(Editor’s Note. The following article continues our practice of presenting real life situations from our consulting practice. It is a highly edited opinion memo addressing a possible challenge toa government’s insistence that a company alter its indirect rate structure by creating two overhead rates after it added another facility (Many of the original memo’s references to FAR,CAS, Cases and even DCAA guidelines are highly abbreviated here.). Though the circumstances are not likely tobe duplicated by others, the regulation citations and arguments put forth by the government and ourselves should be instructive We were aided in this memo by Len Birnbaum of Birnbaum and Associates, a renowned consultant and attorney in contract costing issues who happens to be a member of our “Ask the Experts” board.)
Background
Contractor has two facilities. In Facility 1, employees predominately engage in research and development, program management, contract administration and general and administrative activities. Prior to 2008, this is where the contractor conducted all of its operations since the company’s inception twenty years earlier. Facility 2, started in 2008, is dedicated to manufacturing operations. The company has always used one overhead rate. Since Facility 2 is new, it incurs a significant portion of the company’s depreciation expenses. It also incurs abut 86% of the firms direct labor which is the base in which overhead costs are allocated.
Adult Position
A large cost type research and development proposal with the Department of Energy triggered an audit by DCAA DCAA’s position is that the current method of allocating overhead expenses (particularly depreciation expenses) cause developmental contracts to absorb a disproportionate amount of indirect costs since the direct labor is incurred primarily in Facility 1 whereas the bulk of depreciation expense is incurred in Facility 2. The current system results in an “inequitable” distribution of costs where there is no “causal/beneficial relationships between the indirect expense and the direct labor activity.” Consequently, the contractor should be required to segregate its overhead expenses into two separate “homogeneous expense pools” at each facility starting in fiscal year 2010.
DCAA cites FAR 31.203(b) and 31.203(d) in support of its position. The relevant sections in FAR 31.203(b)states “Indirect costs shall be accumulated by logical cost groupings with due consideration of the reasons for incurring such costs. Each grouping should be determined so as to permit distribution of the grouping on the basis of the benefits accruing to the several cost objectives…The base should be selected so as to permit allocation of the groupings on the basis of the benefits accruing to the several cost objectives.” FAR 31.203(d)states that the cost accounting standards should govern if a contractor is CAS covered and otherwise, generally accepted accounting principles (GAAP) should dictate accounting treatment. The method of allocating indirect costs may require examination when (1)“substantial differences occur between the cost patterns of work under the contract and the contractor’s other work (2) significant changes occur in the nature of the business, extent of subcontracting, fixed-asset improvement programs, inventories, volume of sales and production, manufacturing process, the contractor’s products or other relevant circumstances or (3) indirect cost groupings developed for a contractor’s primary location are applied to offsite locations. Separate cost groupings for costs allocable to offsite locations maybe necessary to permit equitable distribution of costs on the basis of the benefits accruing to the several cost objectives.”
Our Response
Assessment of the Facts. The contractor conducted its manufacturing operation at both facilities during FY 2008 and in the second quarter of 2009, it moved most of its manufacturing operations to Facility 2. While Facility 1 is designed for R&D effort going forward, Facility 2 includes both manufacturing and R&D effort. The contractor’s DOE contract requires a manufacturing facility to qualify for award. This contract identify tasks that specify process, product and performance improvements of manufacturing operations and products. These tasks cannot be accomplished in Facility 1 since it does not have the requisite manufacturing capability. Therefore, there is a direct relationship between the indirect expense and labor activity since the developmental DOE contract is conducted at Facility 2. Consequently, these expenses should be included in one cumulative overhead rate calculation as proposed.
Response to DCAA’s FAR Citations. DCAA’s recommendations infer that FAR 31.203(b) and FAR31.203(d) supports its position that in order for an expense pool to be homogeneous separate pools must be created. This is not correct. First, the cited regulations do not use the term “homogeneous expense pools” nor do they state separate manufacturing pools must be established for each location. FAR 31.203(b) provides, in part, “the base should be selected so as to permit allocation of the grouping on the basis of the benefits accruing to the several cost objectives.” Though FAR 31.203(d)provides that multiple overhead rates may be adopted, there is no stipulation they must be created. Further, GAAP does not address the number of overhead pools that need to be created.
Though the contractor is not CAS covered CAS 418 nonetheless does provide useful guidance with respect to defining homogeneous indirect cost pools. An authoritative text (Accounting for Government Contracts, Cost Accounting Standards by Lane Anderson) states that in assessing the homogeneity of an indirect expense pool, the following four things must be considered:
1. The cost in the pools should represent activities having commonality of purpose.
3. The allocation base should have a direct causal relationship to the costs in the pool and to the cost objectives.
4. Diversity of products (final cost objectives)should be minimal for each cost pool.
The contractor’s use of a single overhead rate is in conformance with these four requirements. (We omit the analysis of the assertions here.)
The Cost Accounting Standards Board, Summary of Objectives, Policies and Concepts (May 1992) is instructive here. The Board states that homogeneity is a matter of degree. Homogeneity exists if the costsor functions allocated by a single base have the same or similar relationship to the cost objectives for which the functions are formed.
Finally there is also a seminal case that is relevant here. The Armed Services Board of Contract Appeals in Litton Systems Inc. Guidance and Controls Systems Division(ASBCA No. 37131) resolved homogeneous pool issues of a major contractor that used a composite overhead pool for two divisions in different geographic areas. The Board stated “the standard does not mention the location of cost incurrence as a relevant factor, nor is it relevant from a purely conceptual view…Nothing in CAS 418 or any other Standard indicates that location of facilities or cost levels of operation has any effect on the characteristics of homogeneity of indirect cost pools as described in CAS 418.50(b)(1).”
Our conclusion is that use of a single overhead rate conforms to regulations, authoritative reference material and case law.
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