ODOT Contract Audit Circular No. 1

Definitions, Audit Authority, and Guidance for Computing Overhead Rates Last Updated: March 23, 2006

CONTRACT AUDIT CIRCULAR No. 1 OHIO DEPARTMENT OF TRANSPORTATION CENTRAL OFFICE, 1980 W. Broad St., 4 th Floor, COLUMBUS, OHIO 43223 SUBJECT: Definitions, Audit Authority, and Guidance for Computing Overhead Rates Last Updated: March 23, 2006 I. DEFINITIONS As used in these Ohio Department of Transportation (ODOT) Contract Audit Circulars 1. A/E firm refers to any business entity that performs architectural, engineering, or other designrelated services to ODOT. In these Circulars, the term consultant is used synonymously with A/E firm. 2. AASHTO refers to the American Association of State Highway and Transportation Officials. 3. A cost is allocable if it is assignable or chargeable to one or more cost objectives (projects) on the basis of relative benefits received or other equitable relationship. A cost is allocable to a Government contract only if it is incurred specifically for the contract; benefits both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received; or is necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown. 4. ASBCA refers to the Armed Services Board of Contract Appeals, which is composed of Administrative Judges. The ASBCA is the authorized representative of the Secretary of Defense, the Secretary of the Army, the Secretary of the Navy and the Secretary of the Air Force, in hearing, considering and determining appeals by contractors from decisions of contracting officers or their authorized representatives or other authorities on disputed questions. 5. Benchmark Compensation Amount (BCA) is the maximum allowable compensation that may be charged against Federal-aid contracts for any senior executive of an A/E firm. The BCA is determined by the Office of Management and Budget s Office of Federal Procurement Policy (OFPP). The OFPP updates the BCA annually, generally in the month of May. The BCA was first established on November 17, 1997, when Section 808 of the 1998 Department of Defense (DoD) Authorization Act was signed into law. 6. Benchmark Corporation refers to any publicly-owned United States corporation with annual sales in excess of $50 million for the fiscal year. 7. The Code of Federal Regulations (CFR) is the codification of the general and permanent rules published in the Federal Register by the executive departments and agencies of the Federal Government. The CFR is divided into 50 titles that represent broad areas subject to Federal regulation. 48 CFR Chapter 12 sets forth the general guidelines used by Departments of Transportation.

Page 3 8. Compensation is the total amount of wages, salaries, bonuses, deferred compensation, taxable fringe benefits, and employer contributions to defined contribution pension plans for the fiscal year, whether paid, earned, or otherwise accruing, as recorded in the consultant s cost accounting records for the fiscal year. 9. Contractor refers to any business entity that provides services under Federal-aid contracts, including A/E consultants and subconsultants. 10. Cost Accounting Standards (CAS) are issued by the Cost Accounting Standards Board (CASB), a section of the Office of Federal Procurement Policy within the U.S. Office of Management and Budget. The CASB has the exclusive authority to issue 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 that involve Federal funds. The CAS are codified at 48 CFR Chapter 99. 11. Cost objective generally means a contract for which cost data are desired and for which provision is made to accumulate and measure the cost of associated processes, products, or jobs. 12. DCAA refers to the DoD s Defense Contract Audit Agency. The DCAA is the primary Federal audit agency that upholds requirements set forth in the Federal Acquisition Regulation. 13. The DCAA Contract Audit Manual (CAM) is the definitive interpretation of FAR Part 31. The CAM is published semiannually by the Defense Contract Audit Agency (DCAA). 14. FAR refers to Part 31 of the Federal Acquisition Regulation, which is codified at 48 CFR Part 31. The FAR is the primary regulation that governs the acquisition of supplies and services with Federal funds. 15. The term Federal-aid contracts refers to agreements for the acquisition of supplies and services that are partially- or fully-funded from Federal sources. Note: In determining the allowability of costs, the treatment of State-funded contracts is identical to that of Federal-aid contracts. 16. The Federal Travel Regulation (FTR) is contained in 41 CFR Chapters 300 through 304. The FTR implements statutory requirements and Executive branch policies for travel by Federal civilian employees and others authorized to travel at the Federal Government s expense. Certain FTR provisions are incorporated into the FAR and apply to contract costs charged by consultants. 17. FHWA refers to the U.S. Department of Transportation s Federal Highway Administration. 18. The Government Auditing Standards, also known as Generally Accepted Government Auditing Standards (GAGAS), are issued by the U.S. Government Accountability Office (GAO). 1 GAGAS prescribe general procedures and professional standards that must be applied when performing audits, reviews, or attestation examinations of commercial entities that conduct business with governmental entities. 19. Incurred Cost refers to the various elements of total cost on Consultants submitted Statements of Direct Labor, Fringe Benefits, and General Overhead; invoices; or other claims for reimbursement. Incurred costs include direct and indirect (overhead) charges, as well as related projects costs such as costs associated with subconsultants. 1 Government Auditing Standards, GAO/OGC-94-4 (Washington, D.C.: June 1994). This document is commonly referred to as the GAO Yellow Book.

Page 4 20. An incurred cost audit involves an examination of the accounting records and source documents that support submitted costs billed against Federal-aid contracts. The examination also includes an assessment of the auditee s internal controls, timekeeping practices, and general operating policies. 21. Internal Controls are policies, procedures, and activities designed to help an organization achieve its management objectives, safeguard resources, report reliable information, and comply with applicable laws. While internal controls cannot completely eliminate the risk of error, fraud, or mismanagement, well-conceived procedures and a good control environment can minimize the potential for abuse. 22. Prime consultant refers to a consulting firm that has contracted directly with ODOT to provide architectural, engineering, planning, or environmental-consulting services. 23. Professional and consultant service fees represent costs of services rendered by persons who are members of a particular profession or who possess special skills and who are not officers or employees of the prime consultant. Such costs include those of outside accountants, lawyers, actuaries, and marketing consultants. 24. The FAR defines senior executives as the five most highly compensated employees in management positions at each home office and each segment of the contractor, whether or not the home office or segment reports directly to the contractor s headquarters. FAR 31.205-6(p)(2)(ii)(B). 25. A Statement of Direct Labor, Fringe Benefits, and General Overhead is a schedule that shows details regarding a consultant s actual total incurred costs for an accounting period. For enhanced readability, in these Contract Audit Circulars the term overhead schedule is used synonymously with Statement of Direct Labor, Fringe Benefits, and General Overhead. A sample overhead schedule is presented in Attachment 1.1. 26. The total cost that may be billed against a Federal-aid project is the sum of the direct and indirect costs allocable to the contract, plus any allocable cost of money, less any allocable credits.

Page 5 II. AUTHORITY ODOT s authority to conduct incurred-cost audits is granted by 23 U.S.C. sections 112(b)(2)(C) and (D), which provides that contracts or subcontracts funded in whole or in part with Federal-aid highway funds shall be audited in compliance with the cost principles contained FAR Part 31. III. ISSUE During an incurred-cost audit, the auditor must determine whether the indirect costs proposed by a consultant are allowable. IV. ALLOWABILITY FAR Part 31 establishes minimum requirements regarding the allowability of total costs charged against Federal-aid contracts. This includes provisions for direct project costs, as well as indirect project costs that are used to establish an overhead rate. In conjunction with the FAR s requirements, the Ohio Department of Transportation (ODOT) has the authority to establish additional, more restrictive guidance, as appropriate. Such ODOT requirements, if different from the FAR, will be discussed in subsequent Contract Audit Circulars. To be considered allowable contract charges, costs submitted by the consultant must be: 1. reasonable, 2. allocable either directly or indirectly to specific contracts, 1 3. allowable in accordance with the FAR and ODOT policies, 4. in compliance with terms of the contract, and 5. in compliance with Generally Accepted Accounting Principles (or Cost Accounting Standards, when applicable). V. APPLICATION Annually, each consultant must prepare and submit a proposed overhead rate in accordance with the FAR, ODOT Circulars, and State regulations. To effect the preparation of its overhead schedules, the consultant must maintain accounting records that properly accumulate, segregate, and allocate costs as required by the FAR. Accounting systems with adequate segregation of costs exhibit the following characteristics: Direct and indirect expenses are recorded in separate accounts. Logically-titled accounts are maintained within each major category of expense. Commingling of items is kept to a minimum. Allowable and unallowable costs are maintained in separate, dedicated accounts. 1 See definition I.3 above for more details.

Page 6 Example 1-1. XYZ Consulting is an engineering-consulting firm. XYZ Employees incurred $20,000 of indirect food-related costs in 2005. Itemized receipts revealed that $2,000 of the cost was attributable to entertainment expense. XYZ properly recorded $18,000 in Account No. 520.00 Meals and $2,000 in Account No. 521.00 Entertainment. When preparing its 2005 overhead schedule, the firm identified the balance of Account No. 521.00 as an unallowable cost and removed it from the overhead-rate computation. VI. OVERHEAD-ALLOCATION BASE ODOT advocates the use of direct labor cost (DLC) as the primary allocation base for overhead. DLC is the preferable allocation base for three reasons. First, most overhead incurred in consulting firms is related primarily to supervision and occupancy, both of which tend to vary directly with the cost of professional labor. Second, DLC data are readily available, and computation of the overhead rate is a simple and economical process for the consultant. Third, the use of DLC greatly facilitates comparability among firms, and audit verification of claimed overhead costs is relatively straightforward. This is the case because labor costs usually are controlled by payroll records and the general books of account. In cases where DLC fails to provide an adequate causal link between the incurrence and allocation of costs, it may be permissible to use a secondary allocation base for a portion of the overhead costs. For example, costs associated with computer operations may be more equitably assigned to contracts through the use of an allocation base tied to central processing unit time rather than through a DLC base. Thus, for special cost items, deviations from the DLC base will be considered on a case-by-case basis. VII. OVERHEAD-RATE COMPUTATION To compute annual overhead rates, consultants must divide total allowable overhead costs (i.e., the sum of general and administrative costs and fringe-benefit costs) by total direct labor. In computing the overhead rate, all overtime premium costs must be removed from the DLC base. (See Contract Audit Circular 7 for guidance on the correct treatment of overtime costs.) A sample overhead schedule is presented in Attachment 1.1. VIII. AUDIT TESTING ODOT auditors will examine proposed overhead costs to determine allowability. Any costs that are prohibited by the FAR, ODOT Circulars, or State regulations will be disallowed. In the event that allowable and unallowable costs are commingled in a single account, the auditors will arrive at a disallowance percentage based on a test sample of the account s underlying transactions. This percentage will be applied to the total account balance to arrive at a proposed disallowed dollar amount. Note, however, that this procedure only will be performed in the first overhead audit of the consultant. If the same type of commingling occurs in a subsequent year, the entire account balance will be disallowed unless the consultant prepares a complete, detailed schedule that discloses each allowable and unallowable cost contained within the account in question.

Page 7 Example 1-2. An examination of XYZ Consulting s year-2005 accounting records revealed that Account No. 514.00 General Maintenance included the following costs: (1) painting and general repairs for XYZ s office building and office equipment, and (2) maintenance costs for a building owned by XYZ Consulting but leased to an unrelated real estate title agency. When preparing its 2005 overhead schedule, XYZ included the entire $65,000 balance of Account No. 514.00 in the overhead-rate computation and computed a 140 percent overhead rate (based on $2 million of overhead and $1,428,571 in direct labor costs). Analysis: (1) The inclusion of the painting and general repairs for XYZ s office building and office equipment are allowable costs, provided that these costs are truly in the nature of repairs and are not required to be capitalized pursuant to the requirements of FASB Statement No. 13. (2) The maintenance costs associated with the building leased to the title agency are unallowable because they are unrelated to any engineering-consulting projects and therefore are not allocable contract costs. Audit Adjustment: Based on a test sample of the source documents for Account No. 514.00, ODOT auditors estimated that $26,000 (40 percent) of the account balance should have been excluded from overhead. As a result, XYZ s 2005 audited overhead rate will reflect a $26,000 reduction to the numerator of the overhead-rate computation, which results in a 138 percent revised overhead rate: ($2 million overhead - $26,000 audit adjustment) / $1,428,571 = 138 percent. Example 1-3. In the following year, ODOT auditors returned to XYZ Consulting. Audit testing revealed that Account No. 514.00 still contained unallowable costs. Consequently, in computing an audited overhead rate, the entire balance of Account No. 514.00 was disallowed. IX. REFERENCES FAR 31.201-3 (determining reasonableness). FAR 31.201-4 (determining allocability). FAR 31.205-14 (Entertainment Costs). ODOT Contract Audit Circular No. 7 (Overtime Premium Costs). For further guidance, see Titles 23 and 48 of the Code of Federal Regulations and subsequent ODOT Contract Audit Circulars.

ODOT Contract Audit Circular Attachment 1.1: SAMPLE OVERHEAD SCHEDULE Sample Consulting Company, Inc. Statement of Direct Labor, Fringe Benefits, and General Overhead For the Year Ended December 31, 2005 Description Direct Labor... Total Costs Per General Ledger/Income Statement Unallowable Costs Notes Allowable Costs Percentage of Total Allowable Indirect Costs Percentage of Total Direct Labor Costs $ 10,450,000 - - $ 10,450,000-100.00% INDIRECT COSTS Fringe Benefits: No. 500 Paid Leave Expense... $ 975,000 - - $ 975,000 6.66% 9.33% No. 501 FICA Taxes Expense... 1,487,925 - - 1,487,925 10.17% 14.24% No. 502 Unemployment Taxes Expense... 147,196 - - 147,196 1.01% 1.41% No. 503 Employee-Bonus Expense... 333,632 (40,000) 1 293,632 2.01% 2.81% No. 504 Group Insurance Expense... 450,000 - - 450,000 3.07% 4.31% No. 505 401(k) Employer-Match Expense... 316,989 (6,000) 2 310,989 2.13% 2.98% No. 506 Workers' Compensation Expense... 39,000 - - 39,000 0.27% 0.37% Total Fringe Benefits... $ 3,749,742 $ (46,000) $ 3,703,742 25.31% 35.45% General Overhead: No. 507 Indirect Labor Expense... $ 9,000,000 $ (3,000,000) 3 $ 6,000,000 41.00% 57.42% No. 508 Rent Expense... 700,000 (25,500) 4 674,500 4.61% 6.45% No. 509 Maintenance and Repairs Expense... 260,000 - - 260,000 1.78% 2.49% No. 510 Travel Expense... 245,000 (7,500) 5 237,500 1.62% 2.27% No. 511 Insurance Expense... 465,000 (9,800) 6 455,200 3.11% 4.36% No. 512 Telephone Expense... 328,000 - - 328,000 2.24% 3.14% No. 513 Printing Expense... 280,000 - - 280,000 1.91% 2.68% No. 514 Utilities Expense... 350,000 - - 350,000 2.39% 3.35% No. 515 Taxes Expense... 300,000 (62,000) 7 238,000 1.63% 2.28% No. 516 Depreciation Expense... 410,000 (86,500) 8 323,500 2.21% 3.10% No. 517 Subscriptions and Memberships Expense... 175,000 (42,500) 9 132,500 0.91% 1.27% No. 518 Advertising and Public Relations Expense... 125,000 (88,000) 10 37,000 0.25% 0.35% No. 519 Employee Training and Recruitment Expense... 250,000 (29,500) 11 220,500 1.51% 2.11% No. 520 Professional Fees Expense... 275,000 (20,000) 12 255,000 1.74% 2.44% No. 521 Interest Expense... 873,000 (873,000) 13 0 0.00% 0.00% No. 522 Bad Debts Expense... 327,000 (327,000) 14 0 0.00% 0.00% No. 523 Computer Charges... 475,000 - - 475,000 3.25% 4.55% No. 524 Automotive Expense... 375,000 - - 375,000 2.56% 3.59% No. 525 Supplies and Miscellaneous Expenses... 345,000 (56,000) 15 289,000 1.97% 2.77% Total General Overhead... $ 15,558,000 $ (4,627,300) $ 10,930,700 74.69% 104.62% Total Indirect Costs... $ 19,307,742 $ (4,673,300) $ 14,634,442 100.00% 140.07% OVERHEAD RATES (expressed as a percentage of Direct Labor cost): Overhead Rate Attributable to Fringe Benefits... Overhead Rate Attributable to General Overhead... Total Overhead Rate... 35.44% 104.60% 140.04% NOTES: (1) (2) (3) (4) (5) (6) (7) (8) Costs of employee stock options provided as incentive compensation are disallowed per FAR Section 31.205-6(i)(1). Pension costs that are accrued but unfunded by the time set for filing of the Federal income tax return (or extension thereto) are disallowed per FAR Section 31.205-6(j)(1)(i). Costs of executive salaries in excess of the benchmark compensation amount are disallowed per FAR Section 31.205-6(p). Costs associated with idle facilities are disallowed per FAR Section 31.205-17(b). Travel costs associated with the collection of bad debts are disallowed per FAR Section 31.205-3. Officers' life insurance premiums are allowable only to the extent that such costs represent additional compensation. See FAR Section 31.205-19(e)(2)(v). Costs associated with Federal income taxes are disallowed per FAR Section 31.205-41(b)(1). Depreciation expense attributable to the personal use of vehicles (a fringe benefit) is disallowed per FAR Section 31.205-6(m)(2). Depreciation costs attributable to idle facilities are disallowed per FAR Section 31.205-17(b). (9) Costs of memberships in social, dining, or country clubs are disallowed per FAR Section 31.205-14. (10) Advertising costs incurred for corporate image enhancement are disallowed per FAR Section 31.205-1(f). (11) Entertainment costs associated with employee training and recruitment are disallowed per FAR Section 31.205-14. (12) Professional fees attributable to corporate reorganization are disallowed per FAR Section 31.205-27(a)(3). Professional fees associated with the collection of bad debts are disallowed per FAR Section 31.205-3. (13) Interest expense is disallowed per FAR Section 31.205-20. (14) All costs associated with bad debts are disallowed per FAR Section 31.205-3. (15) Direct supplies are disallowed from the indirect cost pool per FAR Section 31.202.