The topic of government contract cost accounting is one

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1 The topic of government contract cost accounting is one that is distinguished from accounting for commercial contracts. Not surprisingly, there are requirements unique to U.S. government contracts. Most notable among these unique requirements is that costs should be allowable and properly allocable to a government contract. Cost Allowability In general, cost allowability is a term that refers to whether certain expenses may or may not be charged to a government contract or grant. It is a threshold question. If a cost is allowable, then the organization must then decide how to assign that cost. On the other hand, if a cost is unallowable, it should be placed in the unallowable cost account. Regarding cost allowability, costs may be classified into one of three categories: Allowable; Unallowable; or May be allowable. is defined in the negative, i.e., allowable costs are those costs that are not considered to be unallowable. FAR defines cost allowability as follows: The factors to be considered in determining whether a cost is allowable include the following: 1. Reasonableness. 2. Allocability. 3. Standards promulgated by the CAS Board, if applicable; otherwise, generally accepted accounting principles and practices appropriate to the particular circumstances. 4. Terms of the contract. 5. Any limitations set forth in this subpart [FAR ]. Each of these factors is discussed in FAR Part 31. The difficulty with the first factor, reasonableness, is that it is subjective and hence judgmental. FAR sets forth the following helpful guidance: Allowable costs are not specifically defined in the Federal Acquisition Regulation (FAR). It is said, however, that the term allowable costs a.) A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the 38 Contract Management August 2010

2 b.) conduct of competitive business. Reasonableness of specific costs must be examined with particular care in connection with firms or their separate divisions that may not be subject to competitive constraints. No presumption of reasonableness shall be attached to the incurrence of costs by a contractor. If an initial review of the facts results in a challenge of a specific cost by the contracting officer or the contracting officer s representative, the burden of proof shall be upon the contractor to establish that such cost is reasonable. What is reasonable depends upon a variety of considerations and circumstances, including Whether the type of cost is generally recognized as ordinary and necessary Generally accepted business practices Arm s length bargaining Federal and state laws and regulations Responsibilities to the government, other customers, owners, employees, and the public at large Deviations from established practices. Fortunately, in this murky area cost disallowances based solely on reasonableness are infrequently sustained by the contracting officer. Contract Management August

3 The final category of allowable costs concerns costs that may be either allowable or unallowable. In this category, there are certain legal criteria that have been established and the costs are allowable when they meet those criteria. Most (but not all) of these criteria are found in the FAR Part 31 cost principles. With the criteria in some cost principles, the decision on cost allowability is a close one. Not surprisingly, government auditors may look at the same facts but come to a different conclusion. In brief, cost allowability issues sometimes arise in which knowledgeable people in good faith reasonably disagree. However, all is not lost for the contractor where a government contract auditor challenges certain costs. The Contract Disputes Act established a process by which contractors may appeal adverse cost allowability determinations. 3 Fortunately, the appeal procedures are neither time consuming nor expensive, as is the case for commercial contract disputes. In addition to the five cost allowability factors in FAR , all contractors are required under FAR (d) to adequately substantiate their costs: Cost Allocability Cost allocability is a term that sounds very similar to cost allowability, but the two should not be confused. While cost allowability refers to whether costs are chargeable (billable) to the government, cost allocability is a term that addresses how allowable costs are assigned to particular contracts or grants. In other words, cost allocability does not concern itself with allowable or unallowable costs. Rather, cost allocability is the process by which costs are apportioned to government contracts and grants. A contractor is responsible for accounting for costs appropriately and for maintaining records, including supporting documentation, adequate to demonstrate that costs claimed have been incurred, are allocable to the contract, and comply with applicable cost principles in this subpart and agency supplements. The contracting officer may disallow all or part of a claimed cost that is inadequately supported. In other words, in circumstances where allowable costs cannot be documented they are generally deemed to be unallowable (for lack of support). Unallowable costs are any costs which, under the provisions of any pertinent law, regulation, or contract, cannot be included in prices, cost reimbursements, or settlements under a government contract to which it is allocable. A couple of illustrative examples of unallowable costs are charitable donations 1 and alcoholic beverages. 2 It is very important for government contractors to separate their unallowable costs from any billing, indirect cost pools, claim, or proposal submitted to the government. The identification of and separate accounting treatment for unallowable costs is one of the cardinal differences between government cost accounting and commercial accounting. Of course, unallowable costs need to be properly identified in order to be separated. For this to be accomplished, government contractors should have personnel trained in this aspect of government cost accounting. Indirect Costs There are two types of indirect costs: overhead and general & administrative (G&A). Generally speaking, G&A costs are those costs associated with a contractor s home office, i.e., they are costs incurred to operate as a business. Illustrative G&A costs are expenses such as rent, utilities, security, telephone, salaries of home office personnel, advertising, travel, and so on. A medium-sized government contractor may have dozens of accounts that comprise its G&A pool. Overhead costs are costs more closely associated with the performance of the work; whatever that may happen to be (construction, research and development, professional services, production of goods, etc.). Depending on the contractor s organization and the type of work involved, there may be different kinds of overhead pools, such as material overhead for a supply contract, field office overhead for a construction contract, and so on. It is not uncommon for a contractor to have multiple overhead pools along with the single G&A pool. Most of the regulations in this area are found at FAR 42.7, Indirect Cost Rates. Specifically, this section of the FAR sets forth the requirements for billing rates and final indirect cost rates. Billing rates are also known as provisional rates because their use is temporary. Indeed, a billing rate is defined in FAR as follows: 40 Contract Management August 2010

4 Billing rate as used in this subpart means an indirect rate 1. Established temporarily for in- terim reimbursement of incurred indirect costs; and 2. Adjusted as necessary pending establishment of final indirect cost rates. Overhead Any indirect cost rate is merely a ratio between a numerator and a denominator. The ratio generally used by government contractors to determine an overhead rate is: All allowable costs Total direct labor costs The numerator, all allowable costs, indicates that all of the unallowable costs have been purged from the collection (or pool) of overhead costs for that period. This is accomplished by screening each of the accounts in that overhead pool and ensuring that all unallowable costs have been eliminated and transferred to the unallowable cost account. The denominator is the total amount of direct labor costs for the same period. The following illustrative example demonstrates how a proposed overhead rate may be determined. There are, of course, other methodologies that may be used but the structure of how the underlying data is used should be similar to what is presented in FIGURE 1 on page 42. There are several aspects to this hypothetical data that are instructive. To begin with, the mathematics of how an overhead rate is put together can be straightforwardly discerned. Second, one can note how the amounts in the column for the 2010 budget are estimated, while all the other figures are actual. This is consistent with everyday practice, i.e., future expenses are usually based on past experience. As shown in this example, the actual amounts in every cost element in the overhead pool are reviewed. Then a judgmental determination is made regarding those costs in the upcoming year. Contract Management August

5 EXPENSE ESTIMATED ACTUAL EXPENSES EXPENSES FY2009 FY2008 FY2007 Salaries Indirect 260, , , ,000 Payroll taxes 118, ,000 98,000 66,000 Fringe indirect 110,000 98,000 90,000 61,000 Bad debts* 5,000 5,000 3,000 2,000 Office equipment 18,000 4,000 1,000 2,000 Depreciation 4,000 4,000 4,000 4,000 Prof. subscriptions Travel 14,000 12,000 9,000 9,000 Office supplies 2,000 2,500 2,800 1,500 Rent 12,000 12,000 12,000 9,600 Telephone 3,500 3,500 3,100 3,000 Property insurance Donations* 1,000 1,000 1,000 1,000 Training 15,000 18,000 18,000 9,000 Prof. dues 2,000 2,000 1,600 1,500 Recruiting 3,000 8,000 8,000 3,000 Security 18,000 18,000 15,000 15,000 Utilities 3,500 3,400 3,400 3,300 Delivery services Miscellaneous TOTAL *Less Unallowables 6,000 6,000 4,000 3,000 Net Allowables 585, , , ,650 Allocation Base Direct Labor 935, , , ,000 Overhead Rate Notes: Any explanatory comments should be set forth at the bottom of the table. Contractors should strive to ensure that any ambiguous entries are clearly explained. FIGURE 1. xyz associates, Inc. overhead budget fy Contract Management August 2010

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7 EXPENSE ESTIMATED ACTUAL EXPENSES EXPENSES FY2009 FY2008 FY2007 Salaries - Indirect 360, , , ,000 Payroll taxes 162, , , ,000 Fringe indirect 151, , , ,000 Entertainment* 5,000 15,000 3,000 8,000 Computers 18,000 4,000 1, Depreciation 4,000 4,000 4,000 4,000 Prof. subscriptions Travel 14,000 12,000 9,000 9,000 Office supplies 2,000 2,500 2,800 1,500 Delivery services 1, Rent 12,000 12,000 12,000 9,600 Telephone 3,500 3,500 3,100 3,000 Property insurance Political contributions* 10,000 10,000 1,000 1,000 Legal 15,000 18,000 18,000 9,000 Professional dues 2,000 2,000 1,600 1,500 Accounting 3,000 8,000 8,000 3,000 Security 18,000 18,000 15,000 15,000 Utilities 3,500 3,400 3,400 3,300 Miscellaneous TOTAL *Less Unallowables 15,000 25,000 4,000 9,000 Net Allowables 770, , , ,650 Allocation Base Direct Labor 15,000,000 12,500,000 12,000,000 11,000,000 Overhead Rate Notes: Again, the contractor should elaborate on all data entries as necessary. FIGURE 2. xyz associates, Inc. G&A budget fy Contract Management August 2010

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9 overhead rate calculation. Fringe rates can be an important cost discriminator in service contracts when cost is a major factor in the award process. They are of less significance in the award of research and development contracts and awards are normally based on the rankings of technical proposals. Fringe rates are rarely award-determinative in either construction or supply contracts. Another indirect cost rate used by contractors is known as a win only rate and is only seen in a proposal. This rate is developed when a contractor bids on a large contract whose award will have a major impact on all its indirect rates, i.e., overhead, fringe, and G&A. However, the contractor s rates will only be affected if it wins the contract. Obviously, the contractor would not want to propose its current rates because they would not be an accurate representation of its costs in doing the proposed work. For this reason, the contractor submits rates that are contingent upon receiving the award of the large contract, which is why such rates are called win only rates. A win only overhead rate is determined as follows: (Actual allowable costs + Estimated allowable costs) (Direct labor costs + Estimated direct labor costs) Will these costs be greater than last year, will they be lesser, or will they stay about the same? What events in the next year are likely to have a cost impact on these expenses? As but one example, suppose XYZ Associates reasonably anticipates receiving more government contracts and expanding its overhead staff to accommodate the additional work. Having more employees could increase the training costs, particularly for a government contractor where having a trained staff is vital. Conversely, if XYZ Associates anticipates having a somewhat stable office staff then its training needs will remain about the same as the prior year. As a similar example, the recruiting costs for XYZ Associates will generally be commensurate with its growth, i.e., XYZ will need more employees as it receives more contracts. The need to expand the workforce will accordingly cause an increase in recruiting costs. In like manner, recruiting costs will stabilize as XYZ acquires a stable workforce. There are also other indirect costs whose calculation is related to the overhead rate. For example, the labor fringe rate has the following formula: All allowable costs Direct Labor The numerator (all allowable costs) consists of all fringe benefits such as pension plan contributions, health plan costs, vacation costs, sick time, jury duty, and other amounts of paid time off. The denominator, in this example, is the same amount used for the To illustrate how a win only overhead rate may be determined, assume the proposal set forth above for fiscal year 2010 by XYZ Associates is essentially adopted after negotiations with only immaterial changes. Assume further that XYZ Associates subsequently develops a proposal for a $50 million contract, which is so large that it dwarfs all of their other contracts combined. In looking over the statement of work, they estimate their direct labor costs would be $30 million and their additional overhead costs would be around $12 million. Should XYZ receive the $50 million contract, the affect on the 62.6 percent overhead rate would be: (Actual FY2010 allowable costs + Estimated allowable costs) (Direct labor costs + Estimated direct labor costs) or ($585,500 + $12,000,000) ($935,000 + $30,000,000) = $12,585,500/$30,935,000 = 40.7 percent. In its proposal for the $50 million contract, XYZ Associates would clearly and repeatedly refer to the 40.7 percent as its win only overhead rate, to distinguish it from its current FY2010 rate of 62.6 percent. Returning to the procedures by which billing rates are arrived at, XYZ s budgeted overhead costs for FY2010 form the basis of its proposal to the administrative contracting officer (ACO). The ACO/ auditor will review the submission and will likely make revisions. At some point, XYZ Associates and the ACO will meet to discuss and agree upon the billing (or provisional) overhead rate for XYZ s 46 Contract Management August 2010

10 government contracts. In those negotiations, the major cost elements in the overhead pool will be discussed between the parties. The negotiations will go back and forth until the parties come to an agreement. (Technically, the budgeted overhead rate and the agreed to billing overhead rate would be identical where the ACO accepts a contractor s proposal without making any changes, but this is not that common.) After the government and the contractor have agreed to the billing rates, the contractor invoices the government on its monthly billings for that fiscal year at the agreed-upon indirect rates. While the contractor is performing the work, it should carefully track its actual costs to the agreed-to rates. Specifically, the contractor tracks its budgeted overhead costs to its actual overhead costs incurred. This is very important to control as this process can prevent a contractor from experiencing a significant cost overrun on the contract due to incorrect rates. General and Administrative (G&A) The mathematics for determining the G&A rate is similar, in that the rate is simply a ratio between a numerator and a denominator: All allowable costs Total Costs Here too, the numerator consists of all the allowable costs in the G&A pool. As with the overhead pool, this is done by carefully reviewing all of the accounts in the G&A pool and transferring any unallowable costs to the unallowable cost account. The denominator consists of all costs of performance for the same period, including all labor costs, costs of materials, other direct costs, and overhead. (See FIGURE 2 on page 44.) Here too, the amounts for FY2007 FY2009 are the actual incurred amounts while the expenses for FY2010 are estimates. The estimated amounts are based on the contractor s experience with the costs of those items, as well as its best business judgment regarding how those costs might rise or fall with the contractor s performance in FY2010. Significant assumptions should be documented in the notes. The goal is to make the contractor s cost proposal as lucid as possible, so that the government evaluators understand the proposal, and therefore will enhance the chances of being accepted. Conversely, the more confusing or inexplicable a contractor s cost proposal may be, the more it will adversely impact the contractor s competitiveness for award. The guidance above concerning win only rates applies just as much to G&A rates as to overhead. Contract Management August

11 Final Indirect Rates Under FAR , the contractor must submit an annual final indirect cost proposal. The final rates are determined either by the contracting officer 4 or with the contract auditor. 5 For guidance on preparing and submitting a final indirect rate cost proposal, contractors should review the information in Chapter 6 of DCAA Pamphlet , Information for Contractors. This pamphlet is available on the Defense Contract Audit Agency (DCAA) website ( mil). Whether the final rates are contracting officer- or auditordetermined, within 120 days after the indirect rates are established the contractor must submit its final invoices for contracts to be closed, which incorporates the agreed-upon amounts. Cost Accounting Standards For certain large-dollar-value contracts, cost allocability is governed by the Cost Accounting Standards (CAS). The CAS apply when certain dollar thresholds are exceeded. The current thresholds, established on April 2, 2000, are: A CAS-covered contract award of $50 million or more during the current cost accounting period (generally, a fiscal year); or Award of $50 million or more in CAS-covered contracts during the preceding cost accounting period (again, in most cases a fiscal year), and at least one contract exceeded $7.5 million. Cost Accounting systems New Contractors New contractors being considered for an award of a flexibly priced contract (i.e., cost reimbursement) will have their accounting systems surveyed by a government auditor prior to the award. The purpose of the pre-award survey is to ensure that the contractor s accounting system meets certain minimum requirements. Unlike fixed-price contracts, all cost reimbursement contracts require an adequate accounting system. This is seen in FAR (h), which states: Before agreeing on a contract type other than firm-fixed-price, the contracting officer shall ensure that the contractor s accounting system will permit timely development of all necessary cost data in the form required by the proposed contract type. This factor may be critical when the contract type requires price revision while performance is in progress, or when a cost-reimbursement contract is being considered and all current or past experience with the contractor has been on a fixed-price basis. The requirement for a contractor to have an acceptable accounting system is repeated in FAR (a)(1): A cost-reimbursement contract may be used only when the contractor s accounting system is adequate for determining costs applicable to the contract Not surprisingly, government auditors complete a form (SF 1408) when performing a pre-award survey. This form evaluates the contractor s accounting system in the following areas: Is the accounting system in accord with generally accepted accounting principles? Does the accounting system provide for: Proper segregation of direct costs from indirect costs? Identification and accumulation of direct costs by contract? A logical and consistent method for the allocation of indirect costs to intermediate and final cost objectives? Accumulation of costs under general ledger control? A timekeeping system that identifies employees labor by intermediate or final cost objectives? A labor time distribution system that charges direct and indirect labor to the appropriate cost objectives? Interim (at least monthly) determination of costs charged to a contract through routine posting of books of account? Exclusion from costs charged to government contracts of amounts which are not allowable in terms of FAR Part 31 or other contract provisions? Identification of costs by contract line item and by units (as if each unit or line item were a separate contract) if required by the proposed contract? 48 Contract Management August 2010

12 5 Ensure that the timekeeping and labor distribution systems apgovernment contract cost accounting principles (part 2 of 3) Segregation of preproduction costs from production costs? Does the accounting system provide financial information: Required by contract clauses concerning limitation of costs (FAR and -21) or limitation on payments (FAR )? Required to support requests for progress payments? Is the accounting system designed, and are the records maintained, in such a manner that adequate, reliable data is developed for use in pricing follow-on acquisitions? Is the accounting system currently in full operation? Experienced Contractors Experienced contractors are using accounting systems that have already been reviewed and deemed to be acceptable. Nevertheless, experienced contractors find it necessary to replace or update their accounting systems from time to time. Whatever new software product the contractor selects will be similarly reviewed by a government auditor. At this time, the FAR does not provide any guidance as to what constitutes an acceptable accounting system, so this determination is largely left to the judgment of the government auditor. (Although government contract auditors may prefer one accounting software product more than another, the decision regarding what particular software package works best for the contractor is a matter left entirely up to the contractor.) The government auditor s judgment about what is and is not acceptable is not without limits, however. In this area, DCAA has established guidance concerning what minimum requirements must be met. The minimum standards set forth below are taken from DCAA s audit guidance titled: Pre-award Survey of Prospective Contractor Accounting System, which may found on the DCAA website (www. dcaa.mil): 1 Verify that the accounting system is in accord with generally accepted accounting principles. 2 Determine whether the system will be able to identify and segregate direct costs from indirect costs. 3 Verify that the system can track direct costs by contract. 4 Test whether the system indirect costs are accumulated into logical groupings and whether allocations are done on a causal/beneficial basis. Contract Management August

13 to get by. To be sure, contractors will need to have an accounting system that also meets their tax reporting requirements (federal, state, local, property), as well as management s requirements for company budgets, trend analyses, performance indicators, internal audits, and so on. propriately identify direct and indirect labor charges to intermediate and final cost objectives. 6 Verify that the system is able to determine the cost of work performed at interim points (at least monthly) due to routine posting of costs to the books of account. 7 Verify that the system can identify and segregate unallowable costs as defined by FAR Part 31 and any applicable contract terms. 8 If required by the contract, ensure that the accounting system will be able to identify costs by contract line item number or by unit. 9 Determine whether the system will be able to segregate precontract costs from contract costs. 10 Verify that the accounting system can provide the minimum necessary cost information required by the FAR limitation of cost clause and applicable progress payment clause. 11 Determine whether the financial records are maintained in such a manner that adequate, reliable data is developed for use in pricing follow-on contracts. 12 Verify that the accounting system is currently in full operation. Of course, most contractors will want to have an accounting system that has capabilities greater than those minimally necessary just summary In retrospect, it can be seen that a contractor s cost accounting capabilities are very significant. Contractors need to not only be conversant in the nuances of cost allowability, allocability, and reasonableness, but they must effect these concepts within their accounting systems as well. Contractors may achieve full cost absorption by establishing and maintaining effective indirect cost systems ones that methodically identify and eliminate unallowable costs. These systems are made possible by acquiring and operating accounting software packages that are appropriate for the nature of the contractor s organization and the types of contracts being performed. Of course, the proper operation of an accounting system requires both trained personnel and effective software that meets current regulatory and statutory requirements. Finally, a program of periodic monitoring by management is also necessary to augment the accounting system to ensure its proper operation and to validate that the results are in accord with the FAR requirements. CM About the Authors GREGORY A. GARRETT, CPCM, Fellow, C.P.M., PMP, is the managing director and practice leader of Navigant Consulting, Inc. s Government Contractor Services practice in Vienna, Virginia. He is an international educator, best-selling author, highly respected consultant, and the recipient of numerous national and international business awards. He has authored 17 books and more than 90 published articles. He is also a member of the NCMA Executive Advisory Council. FRANK J. BEATTY, CPA, is a director in Navigant Consulting, Inc. s Government Contractor Services practice. He has over 30 years of government contracting and audit experience gained from working in, and with, domestic and international companies in the aerospace, automotive, defense, telecommunications, information technology, and healthcare industries. Send comments about this article to cm@ncmhq.org. Endnotes 1. FAR FAR See FAR Part FAR (a)(1). 5. Ibid. at (a)(2). 50 Contract Management August 2010

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