(Editor’s Note. As part of our on-going series on cost principles, we have addressed not only allowability issues but have also confronted cost allocability problems. Generally, the FAR cost principles in section 31.205 cover whether a cost is to be allowed or not while the cost accounting standards address how a cost can be assigned or allocated to a particular government contract or task order. Consequently, we have decided to expand our coverage of cost principles to include cost accounting standards, particularly those relevant to all government contractors, whether or not they are CAS covered or not. The source of information we have used is the actual cost accounting standards including preambles, several texts such as Mathew Bender’s Accounting for Government Contracts Cost Accounting Standards and the Defense Contract Audit Agency Manual (DCAM)
FAR Coverage
Though many contractors believe CAS 402 becomes an issue only if a contract is CAS covered, the intent of government was to have CAS 402 apply to all contractors, whether or not contracts were CAS covered. Like it has done with several other cost accounting standards, the government included the essence of CAS 402 in FAR. The consistency requirements of CAS 402 is clearly included in the definitions of direct and indirect costs. For example, in the FAR definition of direct costs “…No final cost objective shall have allocated to its as a direct cost any cost, if other costs incurred for the same purpose in like circumstances have been included in any indirect cost pool…” Similar verbiage is included in the definition of an indirect cost. So the following discussion will apply whether your contracts are fully CAS covered, modified CAS covered or subject to the Federal Acquisition Regulation.
Basic Requirement
The fundamental requirement of CAS 402 is that all costs incurred for the same purpose in like circumstances be treated as either direct costs only or indirect costs only, with respect to the final cost objectives. The standard drives home this point by saying (1) a cost cannot be an indirect cost if other costs incurred for the same purpose, in like circumstances, are treated as direct costs and vice versa. Although these requirements are stated in terms of costs incurred, they apply equally to estimates of costs for contract proposals. The consistency requirement addresses only those costs that cross the boundary of direct and indirect – hence, inconsistent treat of costs that remain direct costs or indirect costs is not an issue in CAS 402.
The CAS Board (CASB) required a contractor to (1) disclose its cost accounting practices (2) establish criteria, appropriate to its own situation, for selecting alternative accounting practices and (3) adhere consistently to its choices. If a contractor is required to submit a Disclosure Statement then that is the vehicle by which a contractor describes its criteria for selecting cost accounting practices and the circumstances that determine whether or not types of costs are incurred for the same purpose. If a Disclosure Statement is not required the determination of direct and indirect costs “shall be based upon the contractor’s cost accounting practices used at the time of contract proposal.”
A contractor should carefully consider its criteria for selecting alternative cost accounting practices and for distinguishing between direct and indirect costs. Once these criteria are established, any changes to them are considered changes in accounting practices that are subject to contract price adjustments. Generally contractors make decisions about direct or indirect treatment for costs of categories, activities or functions and to the elements that compose those costs. For example, they should consider under what circumstances are the following costs to be treated as direct or indirect – material, labor, supplies, tooling, equipment rental, depreciation, fringe benefits, travel, contract administration, service and support centers, research and development and bid and proposal. There are no inherent characteristics that exists whether these and other costs should be treated as direct or indirect. Also, once a decision is made, then the contractor must decide how to treat associated costs. For example, if material is to be a direct cost it must decide how to treat the other associated cost elements such as insurance, freight, receiving costs, storeroom, etc. Or for direct labor, are fringe benefits to be direct or indirect.
Definitions
CAS 402 defines six terms – “allocate,” “cost objective,” “direct cost,” “final cost objective,” “indirect cost,” and “indirect cost pool.” Though we will not discuss each definition, a few interesting points emerge.
1. Whereas accounting texts address “allocate” primarily with indirect costs, the CAS Board expanded the meaning to both direct and indirect costs.
2. Since contractors recover direct costs dollar-for-dollar while they recover only a portion of indirect costs on contracts, they are often motivated to charge as much costs as possible directly to the contract, especially if it is government work. In addressing what makes a cost direct, the CASB said neither the nature of the cost (e.g. material, labor, etc.) nor the person performing the work (e.g. indirect person performing direct work) should determine whether a cost is direct or indirect. Rather, the essential relationship must be a “causal/beneficial” one, regardless of the goods or services used. So, for example, if material quantities or a labor task is specifically identified with a particular final cost objective, the costs are direct, regardless of who performs the task.
3. A significant difference in terminology exists in the first sentence of the CASB and FAR definitions of direct costs. The FAR reads “A direct cost is any cost that can be identified specifically with a specific final cost objective” while the CASB substitutes “can be” with “is.” Though the writers of the FAR said no difference of meaning was intended, as the years have gone by auditors are finding a difference in the terminology and are implementing the “can be” aspect of the FAR definition. Whereas the CASB version basically states a direct cost is any cost that the contractor calls direct if it meets the characteristic “identified specifically” criterion, the FAR “can be” terminology has been interpreted to mean if you can make a cost direct, you must do so. This “can be” interpretation has, in practice, been used to provide less flexibility to contractors and greater bases to challenge contractors’ decisions on how to treat costs.
What are “Like Circumstances”
The words in CAS 402 are “costs incurred for the same purposes in like circumstances” but it is not always easy to distinguish like from unlike circumstances. It should be kept in mind that contracting officers and auditors do not look favorably on the use of the following criteria to distinguish “like” from “unlike: (1) government work occurs under circumstances unlike those for commercial work (2) fixed-price contract costs are incurred under circumstances unlike those for cost-reimbursable contracts and (3) costs on government work are treated as direct while costs on commercial work are treated indirect. Though these criteria are not specifically forbidden, contractors can expect to have auditors challenge costs allocated by procedures based on these criteria.
An associated problem is when a new circumstance is a like circumstance. For example, whereas a contractor charged test costs, which were not significant, indirectly and now receives a new contract requiring extensive testing with new equipment having no other foreseeable use. Must these costs be charged indirectly or may they be treated as a direct cost? If direct, is this a change or is it a new cost accounting practice for a situation not covered before?
Keep in mind the contractor needs to package the supporting rationale for identifying unlike circumstances. For example, a common rationale for unlike circumstances is if costs are over and above those had there been no contract. In assessing whether costs are incurred in like circumstances, you can expect the auditor to review the contract requirements and determine if the effort is different from or in greater scope than the effort might have been absent the new contract.
Materiality
Immaterial direct costs may be treated as indirect costs. CAS puts three conditions for treating immaterial direct costs as indirect: (1) the cost is a minor dollar amount (2) the accounting treatment for the cost is consistently applied for all final cost objectives and (3) the treatment produces results that are substantially the same as those obtained had the cost been treated as a direct cost. Neither the standard nor DCAA audit guidance establishes what is considered “immaterial” but in practice we usually see DCAA accept as immaterial amounts representing less than 2% of total indirect costs and they will rarely accepts as immaterial anything greater than 5% of total indirect costs. Between 2-5 percent, it will largely depend on the individual auditor’s judgment.
Contract Terminations
Though CAS 402 requires a contractor to classify consistently all costs in like circumstances as either direct or indirect, termination regulations permit contractors to treat otherwise indirect costs as direct for purposes of computing allowable termination costs. To resolve this obvious inconsistency, the government has maintained that terminations result in circumstances that are not “like circumstances.” However, if treatment of costs between different termination claims are different, then the contractor will be cited for a CAS 402 violation.
Use of Advance Agreements
When inconsistent practices and inequitable allocations exist, it would seem that contractors need to change their cost accounting practices. However, there is an alternative. Though CAS 402 does not address it, certain standards (e.g. 403, 410, 418 and 420) provide for special allocations under unique situations and FAR 31.109 recognizes that special treatments under advance agreement are permissible which can apply to CAS 402. An advance agreement would apply only in those situations which are unique to one contract. If the most equitable way to deal with a costing issue for a specific contract is to treat a particular cost as direct for this contract but to treat those costs as indirect for all other contracts an advance agreement can be used. However, the agreement must give assurance that it does not permit double counting (discussed below).
Sometimes Direct, Sometimes Indirect
When addressing whether specific costs are treated direct or indirect, the CAS Disclosure Statement has a classification of “sometimes direct/sometimes indirect.” It is clear the CASB did not favor continual changing of cost treatment with each new contract so it established this category. Generally it depends upon how the contractor defines the structure of its cost accounting system. For example, a contractor has a computer center charged out based on usage. When a contract requires computer services, it is charged for those services as a direct cost of the contract; when the computer service center performs work for the finance function, the charges for the services flow to the G&A pool and become an indirect cost. Likewise, a contractor might define all material and supplies in an undifferentiated category where those that are identified with a contract are direct while those that are immaterial in amount or used for overhead or G&A activities are included in those pools as an indirect cost. The requirement of consistency is achieved not by whether the cost flows as a direct cost to a contract or to an indirect cost pool but in the manner of charging work performed. In the case of the computer service, a charge was determined for all work performed and that charge was assessed against the customer for work – if the customer is direct the cost is direct and if the customer is indirect, the cost is indirect. The underlying essential ingredient is the beneficial/causal relationship existing between the activity/task and the cost objective to which the cost flows.
Proposal Costs – Interpretation No. 1
The CAS Board clarified conditions under which a contractor can charge proposal costs, both direct and indirect, without violating CAS 402. The interpretation concluded that not all proposal costs are incurred in like circumstances – costs of preparing a proposal pursuant to a specific requirement of an existing contract, which can be charged specifically to that contract, was considered to be different circumstances from those which are not required by that contract, which can be charged indirect. Interestingly, the interpretation does not preclude the indirect allocation of costs incurred in preparing all proposals, thus permitting contractors to allocate indirectly those proposal costs that are permitted to be charged direct.
Examples from the Standard
1. Contractor normally allocates all travel as an indirect cost and for a new proposal, contractor intends to allocate travel costs of direct labor directly to the contract. Answer. Since travel cost of direct labor working on other contracts are charged indirectly, their costs must no longer be charged indirect since the costs are incurred for the same purpose.
2. Special tooling costs are allocated directly to contracts while costs of general purpose tooling costs are normally included in the indirect cost pool. Answer. This is considered compliant since both types of costs were not incurred for the same purpose.
3. Contractor proposes to perform a contract requiring three fireman on a 24-hour duty at a fixed post to provide protection for flammable materials used on the contract. Contractor also maintains a firefighting force of 10 for general protection of the plant. Contractor wants to charge the three firemen direct to the contract and the 10 indirect. Answer. This is compliant providing in its disclosed practices the contractor indicates that the costs of the three special firemen serve different purposes than the general firefighting force charged indirect. (Editor’s Note. One might argue that the purposes are the same but the circumstances are different but the CAS Board chose to call attention to different purposes so this should be remembered as the basis for distinguishing the difference when justifying different treatment.)
Examples from the DCAA Contract Audit Manual
1. A contract requires extra effort for planning and cost management where it hired extra people and wants to direct charge them to the contract. The contractor has other people performing the same functions for more than one contract where their labor is charged indirect. Answer. Since the work being performed is the same and the only difference is in the amount of effort required, this practice would not comply with CAS 402. The contractor must either (1) charge all of these costs indirect or (2) direct charge all of these costs. (Editor’s Note. The Bender text states if the extra effort is really a different effort but the contractor classifies it as planning and cost management then the extra effort may be treated as a direct cost. This is because the different effort is unique to the contract and is not performed for other contracts.)
2. A contractor has hundreds of cranes located throughout the shipyard where their maintenance, taxes and depreciation costs are recorded in a general account and allocated to department overhead pools. The Dry Dock has the cost of eight cranes charged directly to its department overhead pool because their use is unique to Dry Dock operations. Answer. Since the Dry Dock cranes are used for special purposes and the Yard cranes for general, this practice does not result in “double counting” i.e. direct charging a contract costs normally charged indirect and then allocating to the contract a portion of the remaining indirect costs. However, if any of the Yard cranes are also used for special purposes (e.g. new ship construction) the practice would result in double counting. In this case, the special purpose cranes need to be eliminated from the general account and charged directly to the using department.
Other Examples
1. The aircraft service center costs are charged to contracts based on pilot flight time. If the CEO takes a flight on corporate business not directly related to a contract, no charges are made i.e. the costs remain in the center cost pool. Answer. This is an inconsistency addressed by CAS 402. If the service center costs are charged directly to contracts then the cost pools benefiting from the service center should also be charged so a charge for the CEO’s travel should be made to the G&A expense pool.
2. A contractor has two business units, one in Phoenix and one in Denver. At the Phoenix location all travel costs are charged directly to contracts while in Denver, travel costs are included in appropriate overhead and G&A pools. Answer. This is not a CAS compliance issue because CAS compliance focuses on the business unit level. Therefore, different business units are not required to have the same distinctions for direct and indirect costs.
3. A contractor has two plants in one of its business units. In Plant 1, electricity for the factory is metered to each machine and department where electricity identified with a machine is allocated to contracts on the basis of machine hours while electricity identified to a department is included in the department’s overhead. In Plant 2, the company only meters the amount of electricity to the factory and this electricity is included in the plant-wide overhead. There are no overhead pools allocated to both plants. Answer. CAS 402 would cover this since there is only one business unit but since there is not an inconsistency between direct and indirect classifications (the inconsistency is the difference in accounting for indirect costs between the two plants) there is no CAS 402 noncompliance.
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