(Editor’s Note. The following article is an edited version of a white paper we prepared for a client. Our client, who will be referred to as Contractor, thinks it may become covered by the cost accounting standards and has asked us to evaluate their method of accumulating and allocating home office general and administrative expenses. The following case study demonstrates that in efforts to be compliant with government cost accounting requirements, contractors can often “overkill” which creates separate problems it would not have otherwise had.)
Contractor has two business units. It accumulates its home office expenses into several centralized costs centers called “homogeneous expense pools” at Business Unit (BU) 1 and allocates them to BU 1 and BU 2 on numerous representative bases. For example, payroll is allocated on a head count base, contract services and accounts receivable on number of contracts, subcontract services on number of subcontracts, new business on number of proposals, travel on number of travel expenses, closing and state income taxes on sales, etc. Also, several other cost centers such as tax accounting, MIS and Outside auditors are allocated to BU 1 and BU 2 based on a three factor formula. In addition, Contractor accumulates costs into three other cost centers considered “residual expenses” and allocates those costs on a three factor formula basis.
Though we have not made an analysis of whether certain costs should be allocated directly to only one of the business units, the type of allocation scheme Contractor uses is certainly compliant with CAS (e.g. CAS 403, Allocation of Home Office Expenses). The government requires indirect costs be accumulated in appropriate groupings and allocated on causal and beneficial bases. The accumulation of costs into various cost centers and the methodology that Contractor has developed for selection of bases certainly conforms to this requirement. Rather, my concern is not one of compliance with CAS but whether Contractor’s methodology involves excess administrative burdens and is vulnerable to government challenges.
According to its most recent disclosure statement, Contractor uses 22 cost centers and 13 allocation bases in addition to its three residual expense pools. Generating complete, accurate and timely data for both the cost centers and bases must be a challenging task. Especially when it is CAS covered but also even when not if the dollar amount is significant, government auditors frequently audit the accuracy of cost pool and base data in both forward pricing and incurred cost proposals and when they conclude it is inaccurate, they often cite contractors for non-compliance with CAS or if not CAS covered, inadequate accounting practices. The existence of so many pools and especially bases makes Contractor particularly vulnerable to such reviews and conclusions. Government assertions of non-compliance and questionable accounting accuracy can certainly affect contract pricing and can even lead to assertions of an inadequate accounting system that can adversely affect obtaining contract and subcontract awards.
CAS 403 does not specify the required number of expense groupings and allocation bases. (We plan to address CAS 403 in depth at a later date.) CAS 403 does provide that each service or management function will be separately identified for allocation purposes so Contractor is certainly compliant here. However, the contractor need not identify and allocate different functions separately if the beneficial or causal relationship is adequately measured by using a common allocation base. The standard cites an example where a home office personnel department (considered a “centralized service function”) and a group that establishes personnel policies (considered a “staff management function”) can use a headcount base and need not be separately identified in separate cost centers.
In practice, if a contractor can demonstrate that less groupings and less bases result in similar allocations, then less groupings and bases may be used. In Contractor’s case, though there may be business reasons to maintain its 22 plus cost centers (e.g. tracking functional costs), it need not maintain so many allocation bases. We have seen companies use 1-3 allocation bases for anywhere from five to 75 cost centers in addition to a residual pool of costs being allocated on a three factor formula. For example, one of our CAS covered professional services clients of comparable size to Contractor who previously used 10 bases to allocate 20 cost center pools proposed using only a headcount base to allocate ten of its cost centers and a three factor formula to allocate the other ten cost centers. It successfully demonstrated that (1) the new scheme resulted in a similar allocation of costs to the old methodology and (2) a headcount was a logical surrogate measurement for the other bases.
I recommend selecting two bases – say, a three factor formula and headcount base. Next, I would allocate the costs in the cost centers utilizing one of the two bases and then conduct a sensitivity analysis to determine if the result of allocating the costs on these two bases was materially different than using the current methodology. If possible, I would use data both from the most current incurred cost period as well as budget data going forward. If the result is materially different, then I would select an additional base that would be easy to track (e.g. number of vendors) and conduct a similar sensitivity analysis. Once the impact is not material from the current method, I would consider how to present the rationale (e.g. the new bases represent accurate surrogate bases) to the government.
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