(Editor’s Note. Though the government is required to pay a “fair” price for its products and services, there is considerable effort put into lowering prices paid. One of the most fruitful methods of lowering the price paid is to assert that a given cost allocation method adopted by a contractor should be altered to achieve a more “equitable” (translated – lower) price. We frequently encounter such positions in our consulting practice and when we think the government’s position is wrong, we challenge them. In our ongoing interest to provide our readers with “real life” case studies, we thought we would present the results of a consulting engagement we had to challenge a Defense Contract Audit Agency draft report questioning significant costs on the grounds the expenses were “commercial” and hence not allocable to government contracts. The following presents a highly compressed list of challenges we presented where though every point put forth would likely not apply to your unique circumstances, some most definitely will.)
Background
The company (the contractor is real but we will not divulge the name) creates and sells software and provides IT services to a variety of government and commercial clients as both a prime contractor and subcontractor. The market for its software products and IT services varies. Products originally intended
for the government market sometime become potential and actual sources of commercial business while, conversely, products developed for commercial use often become attractive to its government sector clients. For example, many of its products and IT services originally targeted for the commercial market are included in GSA schedules marketed to the government sector.
In 2005, the company purchased a company that sold software to a variety of commercial companies in the energy field. The company was attractive because its technology could enhance Contractor’s existing line of products and it saw a large potential business in both the commercial and government markets. Though some of the technologies were adapted to Contractor’s existing product line, the product line of the new company was discontinued in 2007 due to significant software problems that could not be fixed. Included in the labor overhead pool are costs associated with the new business line where Contractor chose to capture these costs in three separate accounts to ascertain what its investment was.
DCAA conducted an accounting system audit in early 2006 where it concluded Contractor’s accounting system was “adequate” and provided “a logical and consistent method for allocation of indirect costs to intermediate and final cost objectives.” During earlier incurred cost proposal audits in 2004 and 2005, the company actually proposed creating separate commercial and government rates where DCAA rejected that suggestion, recommending instead that the overhead pool be established on a companywide basis. Contractor agreed not to attempt to segregate overhead between government agencies and commercial customers and subsequently submitted its 2005 Fiscal Year Overhead Submission on a basis which did not distinguish overhead rates based on the class of customer. This was accepted by DCAA.
DCAA’s Position
In its audit of Contractor’s 2006 incurred cost submittal, DCAA eliminated $650,000 of indirect costs from its overhead pool representing the three cost accounts discussed above, asserting these costs were related to “commercial activity.” DCAA also eliminated $75,000 from the overhead labor base asserting these were direct costs associated with the “commercial” contracts of the acquired company. The result of these questioned costs were to reduce Contractor’s overhead rate by over 30 percentage points.
The basis of DCAA’s position was that allocation of about 50% of the firms overhead costs were associated with “commercial activities” of the new product line while the labor base associated with this activity represented only 10% of the total overhead base of direct labor. They asserted the commercial contracts provided little “proportionate benefit” to the government and resulted in an “inequitable” allocation of costs to government contracts. DCAA asserted these costs “represent(s) indirect expenses identified to Contractor’s commercial product lines that are not allocable to government contracts and should be allocated to the commercial contracts through a commercial direct labor base.” Rather, consistent with FAR 31.201-4(b) and 31.203(b) Contractor should create separate indirect rates for its commercial work.
Basis for Disagreeing with DCAA’s Position
1. Contractor’s energy product lines and technologies are not a “commercial product line.” The energy product line is really a family of software products and technologies intended to meet a broad range of needs in both the government and commercial marketplaces. We provided several examples of (1) where the technologies of the new product lines were incorporated into many items of its existing work including several government prime contracts and subcontracts and (2) government contracts were not only envisioned but were being actively pursued with, for example, the Departments of Energy and Defense.
2. The costs questioned are homogeneous with other costs in the overhead pool and do not call for separate overhead rates based on classes of customers. The nature of Contractor’s efforts and processes to develop, sell and produce the products are no different than any of its other products. These same types of costs in support of other product lines and technologies are included in the same overhead pool and allocated on the same direct labor base, thus undermining any rationale to create and maintain separate rates for the energy products by any other criteria including class of customers. Further, the energy product line does not meet the conditions usually associated with establishing separate overhead rates for commercial and government business. Generally, such practices may be encountered at large firms that maintain separate facilities, have distinctly different production processes and produce unique products or services for each marketplace. None of these conditions apply here.
3. The expense incurred on the energy products are related to expanding the sales and cost base of the company as a whole. Even if the energy product line was exclusively commercial there is a long history of court and board decisions that provide a wide range of costs are allowable and allocable to government contracts when they are necessary for operation of the business and contribute to increasing the company’s revenue (Lockheed Aircraft Corp. vs. United States, 375F.2d 786 and TRW Systems Group of TRW, Inc. ASBCA, 11499). The Boards held the prospect of increasing non-government business benefits the contractor’s government contracts by absorbing overhead and G&A in the new contracts. Even when commercial business did not develop, the Board ruled in Data-Design Laboratories (ASBCA 27535) the costs were allocable because the government would have benefited from a reduction in overhead cost had a commercial market developed.
4. The costs questioned are “G&A and IR&D” type expenses. After we presented the cases discussed above DCAA asserted they were irrelevant because the disputed costs were included in the overhead pool while the cases discussed only “G&A and IR&D type expenses.” We disagree with DCAA’s position for two reasons. First, as we have repeatedly asserted and DCAA has not challenged, the costs in question are primarily research and development (e.g. fixing software glitches, researching industry trends) and marketing-type costs (e.g. identifying end user needs) which certainly qualify as “G&A or IR&D type expenses.” The fact Contractor chooses to assign these costs to their overhead rather than the G&A pool does not contradict the fact they are the type of costs addressed by the cases which mostly address IR&D and marketing and sales type costs. We do admit the costs in question could have, and perhaps even should have, been included in the G&A pool rather than the overhead pool. Second, whether the indirect costs are included in the overhead or G&A pool for allocation purposes only makes a difference if a contractor uses the “total input cost” method to allocate G&A. Under these circumstances, the costs are allocated over a broader base. Contractor, however, uses the “value added” method to allocate G&A costs, which excludes subcontract costs and material costs from its base. Therefore, direct labor is the only driver. In other words, the indirect costs in question will be allocated in the same manner whether such costs are included in overhead or G&A.
5. DCAA’s proposed change would contradict its earlier pricing methodology. The pricing of Contractor’s negotiated government contracts and commercial services and products listed on the GSA Schedule were based on its long-standing, established and accepted cost accounting practices. Any retroactive adjustment establishing separate indirect costs pools would have a dramatic effect on the pricing of commercial work, which is the basis for establishing prices on the GSA Schedule. Contractor cannot reprice its existing contracts retroactively.
6. There is a history of acquiescence by DCAA of Contractor’s established accounting practice. We showed that for its 2004 accounting system a review of an indirect rate structure is a basic audit step and should have been reviewed for an accounting system survey. The fact the accounting system was accepted in 2004 does not mean it is irrelevant for a 2006 incurred cost audit – DCAA is now, in 2006, attempting to change a system it previously (in 2004) accepted.
(Editor’s Note. In the past, we have successfully put forth the equitable estoppel argument. The principle, supported by many court and board decisions, will not permit a retroactive disallowance of costs when the contractor can show that it reasonably relied on the government’s prior conduct especially when it can show a history of acquiescence or approval of a particular cost accounting practice by the government which is the case here. However, recent cases have established that the hurdle for asserting the equitable estopple argument is significantly higher where now the Contractor must show the existence of bad faith on the part of the government in addition to the other conditions.)
7. We disagree with DCAA’s references to FAR 31.2014 and FAR 31.203(b) as grounds for disallowing the costs. FAR 31.201-4 provides that one of three conditions be met in determining whether a cost is allocable to a government contract – as a direct cost or an indirect cost either as a cost that benefits more than one contract or is necessary for the overall operation of the business. The costs being questioned by DCAA certainly are necessary for the overall operation of the business. As for DCAA’s observation that the direct costs of the energy product labor represents only 10 percent of Contractor’s direct labor base, this is perfectly consistent with the nature of most R&D expenditures – the indirect labor is expended first in order to develop the product and then once the product is viable, revenue and direct costs are realized. DCAA has inappropriately taken the normal expenditure sequence of developing products to be indications of a misallocation of costs to government contracts.
Whereas FAR 31.203(b) provides general guidelines in grouping indirect costs (i.e. logical groupings such as manufacturing overhead and G&A, selecting an appropriate distribution base) there is no suggestion that overhead pools should be grouped by customer type. It is simply too great a stretch to reference this FAR section as providing support for distinguishing commercial versus government costs and then advocating that separate rates be established.
8. Adopting DCAA’s position would violate certain other government accounting requirements. For example, FAR 31.203, which DCAA cites part (b) of that section in support of its position, fails to consider section (c) which prohibits fragmenting the base – “once an appropriate base for distributing indirect costs has been accepted, it shall not be fragmented by removing individual elements.” DCAA has fragmented the base and attempted to retroactively establish indirect cost pools based on the type of customer rather than considering the operational nature of the work.
Though Contractor is not CAS covered, the cost accounting standards are instructive. It should be noted that there would be a violation of CAS 401 (consistency of how costs are proposed , accumulated and reported) because DCAA’s proposed retroactive establishment of separate rates would confl ict with the manner in which it proposed prices on its prior contracts including its prices used on the GSA schedule. Further, CAS 418 provides that indirect costs shall be accumulated in indirect cost pools, which are “homogeneous.” The Standard provides in part: “An indirect cost is homogeneous if each significant activity whose costs are included therein has the same or a similar beneficial or causal relationship to the cost objectives as the other activities whose costs are included in the cost pool.” (underscored for emphasis). Contractor’s overhead pool is homogeneous. The elements included in its overhead pool, for the most part, have the same or similar beneficial or causal relationships. As stated above, Contractor is a laborintensive business and the support costs are similar for both government agencies and commercial customers. Contractor’s employees are not assigned by class of customers and they work on both government and commercial contracts.
9. DCAA misinterprets the concept of “benefit”. DCAA’s allusion to Contractor’s practices not providing “benefit” to the government resulting in an “inequitable” allocation of costs indicates they are unaware of a seminal case – Boeing North American, Inc. v. Roche, 282 F.3d.1320. That case ruled “the word ‘benefit’ as used in FAR 31.201-4, refers to an accounting concept and does not impose a separate requirement that a cost benefit the government’s interest for the cost to be allowable.” The case held the concept of “benefit” used in FAR 31.201-4 refers only to an accounting concept which describes the “nexus” required between the cost and the contract to which it is allocated. The Court held “the requirement of a ‘benefit’ to a government contract is not designed to permit…an amorphous inquiry into whether a particular cost suffi ciently benefits the government so that the cost should be allowable.”
We are waiting to hear DCAA’s response.
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