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Special Allocations

(Editor’s Note. Judicious use of special allocations providesan important tool to create pricing flexibility on specific contracts. We have addressed the issue of special allocations in the past but in working with several clients to establish and get them approved we have confronted many administrative problems. Since both contractors and government officials are usually unfamiliar with special allocations, we thought it would be a good time to both review the basic requirements and address some of the administrative issues such as when is it appropriate to use, is it considered to be an accounting change, disclosure requirements, is it limited to one contract, timing of its negotiation and who should approve it. We have used a recent article by Karen Manos of the law firm of Dickson, Dunn and Crutcher in the September 2011 issue of CPA Report as our primary source. Though Ms. Manos explicitly deals with the subject from the perspective of what the cost accounting standards say we believe most of the insights apply to

Basic Requirements

The topic of special allocations is addressed in four cost accounting standards – CAS 403, allocation of home office expenses, CAS 410, allocation of segments general and administrative costs, CAS 418,treatment of direct versus indirect costs and CAS 420, treatment of independent research and development/bid and proposal costs. So the explicit coverage in the CAS covers a great many types of costs.

The CAS emphasizes consistency, all four standards recognize the need on occasion to adopt a special allocation to achieve a more equitable result – a method different than that normally used - and they prescribe the same technique for applying it. A special allocation occurs where a certain amount of costs are taken from the normal pool of allocated costs and assigned directly to a specific segment or contract. When this occurs the special allocation amount is subtracted from the indirect cost pool and the amount of the allocation base for the contract is subtracted from the indirect cost pool base. So, for example, if a normal G&A rate includes $100,000 in the pool and$1,000,000 in the base and $20,000 of the pool is a special allocation for Contract A where Contract Ahas a total cost base of $50,000 then the remaining pool and base of costs for calculating the new G&A rate is $80,000 ($100K minus $20K) and the base is$950,000 ($1 million minus $50K). The new G&A rate is not applied to Contract A under a special allocation.

Sometimes a special allocation is confused with a direct allocation where, in fact, there is a big difference. When there is a direct allocation, that allocation is assigned to Contract B and the resulting G&A rate is applied to all contracts including Contract B whereas under a special allocation, the new G&A rate would be charged to all contracts except Contract B.

One other basic concept is that under three of the standards – CAS 403, 418 and 420 – a special allocation is permitted when an allocation using the contractor’s normal indirect cost allocation method produces inequitable results whereas under CAS 410a special allocation is required.

Examples of Circumstances When A Special Allocation May be called for.

Several of the standards as well as the FAR, DCAA and DOD CAS Working Papers provide illustrations of when a special allocation is warranted. Below are some examples.

CAS 403. A special allocation of residual home office costs (the remaining amount after direct and indirect methods have been applied) may be called for when a specific segment receives more or less that may occur when a contractor uses is normal way to allocate such costs (e.g. three factor formula). Foreign subsidiaries, government owned contractor operated or domestic subsidiaries with less than a majority ownership are examples where a special allocation may be called for. Indications where special allocations may be desirable is when different uses of home office services or size affects the equitability of allocating the residual pool. A special allocation may apply when, for example, a segment performs on its own many of the functions that are included in the residual pool or conversely, unlike the other segments, it may have an unusually high reliance on the home office services. Another indication is where due to its small size it may have little to no allocation of costs or due to its large size, may have an inequitably large allocation.

CAS 410. This standard requires use of a special allocation for G&A costs when a particular contract receives more or less of its fair share using normal G&A allocation. An example in the standard calling for a special allocation is when there is a total cost input G&A base for a construction firm that receives an unusually high amount of equipment and vehicles in addition to its normal construction costs. Or, under the same TCI base, a contract incurs an unusual amount of subcontract or material costs where others do not then a special allocation may be needed.

CAS 418. CAS 418 is kind of a catch all standard that covers allocation of costs not covered in the other standards. Though the standard does not provide illustrations, the FAR 31.203(d)(1)-(d)(3) provides numerous example of circumstances where a special allocation may be called for such as significant changes in the nature of the business, extent of subcontracting fixed asset improvement programs, inventories, volume of sales and production, manufacturing processes, contractor products or existence of off-site locations.

CAS 420. An inequitable allocation of IR&D/B&P may occur at the segment or contract level where a special allocation may be called for. The standard cites a circumstance where a segment may not receive any IR&D benefit while the allocation scheme of the home office costs call for allocations to all segments where the special allocation would occur by eliminating the non-benefitting segment(s). Though the standard does not provide an example, Ms. Manos states that circumstances applicable to a business unit’s G&A expenses may apply to IR&D/B&P costs.

Is a Special Allocation a cost cutting Change

Whereas CAS covered contractors are often required to go through burdensome steps when an accounting changes occurs, non-CAS covered contractors are often required to go through similar actions (e.g. communications with the government, reasons and justification for changes, cost impacts on relevant contracts, etc.). Ms. Manos states that neither the illustrations of what constitutes a change found at CAS 9903.302-3 nor the regulatory history suggests the CAS Board ever intended a special allocation to be an accounting change. The author cites two cases that confirm this assertion.

Is Disclosure of a Change Required

The author states because a special allocation is not considered an accounting change then no change to disclosed practices should be required. She presents arguments why no such disclosure should be required. Nonetheless, DCAA takes the position that a special allocation must be described in at least a CAS Disclosure Statement, which the DOD CAS Work in Papers agreed to, where failure to do so constitutes an inadequate description of practices.

Can a Special Allocation be Applied to More than One Contract

Disclosure Statement section 4.5.0, Application of Overhead and G&A Rates, provides for recurring special allocations so the author states it is “self evident” that more than one contract may be subject to a class of transactions and cost elements where a special allocation is applied. The author argues that Working Group Item 78-21 addresses a “class of contracts” and that the standards do not place an expressed limitation to the number of special allocations. Nonetheless, at some point, the absolute limit may indicate the need to revise the indirect cost pool or base.

What is the Timing for Negotiating a Special Allocation

Normally, if a special allocation is necessary for a given contract then ideally it should be negotiated as part of the contract price. However, since it is not an accounting change there is no limitation in FAR30.603-2(d)(3) to provide retroactive changes. Neither the FAR nor CAS provide any guidance on the timing of negotiation of a special allocation. Even the provisions in FAR 31.109 covering advance agreements state they should be negotiated before costs are incurred but not that they must be.

What official Should Approve the Special Allocation

Normally the cognizant agency official – the administrative contracting officer – is responsible for CAS administration matters. But since the special allocation affects the pricing of a contract and does not constitute an accounting change the author states the procuring official of the impacted contract, as opposed to the ACO, is the most appropriate official to approve a special allocation. The author points out that the AM General case substantiated this position.