot of the financial position of the organization at a specific point in time, the income statement represents transactions over a period of time. The income statement, therefore, serves as the financial bridge between two balance sheets. The construction of the income statement follows a logical sequence and can be broken down into three major components: 1. Revenue Revenue is the monetary quantification of the sales that occurred during the period covered by the income statement. Revenue is not recognized on the income statement until it has been realized. Realization is generally considered to have occurred when: The goods or services have been substantially completed and the sale is certain to occur An exchange of assets between the buyer and seller has occurred The asset received by the seller is cash or is convertible to cash within a reasonable period of time When these criteria have been met, it is considered that revenue has been realized and it is accordingly recognized (recorded) on the income statement. 2. Expenses The expenses shown on the income statement are either expenses incurred during the period (e.g., direct labor, rent, or utilities), or else represent the consumption of assets acquired in prior periods (e.g., depreciation, inventory, or the amortization of lease rights or leasehold improvements). Assets acquired in prior periods that provide benefit to the current and future periods are carried on the balance sheet until they are consumed in the generation of revenue. The important concept here is that the income statement attempts to match the revenue generated during the period with the expenses incurred in generating that revenue. 3. Income The result of deducting the operating expenses from operating revenue is commonly referred to as "income from operation" or "operating income." Organizations normally incur other kinds of expenses notably interest expense which are not considered operating expenses and which must be deducted from the operating income to arrive at income before taxes. The last step, deducting the tax expense from income before taxes, results in net income. Assuming no dividends are paid to stockholders, the net income is added to the "Retained Earnings Account" in the equity section of the balance sheet. It is important to keep in mind that the income statement reflects the results of operations during the year and does not necessarily portray actual cash flow during that same year. For example, a large portion of the sales could be credit transactions and may not represent actual cash received until a following accounting period. Similarly, depreciation is an expense item but does not represent a cash disbursement. It is inappropriate, Page 10

11 therefore, to consider net income and its accumulating account, retained earnings, as representing cash available to the organization. Figure 4: Sample Income Statement Page 11

12 CHAPTER 4: COST ACCUMULATION AND ALLOCATION Accounting systems are designed to accumulate financial and cost data for such purposes as the determination of product unit costs and prices, the measurement of income, and the portrayal of the financial condition of the business. Cost accounting (also known as managerial accounting) can best be differentiated from financial accounting by recognizing the different uses of the information generated by the accounting system: Financial statements, which are end products of the financial accounting process, are used by sources outside the company to make investment decisions or to determine the credit worthiness of the firm. Managerial cost reports, which are end products of the cost accounting process, are used almost exclusively by personnel inside the company. Most of the reports generated by the cost accounting process are extremely sensitive and are frequently closely held, even within the company. For example, cost accounting reports typically provide detailed proprietary data relating to the costs of manufacturing and selling each product. Another important differentiator between financial and cost accounting is the frequency of outputs: The financial accounting system usually generates reports on a monthly basis. The cost accounting system often generates reports on a weekly, daily, and in some cases, on a real-time basis. The cost accounting system used by the contractor is an area of significant concern for the Defense industry customer (the military buyer) since DoD negotiates approximately 80% of the dollar value of its contracts based on the contractor's cost data rather than on the basis of a competitive market price. The financial interest of defense contractors is generally best served by charging (consistent with Government regulations) as many costs as possible directly to contracts and structuring indirect cost pools and service centers in a way that properly allocates maximum costs to Government contracts. It is essential that Government personnel be familiar with the contractor's cost accounting system in order to determine that the component elements of the negotiated price are fair and reasonable. To understand how a cost accounting system works, it is necessary to be familiar with the basic vocabulary of cost accounting terms such as those defined and discussed in the next several pages. Page 12

13 Cost objective Direct cost Direct materials Direct labor Other direct costs Indirect cost General and Administrative Expense Standard cost Variable cost Fixed cost Cost Accounting Terms A contract, function, organizational subdivision, or other work unit for which cost data are desired and for which provision is made in the cost accounting system to accumulate and measure the cost of jobs, products, processes, capitalized projects, etc. Any cost that is identified specifically with a particular cost objective. Direct costs are not limited to items incorporated in the end product as material or labor. Costs identified specifically with a contract are direct costs of that contract. All costs identified specifically with other final cost objectives of the contractor are direct costs of those cost objectives. Includes raw materials, purchased parts, and subcontracted items required to manufacture and assemble completed products. A direct material cost is the cost of material used in making a product and is directly associated with a change in the product. Raw materials Raw and processed material in a form or state that requires further processing. Subcontracted items Interdivisional transfers Purchased parts Standard commercial items Parts, components, assemblies, and services produced or performed by other than the prime contractor usually in accordance with the prime contractor's design, specifications, or directions, and applicable only to the prime contract. Materials sold or transferred between a prime contractor's divisions, subsidiaries, or affiliates that are under a common control. There are two categories of purchased parts: Common parts used by many companies in many different applications (e.g., nuts, bolts, and screws). Parts, components, or simple subassemblies built by others and manufactured either to the prime contractor's design, or the vendor s design. Items that are fabricated by the prime contractor and stocked in inventory for sale for other than Government purposes in the commercial market place. Examples are computer chips, boards, components, etc. used for commercial applications. Labor that is specifically identified with a particular final cost objective. Manufacturing direct labor includes fabrication, assembly, inspection, and test for constructing the end product. Engineering direct labor includes reliability, quality assurance, test, design, etc., which are readily identified with the end product. Costs for special facility rental, computer, reproduction, travel by direct personnel, consultants, etc. Any cost not directly identified with a single cost objective, but identified with two or more cost objectives. A grouping of indirect costs by a defense contractor is often referred to as an "indirect cost pool." Any management, financial, and other broad type of expense incurred by or allocated to a business unit for the general management and administration of the business unit as a whole. A carefully predetermined cost that should be attained. A cost that changes with the production quantity or the performance of services. A cost that, for a given period of time and range of activity called the relevant range, does not change in total but becomes progressively smaller on a per-unit basis as volume increases. Figure 5: Cost Accounting Terms Page 13

14 See Figure 6: Components of Contract Price, which summarizes direct and indirect costs for a typical Government contract. Regardless of whether a company (immaterial if it does only commercial business or if it is a federal contractor) maintains an official cost accounting system or not, a company should be aware of the total cost of each product it sells. Total cost includes not only the direct costs associated with the product, but also the indirect costs that should logically be allocated to that product. Only by knowing the total cost of the product will the company be able to determine if it is making a profit on that product. The internal cost accounting system enables the company to better understand all of its various costs. Figure 6: Components of Contract Price Page 14

15 Figure 7: Summary of Cost Flow INDIRECT COST MANAGEMENT DIRECT VS. INDIRECT COSTS Direct costs are costs that can be identified with a single cost objective such as a product or contract. They normally include such items as the subcontracted costs related to that cost objective, the material incorporated into the product and the wages of personnel who actually design, build, or otherwise work on the product or contract. Indirect costs include all costs that are not direct. They relate to two or more final cost objectives and usually include support-type costs that are required to continue operations but are not associated with a single product or contract. Examples generally include items such as the expended cost of buildings and equipment in which production takes place, the cost of indirect labor such as plant security or production control, and the cost of fringe benefits such as vacation time and pension costs. In the Government contracting environment, indirect costs are usually divided into two broad subcategories: overhead and G&A (general and administrative). Overhead costs are indirect costs that support a specific part or function of the company but not the whole company. For example, maintenance costs of the factory can logically be associated as support costs to the various manufacturing jobs performed in the factory. On the other hand, the cost of the engineering library would logically be associated with the engineering department and not with material handling or the accounting department. Page 15

16 General and Administrative (G&A ) costs, by contrast, are costs that cannot logically be associated with any particular group of cost objectives but are required to support the business as a whole. Common examples of G&A costs are the salary of the chief executive officer, legal and accounting costs, marketing expenses, Independent Research and Development (IR&D) costs, and Bid and Proposal (B&P) costs. It is important to note that the classification of costs as direct or as overhead or G&A does not hinge on the allowability or reasonableness of the cost related to a Government contract. The classification of direct vs. indirect has to do with the relationship of the cost to a final cost objective. Overhead and G&A costs are indirect because they are caused by and benefit more than one cost objective. Depreciation of factory machines, usually an indirect cost, is just as necessary as the direct cost of the machine operator. Reasonableness of a cost is determined in terms of what was bought and how much was paid, regardless of whether the spending was a direct or indirect charge. Allowability of a cost is determined by the fact that the cost is reasonable, allocable, and not on a specific list of unallowable costs included in the FAR. ACCOUNTING FOR INDIRECT COSTS As indicated earlier, the accounting system simultaneously provides information supporting the contractor's management needs and the Government customer's requirement for fair pricing and payment. To fulfill these information requirements, the accounting system must identify and collect costs and assign those costs appropriately to contractor organizational units, products, and contracts. A main question is: how much cost should be assigned to a specific cost objective? In the case of a direct cost, the answer is relatively straightforward: assign all of the direct cost to the cost objective that benefits from the cost incurrence. Direct costs are, by definition, costs incurred to perform that cost objective. With indirect costs, however, the assignment or allocation of costs to a cost objective is more difficult. Many theoretical issues arise in accounting for indirect costs. In reality, however, theory often gives way to simplified practical applications. The first step in accounting for indirect costs is to create indirect cost pools in which costs are accumulated that are of the relatively same type that relate in a common way to a group of cost objectives. The second step is to determine an allocation base appropriate to that cost pool (i.e., what the cost objectives have in common with the costs in that pool). The third step is to compute the allocation rate by which the cost pool will be allocated to the benefiting cost objectives. The fourth step is to calculate the dollar amount of the cost pool to be allocated and then to actually allocate that amount to the benefiting cost objectives. Page 16

17 1. For example, let us assume that a company decides to aggregate all the indirect costs which support factory operations in a manufacturing overhead pool as follows: 2. The company has determined that there is a logical relationship between the manufacturing overhead pool and manufacturing direct labor. Therefore, manufacturing direct labor is the allocation base. In this example, assume there are three contracts that constituted all of the manufacturing cost objectives. These contracts had manufacturing direct labor charges during the year as follows: 3. Determine the allocation rate by dividing the cost pool amount by the base amount. If both amounts are stated in dollars, the resultant rate will be expressed as a percentage. If the cost pool amount is stated in dollars and the base amount is stated in another form (e.g., hours), the resultant rate will be expressed as a dollar per base item (e.g., $x per hour). In this example, the cost pool amount is the total manufacturing overhead pool of $2,000 and the base amount is the total direct labor of $1,500. Therefore, allocation of the manufacturing indirect cost pool is based on 133.3% of the dollar amount of the direct labor charged to the benefiting cost objectives. Another way to consider this allocation is for every dollar of direct labor cost to the cost objective, there should be another charge of $1.33 to that cost objective. 4. Regardless of whether the allocation rate is a percentage or a dollar amount per base item, the allocation rate is used to calculate the dollar amount of the cost pool to be allocated to each benefiting cost objective. The dollar amount of the allocation base (direct labor in this example) is multiplied by the rate to determine the amount Page 17

18 allocated to the various cost objectives. It is also necessary that the entire dollar amount in the indirect cost pool be assigned to cost objectives. POOL AND BASE CONSIDERATIONS The FAR (31-203(b)) indicates that "... indirect costs shall be accumulated by logical cost grouping with due consideration of the reasons for incurring such costs. Each grouping should be determined so as to permit distribution of the groupings on the basis of the benefits received by the several cost objectives." Structuring of the pools is typically related to some organizational basis. Manufacturing overhead, engineering overhead, material handling costs, off-site support costs, and G&A expenses are usually grouped separately. The CASB (see sidebar to right for definition of CASB) uses the term "homogeneous costs" to explain which expenses should be aggregated in a single pool. Homogeneity means that the costs pooled together and allocated by a single base have the same or similar relationship to the cost objectives that the indirect functions support. It is important to recognize that the number of indirect cost pools will vary from contractor to contractor. The regulations do not specify a certain number of pools (except that federal contractors are expected to have a minimum of two: overhead and G&A). Some smaller contractors have a simple system where a single rate applies all indirect costs to all jobs; on the other hand, most larger contractors require multiple rates in order to properly allocate costs. Some accountants believe that more cost pools provide more accurate accounting and cost allocation. However, a large number of small pools tend to have greater OFFICE OF FEDERAL PROCUREMENT POLICY (OFPP) COST ACCOUNTING STANDARDS BOARD (CASB) The CASB is an independent statutorily-established Board consisting of five members: the OFPP Administrator, who serves as the chairman, and four members with experience in Government contract cost accounting, two from the Federal Government (DoD and GSA), one from industry, and one from the accounting profession. The Board has the exclusive authority to make, promulgate, and amend cost accounting standards and interpretations designed to achieve uniformity and consistency in the cost accounting practices governing the measurement, assignment, and allocation of costs to contracts with the United States. The Board's regulations and standards are mandatory for use by all executive agencies and by contractors and subcontractors in estimating, accumulating, and reporting costs in connection with pricing and administration of, and settlement of disputes concerning, all negotiated prime contract and subcontract procurement with the United States in excess of $700,000, provided that, at the time of award, the contractor or subcontractor is performing any CAS-covered contracts or subcontracts valued at $7.5 million or greater. Page 18

19 volatility, are more difficult to use for rate predictions, and are more costly to maintain from an administrative perspective. A structure containing too many pools can also be difficult to understand and explain. In aggregating indirect costs, one must consider the common denominator that related those costs to the cost objective. That common denominator is the allocation base. Although the regulations do not specifically define an allocation base, the FAR and CASB do provide guidance concerning its selection. The FAR (31.203(b)) indicates that the base must be common to all cost objectives to which the pooled costs will be allocated. The selected base must also provide for allocation of indirect costs on the basis of the benefits received by the cost objectives. Factors commonly used as allocation bases include the following: Direct labor dollar costs or direct labor hours worked for allocation of manufacturing or engineering overhead. Direct material cost to allocate material handling costs. Total cost other than G&A for allocation of G&A expenses. The selection of the pool and base determines how indirect costs are allocated to contracts. Indirect costs represent a large portion of the total costs incurred by most contractors. Consequently, management decisions concerning accounting for indirect costs can have a significant impact on total contract cost. Although an acquisition manager will generally not be expected to deal with the technical accounting matters, he or she should recognize that from the Government view point, equity is the dominant criterion for cost allocation. INDIRECT COST ANALYSIS AND MANAGEMENT Indirect costs typically represent between one third and a half of the cost of a contract. Clearly then, it is a cost area that merits the attention of both contractor management and the DoD. Analysis and control of indirect cost is, however, a complex and difficult task. Comparing rates from different contractors can be misleading since two similar contractors may have different rates for several reasons. For example, accounting systems may be different. One contractor may classify production control as indirect labor while the other contractor charges it as direct; or one contractor may include purchasing and warehousing costs in a material handling pool while the other may have some of those costs in manufacturing overhead and some in G&A. Contractors' rates may also differ because of different products or production. For example, the first contractor produces a product using a manual method while the second contractor makes the same type of product in a highly automated facility. The automated contractor is likely to have a higher overhead rate because additional depreciation of the automated equipment, an indirect cost, is charged against a smaller direct labor base. The automated contractor is likely to experience higher overhead rates than his less automated counterpart even though his total product cost may be lower. Such differences make it important to remember that the Government's objective is not to reduce overhead rates, but rather to reduce total costs. Although comparing rates between contractors may not be fruitful, it may be useful to chart the trend of one contractor over time. Even this trend analysis would require adjustment for accounting process, or business base changes. The most useful analysis is one that looks at the indirect cost and cost trends in dollars rather than at rates and rate trends. Are costs reasonable and well controlled? This type of cost analysis requires significant effort. It is the type of analysis done by the Administrative Contracting Officer (ACO) and auditor in their review and negotiation functions. Management of indirect costs is a contractor responsibility. Contractors who do significant military business must manage their indirect costs within the framework established by Government policies. The role of the ACO and Page 19

20 auditor is to assure that the contractor has an appropriate cost accounting system and that he operates in accordance with it and with Government requirements. The auditor also reviews and the ACO negotiates the contractor's overhead rates. Acquisition Managers (AMs) and their staffs are usually not involved in the day-to-day administration of contractor overhead. When prices are based on cost, however, the AM must understand the contractor's cost. Although the AM does not directly manage costs, he or she can encourage the contractor to be an aggressive cost manager. As a customer, the AM has clout and as a Government officer, the AM must get the taxpayer his money's worth. TYPES OF INDIRECT COST POOLS Like kinds of indirect costs are added or "pooled" together in order to more accurately allocate all indirect costs to all the different kinds of contracts going on at the same time within any company. Manufacturing support costs such as factory supervision, machine maintenance, and production supplies (i.e., sanding belts, drill bits, rubber gloves, small tools) are typically added together and divided by total manufacturer direct labor in order to arrive at a manufacturing overhead rate. Likewise, all engineering support costs such as drafting supervision, director of engineering, engineering library expense, and engineering laboratory supplies are "pooled" together and divided by total engineering direct labor to arrive at an engineering overhead rate. Some companies break down their overhead pool structure into many overhead rates, while others have only a very few. The minimum would be two pools: 1. Overhead 2. General and Administrative (G&A) Expenses Theoretically, there is no maximum, however, practical considerations should govern. In order to arrive at a large number of overhead pools it is necessary to break the manufacturing pool down into several pools: manufacturing fabrication, manufacturing assembly, manufacturing plating, manufacturing painting, etc. The engineering pool might be segmented into engineering drafting, engineering mechanical design, engineering electrical design, production engineering, etc. Most companies will have separate overhead pools for at least manufacturing, engineering, material handling, offsite, and G&A expense. TYPES OF INDIRECT COST IN EACH POOL There are four major categories of indirect costs that are generally found to exist in all companies and within all pools: 1. Indirect Labor Some major categories of labor are generally identified as indirect and may fall in all indirect pools or in one or more. They include management, supervision, clerical, and secretarial. Indirect labor may also include certain types of maintenance, technical, and analytical labor. Page 20

21 2. Direct Charging Indirect There are many conditions and circumstances that arise when a person hired to perform direct labor cannot charge his/her time directly and must temporarily charge to indirect. Examples of this are when a person is on an integrated product team, training, jury duty, military duty, union duty, while waiting for equipment to be repaired, while waiting for material to arrive during temporary shortages, while cleaning up a work area, etc. 3. Fringe Benefits Many companies treat all fringe benefits as indirect costs regardless of the way the person is charging. In other words, fringe benefits on direct labor and indirect labor may be categorized as indirect costs. The kinds of costs classified as fringe benefits are FICA, holidays, vacation time, all personnel type insurance, (i.e., medical, life, longterm disability, workers' compensation, federal and state unemployment, etc.), sick leave, etc. 4. Other Indirect Costs Just because this is the last category and is designated "other," do not make the mistake of believing that it is small and/or insignificant. In fact, it includes all indirect costs not covered in the above three categories: all kinds of supplies, factory, production, office, computer, as well as such diverse items as electricity, gas, water, maintenance materials, consumables, indirect travel, small tools, outside consultants, purchased computer services, all indirect outside purchased services such as printing, fumigation, etc. Additionally, there is one very large category called "depreciation" on equipment and buildings that would be included in this category. Page 21