(Editor’s Note. An article we wrote in the last issue of the GCA REPORT addressed the issue of when purchased labor can be treated as employees versus other direct costs and we received numerous responses including questions on how to treat purchased labor as employees for billing purposes. Since use of purchased labor, rather than permanent employees, is becoming more prevalent, we decided to update and reproduce an earlier article addressing this issue. There are several acceptable ways to account for contract labor for costing and pricing purposes and each should be considered in the light of your pricing objectives.)
The use of contract labor has definitely increased over the last few years. Several factors have contributed to its proliferation. First, significant downsizing and early retirements in recent years have contributed to a significant staff shortage requiring use of former employees as consultants. Second, a tendency to use more specialized subcontractors and teaming arrangements has expanded the integration of subcontractors into the prime contractor’s work. Thirdly, the price competitiveness of many firms has resulted in the use of temporary staff to cut down on overhead and fringe benefits. Whatever the reason, the use of such purchased labor has proliferated at both the prime and upper tier subcontractors’ own facilities and field offices and no end to this trend appears to be in sight.
There are numerous way of accounting for contract labor that work at the contractor’s workplace:
Direct Costing
The most common way of accounting for this labor when the dollars are insignificant is to allocate the costs to "other direct costs" when the work is for a contract or as "indirect cost" when the work is for an indirect function. However, when these costs are significant, the direct costing allocation may be inappropriate. For example, if half the workforce at a contractor’s facility is contract labor while the other half are employees and all individuals work at the same place, then the normal practice of allocating overhead only on employees may greatly alter cost allocations to specific contracts when the ratio of purchased labor to employees is not uniform. The failure to allocate the workplace costs to both contractor employees and non-employees may be considered inequitable by the government.
Other Costing Methods
One solution for such inequitable cost allocations would be to include the cost of contract labor in the direct labor cost allocation base for overhead. For pricing purposes, when average direct labor rates are used, the cost of contract labor would have to be included with contractor employee costs to determine an average rate. This has the result of increasing direct rates and lowering overhead (because of the high denominator number).
Commonly, burdened contract labor rates per hour are greater than employee rates especially when a company is providing the purchase labor because they may be paying limited fringe benefits and are including a markup. If the entire amount was a direct charge and then indirect costs applied, it would be inequitable for the following reasons: (1) fringe benefits for employees would be allocated to direct labor which includes employees and contract labor which, in turn, already may include fringe benefits and markup (2) contract labor charges may be excessive if they include two fringe benefits allocations (e.g. one from the subcontracting company and one from the contractor) and (3) the markup would be charged only to that contract(s) where the contract labor is used and not to others.
When the rate difference is substantial, other cost accounting techniques may be necessary. One method would be to segregate the invoice from the company (or from the individual consultant or contract employee) into a direct labor cost portion and an overhead portion. The justification for this treatment is that the invoice is comparable to the direct charge plus some overhead of contractor employees. The segregation of costs can be accomplished in three ways:
Segregate the direct labor cost portion based on the direct labor rate of a comparable employee and allocate the remainder of the cost to overhead.
Segregate the direct labor cost portion based on invoice information from the provider.
Prorate the invoice to direct labor and overhead based on the ratio of direct labor to overhead experienced by the contractor.
Though Option 1 is the most common method, the concept underlying all three has been validated by an Armed Service Board of Contract Appeal decision (Software Research Associates, ASBCA 88-3 BCA). In the case, the contractor entered into a time and materials contract where all-inclusive fixed rates for various labor categories were established. During contract performance, the contractor used contract employees and billed at the rate established for direct labor categories. The government argued this labor could not be billed as direct labor because the labor was performed by non-employees resulting in an unfair windfall for the contractor. Rather the contract labor should be invoiced as an "other direct cost" or as "material" of the T&M contract.
The Board disagreed because the work performed by the contract employees was indistinguishable from that provided by contractor employees. The government’s windfall argument was insufficient to overcome this fact and the Board concluded one of the three methods (or a similar alternative) identified above would be acceptable provided the method used was consistent with the way it booked charges for government reporting purposes.
The Defense Contract Audit Agency has a section in its Contract Audit Manual on Purchased Labor in Chapter 7-2102. Unless purchased labor is used to meet temporary or emergency requirements, auditors are told to "carefully study" the contractor’s practice to determine whether additional costs are reasonable, necessary and properly allocated to government contracts.
Initially auditors are told to (1) review any written policies on treatment of purchased labor and analyze the practices of treating purchased labor in the current and most recently completed fiscal year (2) determine the number of purchased labor (3) ascertain their duration of engagement (4) compare number of employees in each relevant classification to purchased labor (5) compare the cost per staff-year with contractor’s comparable personnel (6) evaluate the reasons for using purchased labor especially for periods exceeding one year which should include technical input if needed and (7) determine the extent of purchased versus employee labor on government versus commercial work and on cost type versus fixed price government work and determine whether there is an "equitable" allocation of costs.
The guidance notes that contractors may treat purchased labor as either other direct costs (e.g. subcontractors) or as direct labor with the excess over employee labor charged to overhead. In determining whether the allocation of costs are "equitable" the guidance states auditors should follow the fundamental requirements of CAS 418 that states pooled costs should be allocated to cost objectives in a reasonable proportion to the causal or beneficial relationship of the pooled costs to cost objectives. Purchased labor should share in an allocation of indirect expenses when there is such a causal beneficial relationship and the practice should be consistent with the contractor’s disclosed or normal practices. The guidance states sometimes a separate allocation base may be necessary to allocate significant overhead costs to purchased labor such as supervision and occupancy costs or it may be necessary to eliminate certain costs that do not benefit purchased labor such as fringe benefits.
For example, consider the difference between in-house and offsite purchased labor. When purchased labor is used in-house, the guidance states normal overhead costs excluding fringe benefits may need to be allocated to purchased labor. When purchased labor is performed offsite where supervision and control is by an entity other than the contractor, none of the contractor’s labor overhead costs may be allocable to purchased labor. When contractors use other practices they will need to show that either the impact is not significantly different or that it is justified.
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