Issues in Government Contract Management

1. Issues in Government Contract Management INDIRECT COST ALLOCATION CONCEPTS

2. Agenda • Background • Cost Accounting Systems • Basic Terminology • Cost Allocation • Cost Allowability

3. Background • Federal contracts awarded to commercial organizations are subject to the provisions of the Federal Acquisition Regulation (FAR) and are the focus of this presentation.

4. Background • Federal grants and cooperative agreements are subject to those provisions set forth by the Office of Management and Budget (OMB). • OMB issued an Advance Notice “Reform of Federal Policies Relating to Grants and Cooperative Agreements; Cost Principles and Administrative Requirements (including Single Audit Act) (February 28, 2012). We expect publication of the integrated set of guidelines this Summer and will be discussing these when the new guidance is published.

5. Background • The proposed OMB “uniform guidance” will supersede: • A-21, “Cost Principles for Educational Institutions” • A-87, “Cost Principles for State, Local and Indian Tribal Governments” • A-89, “Federal Domestic Assistance Program” • A-102, “Awards and Cooperative Agreements with State and Local Governments” • A-110, “Uniform Administrative Requirements for Awards and Other Agreements with Institutions of Higher Education, Hospitals, and Other Nonprofit Organizations” • A-122, “Cost Principles for Non-Profit Organizations, and • Sections of A-50 related to Single Audits”

6. Background • The Federal Government, like any large organization, uses a variety of procurement methods when acquiring goods and services. • These can be categorized into two major groups: • Competitive Procurement (Sealed Bids) (see FAR Part 14, “Sealed Bidding”), or • Negotiated Procurement (see FAR Part 15, “Contracting by Negotiation”). • (see also FAR Part 13, Simplified Acquisition Procedures)

7. Background • Competitive Procurement (Sealed Bidding) • Sealed bidding is a method of contracting that employs competitive bids, public opening of bids, and awards. • The government solicitation document is an Invitation for Bid (IFB). • Source selection is based on (lowest) price and price-related factors as submitted by a qualified bidder (sealed bid). • The contract type is firm-fixed price (FFP). • in special circumstances, fixed-price contracts with economic price adjustment may be used

8. Background • Negotiated Procurement • Negotiation is a procedure that includes the receipt of proposals from offerors, permits bargaining, and usually affords offerors an opportunity to revise their offers before award of a contract. • The government solicitation document is a Request for Proposal (RFP). • The award is based on price/technical factors. • Contract type varies

9. Background • Negotiated Procurement • Contract Types can include: • Fixed Price • Cost-Reimbursement • Indefinite Delivery • Others • Time and Materials • Labor Hour • Letter Contracts • Agreements

10. Background • Negotiated Procurement • The Government, like any buyer), seeks a fair and reasonable price. • Under sealed bidding (and competition), the competitive forces in the market place are assumed to provide for a fair and reasonable price. • Negotiated procurements (absent competition) are dependent upon contractor representations of cost for a fair and reasonable price.

11. Background • Negotiated Procurement • “Cost” may be required to determine the: • contract price of goods/services, • amount of periodic billings (e.g., contract financing involves the use of progress payments).

12. Background • Negotiated Procurement • When “cost” is used to determine the contract price of goods/services; this can involve: • Estimated costs, and/or • Actual costs • Actual costs (versus estimated costs) are generally required for pricing: • Cost-Reimbursable • Fixed Price Incentive, and • Time and Materials (T&M) contracts

13. Background • Our interest in accounting systems arises when “actual” costs are required. • For “commercial organizations,” there are two major types of accounting systems to consider: • Financial Accounting, • Cost (or Management) Accounting

14. Background • Financial Accounting • Produces financial reports regarding the company (enterprise) as a whole (i.e., balance sheet, income statement, statement of cash flows) • Primary users are “external” (e.g., investors, creditors, etc.) • Subject to Generally Accepted Accounting Principles (GAAP)

15. Background • Cost (or Management) Accounting • Reports on cost objectives (within the company) • Primary users are “internal” (i.e., management) but can include customers (i.e., Government) • When cost accounting is used to comply with a “financial accounting” objective, costs are measured in accordance with GAAP

16. Cost Accounting Systems • Two major categories of cost accounting systems • Standard Cost • Actual Cost

17. Cost Accounting Systems • Standard Cost • “Standard cost means any cost computed with the use of preestablished measures.” (FAR 31.001) • Pre-established measures can include: labor-rate standard, labor-time standard, material-price standard, and material-quantity standard

18. Cost Accounting Systems • Actual Cost • “Actual Cost means (except for subpart 31.6) amounts determined on the basis of costs incurred, as distinguished from forecasted costs… • (FAR definition includes standard costs properly adjusted for applicable variances.)

19. Cost Accounting Systems • Acceptable Accounting System • Standard Form 1408, “Preaward Survey of Prospective Contractor Accounting System” delineates the characteristics of a government accounting system.

20. Cost Accounting Systems • Acceptable Accounting System (continued) • 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. (A contract is final cost objective.) • Accumulation of costs under general ledger control. • and…

21. Cost Accounting Systems • Acceptable Accounting System (continued) • A timekeeping system that identifies employees' labor by intermediate or final cost objectives. • A labor 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. • and…

22. Cost Accounting Systems • Acceptable Accounting System (continued) • Exclusion from costs charged to government contracts of amounts which are not allowable in terms of FAR 31, Contract Cost Principles and Procedures, 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. • Segregation of preproduction costs from production costs.

23. Basic Terminology • Total Cost • Direct Cost • Indirect Cost • Allowable Cost • Cost Objective • Final Cost Objective • Indirect Cost Pool

24. Basic Terminology • Total cost (re: FAR 31.201-1) • The total cost, including standard costs properly adjusted for applicable variances, of a contract is the sum of the direct and indirect costs allocable to the contract, incurred or to be incurred, plus any allocable cost of money pursuant to 31.205-10, less any allocable credits. In ascertaining what constitutes a cost, any generally accepted method of determining or estimating costs that is equitable and is consistently applied may be used.

25. Basic Terminology • Direct Cost • Generally, a direct cost is any cost that can be identified specifically with a particular final cost objective.

26. Basic Terminology • Indirect Cost • Generally, an indirect cost is any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or an intermediate cost objective. It is not subject to treatment as a direct cost. After direct costs have been determined and charged directly to the contract or other work, indirect costs are those remaining to be allocated to the several cost objectives.

27. Basic Terminology • Allowable cost (re: FAR 31.201-2) • A cost is allowable only when the cost complies with all of the following requirements: (1) Reasonableness. (2) Allocability. (3) Standards promulgated by the CAS Board, if applicable, otherwise, generally accepted accounting principles and practices appropriate to the circumstances. (4) Terms of the contract. (5) Any limitations set forth in this subpart.

28. Basic Terminology • Cost objective means (except for subpart 31.6) a function, organizational subdivision, contract, or other work unit for which cost data are desired and for which provision is made to accumulate and measure the cost of processes, products, jobs, capitalized projects, etc. (re: FAR 31.001 Definitions)

29. Basic Terminology • Final cost objective means (except for subparts 31.3 and 31.6) a cost objective that has allocated to it both direct and indirect costs and, in the contractors accumulation system, is one of the final accumulation points. (re: FAR 31.001 Definitions)

30. Cost Allocation For cost-based pricing and billings, we need to account for both direct and indirect costs (and profit). source: INDIRECT-COST MANAGEMENT GUIDE, NAVIGATING THE SEA OF OVERHEAD, Third Edition, October 2001, DEFENSE SYSTEMS MANAGEMENT COLLEGE PRESS, FORT BELVOIR, VA

31. Cost Allocation • This type of cost accounting is sometimes referred to as “full-absorption cost accounting.” We need to capture all costs to assure a reasonable price (or representation of cost). • Direct costs are charged to cost objectives (e.g., contracts). To recover indirect costs on cost objectives, contractors use indirect rates to allocate the indirect costs.

32. Cost Allocation • Indirect Rates • Indirect rates determine the portion of indirect costs that a cost objective (e.g., contract) will be allocated.

33. Cost Allocation • To cost its contracts, a contractor will generally: • Identify cost objectives (e.g., contracts), • Identify direct costs of cost objectives, • Identify indirect cost pool(s), • Select an indirect cost pool allocation base(s), • Calculate the indirect rate(s) • Allocate indirect costs to cost objectives using indirect rate(s)

34. Cost Allocation • Common contractor indirect rates include: • Fringe Benefit • Overhead (e.g., Manufacturing/Production, Engineering, Material Handling) • General & Administrative (G&A)

35. Cost Allocation • This example shows direct costs (Engineering labor, Manufacturing labor and Material) and indirect costs (Overheads (labor and material) and G&A) source: DCAA Pamphlet 7641.90,Information for Contractors, dated June 26, 2012

36. Cost Allocation • This example shows the basis for the proposed Material Handling Overhead rate. source: DCAA Pamphlet 7641.90,Information for Contractors, dated June 26, 2012

37. Cost Allocation • Indirect costs, for government contract accounting purposes, are adjusted for unallowable costs.

38. Cost Allowability • Allowable cost (re: FAR 31.201-2) • A cost is allowable only when the cost complies with all of the following requirements: (1) Reasonableness. (2) Allocability. (3) Standards promulgated by the CAS Board, if applicable, otherwise, generally accepted accounting principles and practices appropriate to the circumstances. (4) Terms of the contract. (5) Any limitations set forth in this subpart.

39. Cost Allowability • Reasonableness • 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 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 effective competitive restraints. 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. • (FAR 31.201-3 - Determining Reasonableness (in part…)).

40. Cost Allowability • Allocability • A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship. Subject to the foregoing, a cost is allocable to a Government contract if it – • Is incurred specifically for the contract; • (b) Benefits both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received; or • (c) Is necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown. • (re: FAR 31.201-4 -- Determining Allocability)

41. Cost Allowability • Cost Accounting Standards (CAS) • Applies to certain negotiated procurements exceeding $700,000 (subject to certain exemptions) • CAS clause requirements include: • Disclose Cost Accounting Practices (CASB DS), • Follow disclosed cost accounting practices consistently, • Agree to equitable adjustment for required changes, • Negotiate proposed changes (voluntary cost accounting change) but no increased cost, • Agree to adjustment for increased costs for failure to comply

42. Cost Allowability • FAR Part 31, “Contract Cost Principles and Procedures” include the following examples: • FAR 31.205-51, Alcoholic Beverages, • FAR 31.205-3, Bad Debts, • FAR 31.205-8, Contributions or Donations, • FAR 31.205-14, Entertainment Costs, • FAR 31.205-15, Fines, Penalties, & Mischarging • FAR 31.205-49, Goodwill • FAR 31.205-20, Interest & Other Financial Cost

43. Summary • Our discussion of Indirect rate concepts with attention to contracts with commercial organizations, included: • The influence of the method of acquisition on the need for indirect cost information (sealed bid v. negotiated), • The type of contract and need for indirect cost information • Types of accounting (financial v. cost, standard cost v. actual) • Attributes of an acceptable accounting system • Cost allocation and indirect rates • Cost Allowability

44. Questions