(Editor’s Note. The following article is an edited version of a position paper we prepared for a client. Our client asked us to evaluate their indirect rate structure – method of allocating indirect costs to final cost objectives – since they were expecting some of their contracts to become covered by the cost accounting standards (CAS) and wanted to determine if they had potential compliance problems. We decided to present the position paper here because it illustrates many of the issues that contractors need to consider when designing or altering their indirect rate structure, whether or not they are CAS covered. We have disguised our client’s name – calling it “Contractor” - and names of its overhead rates and have eliminated some of the topics addressed in the paper.)
In response to your request, we have evaluated Contractor’s indirect rate structure, identified potential CAS non-compliances and recommended some relatively modest changes.
Contractor currently maintains five separate indirect rates. The current indirect rates are as follows:
General Overhead. This is the primary overhead rate that is applied to Contractor’s primary lines of business such as systems engineering.
Capital Overhead. This rate is used for work requiring a relatively high level of asset utilization where the pool of costs reflect higher facilities, infrastructure and depreciation costs. The rate is applied to certain research and development as well as production projects.
Special Overhead. This rate is used for work where there is a relatively high rate of labor utilization resulting in lower non-direct labor as well as lower facility and equipment costs.
The allocation base for the three overhead pools identified above is a direct labor dollar base consisting of direct labor of individuals assigned to the respective pools, as well as B&P/IR&D labor dollars.
Material and Subcontract Handling. For purchases of direct material, direct subcontract and direct consulting dollars in excess of $50,000, Contractor segregates and accumulates the indirect expenses associated with these purchases (e.g. subcontract administration, purchasing) and allocates these costs on a base consisting of these direct expenses.
General and Administrative (G&A). Contractor’s G&A pool includes expenses related to operating the entire company and includes a prorata share of home office expenses. The allocation base is a modified value-added base consisting of all costs except those costs included in the material and subcontract handling base. Note the G&A base includes direct material, subcontract and consulting expenses that are less than $50,000.
Our conclusion is that Contractor’s current rate structure represents the best alternative for its needs at this time. We believe its current practices should remain in tact and we should focus on ensuring the government accepts your practices.
First, and perhaps most important, your various overhead rates as well as material handling versus G&A rates applied to certain Other Direct Costs (ODCs) provide great pricing flexibility. Contractor’s system allows the company to provide low prices for price sensitive, highly competitive bidding (Special Overhead), profitable yet competitive pricing in its primary lines of business (General Overhead) and higher more profitable pricing in less price sensitive circumstances (Capital Overhead). Its treatment of direct materials, subcontracts and consulting costs allows the company to maintain a healthy G&A rate while still providing opportunities for add-ons to high dollar subcontracts and material purchases when price is based on cost-build ups.
Second, the fact that DCAA has reviewed Contractor’s structure and has not expressed objections is quite positive. We attribute some of this acceptance to having an usually accepting group of auditors and audit office. Many companies with less controversial structures are occasionally challenged on their structures, particularly when new auditors/supervisors take over. Contractor should not assume things will be so accepting if the audit office is consolidated or a different audit team takes over. But be that as it may, DCAA's acceptance of Contractor’s structure means it has an established practice where the burden of change should fall on the government. Also, prior acceptance of Contractor’s current practices should minimize assertions of inadequate allocation practices in the past which should mean little chance of having to prepare onerous cost impact analyses or giving back funds already received.
Third, though open for challenge, I believe Contractor has some solid rationale for its practices. However, we should realize that prior acceptance goes a long way if you are not CAS covered, but new coverage will likely trigger a fresh look at your practices - often different personnel and supervisors are responsible for these determinations.
In the light of my analysis and our preliminary discussions the remaining portion of this report will address three issues:
1. Application of the capital overhead rate to both research and development and production projects.
2. Different treatment of direct material, subcontract and consulting expenses.
3. Potential problems using the special overhead rate
(Editor’s Note. Though too extensive to recount here, we provided a detailed analysis of CAS 418 with particular emphasis on what constitutes “homogeneous” costs. Let it suffice here to define “homogeneous allocation of costs” as making sure the pool of costs, base used to apply them and resulting allocation to contracts are al balanced appropriate and the result is “equitable” where it does not result in a disproportionate allocation of indirect expenses.)
Appropriate Pool
Contractor has established a separate capital overhead rate to apply to all contract effort that utilizes a relatively high level of equipment and facilities assets. The pool represents similar costs of other overhead pools (e.g. indirect costs, fringe benefits, etc.) as well as a higher level of asset-related costs. The asset utilization aspect is the criteria used to apply the capital overhead rate. The indirect costs in the capital overhead pool include a higher level of costs related to certain activities of the company. Some projects of the company, such as certain production and direct research and development effort, utilize a high level of equipment and facilities-related expenses and hence the pool includes relatively high levels of depreciation expenses resulting from capitalized assets, facilities expenses and infrastructure costs. The creation of a separate overhead pool for certain work requiring a high level of asset and facility utilization clearly meets the requirement for a homogeneous indirect cost pool. The costs in the pool (e.g. indirect expenses plus relatively high level of asset and facilities-related expenses) are homogeneous because they have been incurred to support certain types of projects (e.g. those utilizing a high level of asset and facilities-related support).
Conversely, inclusion of these capital asset and facilities-related expenditures in a pool of costs where the direct projects do not utilize those assets would be considered non-homogeneous. If these asset-related expenditures were included in one of the other two overhead pools, the two conditions of non-homogeneity established by the CAS Board would be met: (1) allocating substantial asset-related costs to direct projects not utilizing them represents a non-causal and non-beneficial relationship to final cost objectives and (2) if the costs were allocated separately as they are done under the current system, the allocation to final costs objectives does result in materially different cost allocations. To allocate these asset-related expenses to projects not utilizing a significant amount of the assets would generate an inequitable result.
Appropriate Base
Currently, the type of direct labor used for R&D and production effort varies. Specifically, direct labor required to perform R&D tasks consists of higher paid engineers while production effort is accomplished by lower paid production personnel. Consequently, Contractor is vulnerable to the assertion of non-homogeneity because a disproportionate amount of pool costs are allocated to the higher paid engineering labor. If this disproportionate allocation cannot be justified, then a direct labor hour base (as opposed to direct labor dollar base) may be appropriate. As we discussed, it is probably best to maintain the current practice since it has been used and not challenged for many years. The adoption of an alternative direct labor hour base may represent an acceptable compromise position if the current method is challenged in the future.
CAS 418 and the concept of homogeneous indirect pools also applies to the question of having one or separate indirect rates applied to high and low dollar material, subcontract and consulting (MSC) costs. The obvious question is whether it is appropriate to apply different rates (G&A versus subcontract handling) to seemingly similar costs, differing only in dollar value.
The support costs for MSC activity is not a linear function. That is, each MSC expenditure requires approximately the same level of administrative and supervisory effort no matter what the dollar value of the purchase is. For example, approximately the same level of G&A effort related to subcontract administration, accounting, contracts, establishing technical specifications, purchasing, etc. are required on each subcontract, no matter what the dollar value of the subcontract is. However, applying the same pool of indirect costs to the dollar value of MSCs would result in a disproportionate allocation to higher dollar value MSCs which does not reflect the equal administrative effort required on each MSC purchase.
Allocation of G&A to all other direct costs including low value MSCs is proper, meeting the criteria of homogeneity. However, application of G&A to all MSCs including high dollar ones results in a disproportionate allocation of G&A to those high value MSCs not to mention the fact most contracting officers would not allow a high markup to large ODCs. This disproportionate allocation, which translates into an inequitable allocation of costs to contracts with high dollar MSCs, would render the G&A pool non-homogeneous. The same disproportionate allocation would exist if all MSCs were included in a separate rate – support costs would be disproportionately allocated to higher dollar MSCs. To eliminate this allocation distortion, Contractor has created a separate indirect cost rate for large MSC costs only. This solution significantly reduces the disproportionate allocation of G&A or MSCs support costs to large subcontract costs.
DCAA’s position on CAS 418 provides further justification for continuing the practice Contractor has been following. DCAA calls homogeneity of indirect costs pools a “significant requirement of the standard.” It states that a pool may be considered homogeneous if the separate allocation of costs of dissimilar activities would not result in a materially different allocation of costs to cost objectives. Logically, the opposite would also hold – a pool would be considered not homogeneous if the costs of similar activities would result in a materially different allocation of costs to cost objectives.
However, once Contractor becomes CAS covered, there can be a problem with CAS 410. CAS 410 prescribes three acceptable bases of allocating G&A costs – single element, value added (total costs minus material/subcontracts/consulting) and total cost input. Utilization of a $50,000 threshold represents a modified value added base. When a CAS covered contractor wants to use a base different than the three bases used, it must obtain the approval of the contracting officer. The rationale discussed above would constitute a strong argument for obtaining CO approval of the modified base but keep in mind that a written justification and quantitative cost impact analysis would likely need to be made when Contractor does become CAS covered.
Special Overhead
As we mentioned above, Contractor’s use of a special overhead rate provides an excellent opportunity to offer low bids on highly price-sensitive work. We have discussed the possibility of applying the special overhead rate to other price sensitive work where there is a high level of labor utilization. However, CAS 402 requires consistent treatment of like costs incurred under like circumstances. After discussing the issue with a couple of colleagues, we doubt whether the high labor utilization factor in itself constitutes a justifiable basis (e.g. unlike costs) to create a separate overhead rate.
To counter CAS 402 challenges, other factors need to be put forward. For example, if a contract is expected to utilize a significantly lower level of asset utilization as well as labor utilization then a more plausible justification can be made because unlike circumstances exists. Most persuasively, if the special overhead rate is used on future programs, you need to attempt to ascertain whether the nature of the work is “unlike circumstances.” Examples of unlike circumstances might include a different type of service (e.g. technically, less challenging) or different labor categories performing work (e.g. technicians rather than engineers). Though it could be problematic to justify a separate rate based on the fact the contract is performed at a dedicated facility – auditors can assert that separate locations are not a basis for other work or maybe you should create location-based overhead rates – the separate location on some of the jobs using the special rate could represent additional evidence of “unlike circumstances. As you know, justifying allocation decisions are not based on solid scientific criteria – it is a matter of citing evidence to justify your decision and one of auditor judgment which can vary significantly among different auditors.
The essential requirements of CAS 402 are duplicated in FAR. Consequently, DCAA has had ample time and regulatory justification for challenging use of the special overhead rate, whether or not Contractor was CAS covered. The fact they have not done so provides some optimism that Contractor’s practices will not be challenged when the company becomes CAS covered. However, Contractor needs to be careful on future acquisitions to not utilize the special overhead rate excessively in order to minimize the careful scrutiny of this unique, useful rate.
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