(Editor’s Note. We have received numerous inquiries and have had several consulting engagements recently where contractors wanted to change their G&A total cost input base to a value added one. Continuing our practice of illustrating a cost allowability or allocation issue using a real life situation, we will address the change from the perspective of challenging the Defense Contract Audit Agency’s rejection of a proposed change that was prepared by a colleague of ours Len Birnbaum of Leonard Birnbaum & Company, LLP in defense of his client. Len is a member of our “Ask the Experts” panel where subscribers can email cost, pricing and contracts questions and have a member of our panel respond at no charge.)
Background
Len conducted a thorough review of his client’s accounting practices and provided a position paper recommending Contractor (we will use “Contractor” in place of the actual firm) revise its G&A rate calculation using the value-added method rather than the total cost input (TCI) method. Contractor incorporated the new method in its forward pricing rates and continued to do so for the next four years.
In its draft audit report of Contractor’s forward pricing proposal four years after the change, DCAA rejected Contractor’s change from a TCI to a value added base(total costs excluding material and subcontract expenses) to allocate general and administrative costs. DCAA’s position was the “abrupt” change would “adversely impact the allocation of G&A expense to existing cost reimbursable contracts.” Acknowledging that FAR 31.203 (Contractor was not covered by the cost accounting standards) does not specifically require a total cost allocation base be used to allocate G&A expenses, DCAA cites FAR 31.203(c) in defense of its position stating “once an allocation base has been accepted it shall not be fragmented by removing individual elements.” Contractor asked Len to prepare a response to DCAA that would be incorporated in the “Contractor’s Reaction” section of the report.
Distortion of Allocating G&A Expense
In its response, Len summarized his early position paper, asserting the value-added cost base isappropriate when inclusion of material and subcontractor costs would significantly distort the allocation of the G&A expense pool in relation to benefits received. The breakdown of direct labor and direct materials/subcontractors was:
Based on the above, the use of the total cost input method for allocating G&A expense would result in a gross distortion of such expense. First, 72% of the G&A type expense, based on the combined value of direct material/subcontractors and direct labor would be allocated to material and subcontractor costs which would not produce realistic results. The unrealistic results stem from the nature of G&A expenses which is closely associated with managing personnel and manufacturing operations as well as research and development rather than materials and subcontractors. Second, if each dollar of material is considered equivalent to each dollar of labor this would also result in a gross distortion in the allocation of G&A type expenses between the R&D contracts and manufacturing operations.
• Fragmenting the Base
As to DCAA’s assertion the change will “fragment the base” a change in the method of allocation is not the same as “fragmentation.” As FAR 31.208(c) suggests, fragmentation refers to the elimination of a portion of the cost input base (e.g. unallowable costs that are normally part of the base should remain in the base).If DCAA’s logic is accepted, then a contractor, not withstanding major changes in its operations, would never be allowed to make a change in the method of allocating indirect costs. In other words, once a contractor adopts an accounting method it would be required to use that method in perpetuity – an obviously incorrect result. FAR 31.203(d) provides that the method of allocating indirect costs may require reexamination (i.e. change) when (1) substantial differences occur between the cost patterns of work under the contract and the contractor’s other work and(2) significant changes occur in the nature of the business, the extent of subcontracting, fixed asset improvement programs, inventories, the volume of sales and production manufacturing processes, the contractor’s products and other circumstances.
In Contractor’s case, in the past 10 years it has changed from a pure engineering firm into both an R&D and manufacturing company and its sales volume has increased from $3 million to $70 million. It is true that Contractor’s G&A expenses should be allocated on a base representing its total activity but considering its operations, total activity is best reflected by direct labor and manufacturing overhead. The inclusion of raw materials and subcontract costs in the base produces a gross distortion in activity because as we have seen above, each dollar of material under the TCI method is considered equivalent to each dollar of labor and overhead.
• CAS 410 and the Ford Case
Though Contractor is not CAS covered, the guidance included in CAS 410, Allocating G&A expenses, and associated cases are helpful for illuminating the meaning of total activity. The justification of the use of a value added method in lieu of a TCI method is best illustrated in a classic case, Ford Aerospace and Communications (Aerospace and Communications Corporation Inc. Aeronautic Division, ASBCA 23883). In that case, it was noted the CAS Board in its prefactory comments to CAS 410 stated that “total activity” refers to the production of goods and services during the cost accounting period. It includes material, subcontracts, labor and overhead. In the Ford case, the government maintained that by omitting materials and subcontracts (i.e. using the value-added base) this would result in an inaccurate measure of total activity. The Board rejected this position. Though it noted material and subcontract costs can be “includible in total activity” it is fallacious to conclude “each dollar expended for materials and subcontracts necessarily bears the same relationship to incurrence of G&A expenses as each dollar of labor and overhead.” To the contrary, the total cost of each element comprising total activity “may or may not best represent total activity depending on the circumstances of each business unit. The crucial question is not what activity elements may comprise total activity, but what best represents total activity.”
CAS 410 does not establish a preference for the TCI method. Rather, CAS 410 expressly authorizes three cost input allocation methods (i.e. TCI, value added or a single element representing total activity) and leaves the selection to be based on individual circumstances of the company. In deciding that Ford was entitled to use the value-added method, the Board cited two primary reasons:
This is equally true with respect to Contractor’s operations.
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