(Editor’s Note. For a lot of good reasons, we have seen significant growth in companies forming teaming arrangements and creating new business units within existing firms to pursue government contracting opportunities. We addressed some of the issues in forming these arrangements and selling them to the government in a recent article (DIGEST Q307) where we have received several questions relating to cost issues of these arrangements (not surprising since that is our specialty) so we decided to present an updated version of a piece we wrote several years ago.)
A joint venture is really a legal entity separate and apart from the co-venturers. This entity, which may be a corporation or partnership, is jointly owned and managed by the co-venturers. Common reasons joint ventures are formed include the need to (1) augment a contractor’s expertise and capabilities (2) access critical proprietary technology controlled by others (3) keep costs down by using lower cost partners (4) pool financial resources to meet up-front investments (5) gain greater geographic reach to maximize political support and (6) meet customer preferences (e.g. favored firms). Important topics such as the structure of the venture (e.g. corporation vs. partnership), parties’ respective shares, management structure, key activities, responsibilities and disclosure and use of technical data and software are usually expressed in a joint venture agreement.
A new business unit, which we will call a “strategic business unit” (SBU), is a segment of a corporation where the parent of one organization has control over its operations. When it has the financial and technical wherewithal to do so, a contractor will commonly create an SBU where there is a need to (1) limit financial, tax or legal liability (2) create a self-contained, “lean and mean” organization focused on one program or contract (3) insulate the rest of the company from onerous government rules or (4) eliminate or reduce general and administrative or other indirect expense allocations to allow for greater price competitiveness.
Though legal and business reasons often largely determine the particular type of arrangement, government contractors creating these new entities need to be aware of the accounting, cost allowability and cost allocability issues affecting their creation. The Federal Acquisition Regulations, particularly the cost principles of Part 31, does not separately address cost allowability under contracts performed by joint ventures or SBUs. Rather it is necessary to identify those cost principles that most affect “covered” contracts.
Organization Costs (FAR 31.205-27). This cost principle makes costs unallowable that are in connection with the “organization or reorganization” of the “corporate structure” of a business. Unfortunately, these terms are not defined but it would seem this cost principle would apply to the organization of a corporate joint venture or corporate subsidiary SBU. On the other hand, costs related to other organizations that do not change the “corporate structure” or alter the rights of security holders would be allowable if reasonable in amount. These would include a partnership joint venture or an unincorporated SBU.
Individual DCAA auditors may attempt to take a more expansive view making costs of all joint ventures and SBUs unallowable but they should be reminded of the distinctions above that affect the corporate structure and those that do not. Some may also argue that such organization costs are unallowable because they bear no relationship to the work of the contractor under government contracts. This rationale would be clearly inappropriate when formation of these new arrangements help the contractor compete for and perform their government contracts more effectively and efficiently.
IR&D & B&P Costs (FAR 31.205-18). Changes to the FAR 31.205-18) in the 1990’s and subsequent changes to the DCAA Contract Audit Manual (71707a) have made IR&D costs in support of cooperative arrangements (of which joint ventures are explicitly included) allowable. Contractors should be assured that effort qualifying as IR&D in the absence of a joint venture will qualify when incurred in behalf of a joint venture.
Interorganizational Transfers (FAR 31.205-26). A joint venture or SBU commonly purchases materials, supplies, and services from its co-venturers/parent and such recovery is limited by this “Material Costs” regulation. The cost principle allows transfers at price (including profit) rather than cost only when (1) it is the established practice of the transferring organization to price its interorganizational transfers at other than cost (2) the item being transferred qualifies for an exemption under FAR 15.804-1 (e.g. established catalog or market prices, commercial item) and (3) the CO has not determined the price to be unreasonable.
Rental Costs (FAR 31.205-36). To the extent a joint venture or SBU leases real or personal property, the rental charges will likely be limited to the “normal costs of ownership” – depreciation, taxes, insurance, facilities capital cost of money and maintenance. The only exception to this rule is for personal property leased from a related organization that has an established practice of leasing the same type of property to unaffiliated entities.
Legal and Other Proceedings Costs (FAR 31.20547). This is the only cost principle that expressly addresses joint ventures. The principle disallows the costs of litigation between co-venturers unless the disputed agreement or actions are incurred as a result of compliance with specific terms and conditions of the contract or written instructions from the CO. Disallowed costs include not only outside lawyers and consultants but also the directly associated in-house management, accounting, administrative and clerical personnel costs.
One important reason contractors want to create joint ventures and SBUs is to have the opportunity to allocate either more or less costs to the entity. Whether the new entity is or is not a “segment” of the coventurers often determines what costs can be allocated. For example, a segment will receive both direct costs (e.g. interorganizational transfers for goods or services) and indirect charges such as indirect service center costs based on usage (e.g. occupancy, data processing) and residual home office costs. If the joint venture is not considered a segment, it would not qualify for such home office allocations.
Are joint ventures and SBUs segments? For joint ventures, the CAS definition of “segment” is broad enough to give contractors a great deal of flexibility to make their own determinations that will help them meet their cost allocation needs. The definition of a “segment” (CAS 403-30(a)) includes a joint venture where an organization exercises control. But since most joint ventures consist of joint control, the definition does not clearly apply. On the other hand, if a “segment” determination is desirable, another section of the CAS (403-50(e)) provides a broader definition that allows a home office allocation where control is absent but performs certain functions to justify a home office allocation.
An SBU is more clearly a “segment” since it is typically a subdivision of an organization controlled by a home office. However, when an SBU is essentially a “paper entity” without its own employees, assets or liabilities and no direct responsibility for contract performance (e.g. all work is subcontracted out to other organizations), then it is unlikely a segment.
If the entity is a segment, the co-venturers/parent entities have flexibility in allocating indirect costs to joint ventures and SBUs by either following their established practices for indirect cost allocation or adopting a “special allocation.” For example, an organization may track or estimate the costs of services provided by the home office to the joint venture and remove those costs from the pool and allocate them to the segment. Further flexibility is allowed when the entity has unequal ownership, providing the minority contractor the option of allocating its residual home office costs the joint venture or electing not to do so.
Practically, it should be noted that special allocations need advanced approval by the CO which often encounters delay for pricing proposals. Contractors might price the proposal using the special allocation method assuming approval before contract award and if later not approved, the contractor must revert to its established practice resulting in more cost being allocated than planned. Alternatively, the contractor may price the new work using its established practices and to avoid potential defective pricing allegations, will divulge the intent to adopt a special allocation.
When IR&D & B&P costs are incurred before the entity is created, two choices exist: (1) Since no segment exists, the co-venturer/parent is justified in taking the position that IR&D costs should be allocated in the normal manner to other segments with no allocation to the new joint venture/SBU segment. CAS 420.50(e)(2) justifies this position (2) If the segment is established during the same cost accounting period, it can allocate the costs to all segments including the new one. This second alternative runs the risk of not recovering these costs if contract award is not during the same cost accounting period.
CAS 420 dictates that IR&D & B&P costs accumulated at the home office will be allocated to its segments in two steps: first, direct assigning those costs to a specific segment when the costs can be identified with it and then allocating the remaining amount to all other segments in the same way it allocates its residual home office costs. Sometimes when an entity supports only one contract or product line, it may be that ongoing IR&D or B&P costs do not benefit those limited items as much as other segments or at all. When this occurs, they will likely be required (or may be entitled) to seek a special allocation that will allow less home office IR&D/B&P costs to be allocated to the joint venture.
If a joint venture/SBU segment incurs or is assigned IR&D/B&P costs without yet receiving a contract, then it could be accumulating these costs with no vehicle for recovering them. Opportunities for recovery are limited because FAR 31.205-18 and CAS 420.40(f) as well as GAAP usually require current-year expensing. An exception is allowed for deferred IR&D recovery of current expenses but only if it developed a specific product, at its own risk, in anticipation of recovering development costs in the sale of the product and, in addition (1) the total amount of IR&D costs are identifiable (2) the proration of costs are reasonable (3) the contractor had no other government business or if it did, it chose to not allocate IR&D costs to government contracts (except for prorating specific costs) and (4) no costs of current IR&D programs are allocated to government work.
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