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Material Overhead Rate — Off and On

Back to the recent Armed Services Board of Contract Appeals (ASBCA) Technology Systems, Inc. (TSI) (ASBCA 59577 and the nine areas I believe are worth discussing:

  1. Supporting Material Overhead rate
  2. DCAA Auditor independence
  3. DCAA’s right to change their mind in subsequent audits
  4. Tax vs. Book on depreciation issues
  5. Bonuses
  6. Accrued Costs crossing fiscal year
  7. Unapproved subcontractors
  8. An excellent example of DCAA properly developing findings.
  9. Documenting consultants work product

I talked about unapproved contractors in the last article and today I am going to look at item one: Supporting Material Overhead rate. Again, I am not a lawyer and this is not legal advice.

The material overhead rate did not actually end up as part of this case only because the second DCAA auditor did not pursue it. TSI proposed a material overhead rate of 1.05% that the first DCAA auditor recommended be 100% disallowed while the second auditor accepted the rate. TSI alleged that the first auditor “had it in” for them and we will discuss the minimal discussion on DCAA auditor independence later.

Almost all of this article is speculative on my part and should not be taken to represent what actually occurred, but when I got the page where the initial DCAA auditor rejected all of the material overhead rate I thought “Crap, that has been a long time coming”. When I saw that DCAA backed off in the second stab at the audit, I breathed a sigh of relief and thought, “Not this time”.

Two Sides of the Circle or Contractors with Multiple Government Bosses

It is important to remember that government contractors circle around two extremes of government compliance. On one side, there is the programs staff and their associated contracting officers. These are the guys who issue the RFP, decide you are the guy they want, and issue the contract in coordination with DCMA.

On the other side of the circle is DCAA which looks at the contractor’s costs and business systems then recommends actions to DCMA based on their audit work.

A government contractor needs to make both sides as happy as possible, and I would argue that Material Overhead Rates is one of the bizarre evolutions within government contracting that arose to make this hope of making both sides (programs and compliance) happy a reality. The concept exists in established cost accounting practice but is not as universal as many RFPs would imply.

Just Where Do We Put that Pesky G&A?

The FAR, CAS, and DCAA are strong on contractors allocating general and administrative (G&A) costs utilizing a method labeled Total Cost Input (TCI). TCI allocates G&A costs over all other costs (direct (to include materials and subcontractors), overhead, fringe and so on). CAS actually states “A total cost input base is generally acceptable as an appropriate measure of total activity of a business unit”.

Thus TCI is automatically accepted as a valid way of allocating G&A by everyone. Everyone except the government people on the other side of the circle (programs and their branch contracting officers). It often seems a majority of them think burdening travel, materials, subcontractors, and materials with a G&A rate is an outrageous and immoral act. Addressing this indignation over the years, it is clear to me that many of the associated program people (including buyers) look at this allocation as a mark-up not an allocation of actual allowable indirect costs.

I will give you two recent examples. One was a final four major accounting firm auditing a client’s incurred cost proposal on a DOE contract. The supervisor auditor entered my office at the client site (I was there supporting the audit) and spent a lot of time arguing that allocating G&A on a subcontract was unethical (his words) since the subcontract contained its own G&A and this meant the government was being charged twice.

Obviously he did not enjoy a great deal of experience with value added taxes, and I responded by asserting that was the subcontractor’s G&A and not the prime’s (my client). The two could simply not be compared. A G&A rate is not arbitrary and represents an allocation of legitimate indirect expenses, expenses of both the subcontractor and the prime contractor. It is not a ‘profit’.

He then argued that the allocated G&A simply stood out of proportion to the base cost. It takes a great deal more G&A to administer direct labor than cut a check to a subcontractor. I actually thought this a much stronger argument, but he was still out of his league. I reminded him that the prime is responsible for the subcontractor and it is never as simple as cutting a check.

He still argued on and on about the injustice of the allocation. I finally made two additional points that finally closed the argument. First, all allocation methods are ultimately subjective and arbitrary. Second, please leave my office and come back with a statutory or regulatory basis that supported his argument.

The second example involved an Army contracting officer complaining that because their contract with the contractor was about half materials and the Air Force’s contract was all services, the Army was receiving an inequitable allocation of G&A. I responded by stating that the inequity could only be applied on a government wide level and not a branch level.

The thought behind these arguments and the countless other times I encounter them, is that a dollar spent on direct materials, subcontractors, and even travel, should not receive the same amount of G&A as direct labor. To approach from a different angle, given a G&A rate of 10% it is unfair to burden $500,000 of material costs with $50,000 of G&A.

One way I attempt to explain this to the program’s side is by trying to tie them into the whole picture:

“Okay, if a contractor has $75,000 in direct labor, $25,000 in subcontractor costs with $10,000 in allowable G&A, we have to allocate the $10,000.  The government is legally obligated to pay for the $10,000. Total Cost Input gives $7,500 to the labor costs and $2,500 to the subcontractor costs. How would you do it?”

Too often I get a response such as “I do not know, but that is too much on the subcontractor”.

The Program People Come Up with an Idea

This, I believe led to the development of “Material Overhead Rate”, “Subcontractor Handling Rate” and other similar line items on various RFPs approximately fifteen years ago. These line items are intended to relieve materials and subcontractors of G&A costs while acknowledge there are indirect costs associated with these direct cost elements.

Problem solved?

The number one question I get from contractors working on these RFPs is “What rate do we use?” or “How do we calculate this rate?” In other words, how do contractors separate out from G&A the part of G&A associated with subcontractors or materials. The base is defined, but how do you populate the pool? How do we justify a 3% Material Overhead Rate with a separate 10% G&A rate?

If you want a glimpse at the potential can or worms these rates may open look at questions 12 -21 on the “Contractor Forward Pricing Rate Proposal Adequacy Checklist” under DFARS 215.403-5.

Again, this is supposition on my part, but I wonder if the first DCAA auditor asked TSI for just such documentation, the justification for creation and operation of the Materials Overhead rate. I am guessing she decided it was inadequate. I am also guessing the second DCAA auditor understood the complexity of this issue and decided to focus valuable time elsewhere.

Material Overhead and Subcontracting Handling are legitimate cost accounting objectives The challenges in developing and maintaining the rate are reduced for larger contractors where the size and frequency of activity makes it easier to allocate and define such allocations.

Small business contractors face greater challenges developing, implementing, and defending these rates. If you can identify time spent on handling materials on a specific contract, is this Material Overhead or Direct Labor? The same is true of the time spent reviewing a subcontractor invoice. Even if you feel comfortable with the methodology you develop there is no guarantee DCAA will not question it this year or next year (which is another issue raised in this case that we will address later).

This is one of those rare occasions where I will not share some of my approaches for addressing this issue among small business contractors. I prefer to share these on a case by case basis with DCAA if required. They are ethical and defensible, but vary from contractor to contractor.

Some RFPs appear to acknowledge some of these complexities and replace Material Overhead Rate with Material Overhead Fee. Take them at their word and treat it as a fee, a request not to burden materials or subcontractors with G&A while compensating contractors for the acknowledged costs involved in administrating those costs (materials and subcontractors). Do not include it in your rate proposal.

That is until some bright DCAA auditor wonders if the fee should be included in the base….

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Unapproved Subcontractors — Recent ASBCA Ruling

We are going to spend some time on a recent Armed Services Board of Contract Appeals (ASBCA) Technology Systems, Inc. (ASBCA 59577). The case addresses several government contracting concerns and breaks almost evenly between favoring the contractor and favoring the government (DCAA). The ruling is sixty-one pages and mainly focuses on if DCAA can subsequently change their mind (in this case the answer was yes with a dissenting opinion)

A quick reminder that I am not an attorney and this article represents my thoughts and is not a legal opinion of any sort. It is interesting to note that the owner of Technology Systems was not an attorney either but represented himself and managed to beat the government in several key areas. I stand in admiration but not a practice I would recommend.

The case covers at least nine areas in my mind worth a few moments discussion:

  1. Supporting Material Overhead rate
  2. DCAA Auditor independence
  3. DCAA’s right to change their mind in subsequent audits
  4. Tax vs. Book on depreciation issues
  5. Bonuses
  6. Accrued Costs crossing fiscal year
  7. Unapproved subcontractors
  8. An excellent example of DCAA properly developing findings.
  9. Documenting consultants work product

I am going to start with number 7 – “Unapproved subcontractors”. The relevant section of the FAR 52.244-2 “Subcontracts”. This one the government won and I will let the decision speak for itself and then add a few of my thoughts:

The “Subcontracts” clause, included in all four contracts, generally requires that prime contractors that do not have an approved purchasing system must obtain the CO’s written consent to enter into cost-reimbursement, time-and-materials or labor-hour subcontracts. FAR 52.244-2( d)(l) (1988, 1998). TSI did not have an approved purchasing system (which is not atypical for a contractor of its size (tr. 2/55, 65)) and, as a result, was required by the contract to obtain approval to enter into subcontracts from the CO (tr. 2/55). This, it did not do for the time-and-materials subcontracts questioned by the ACO (R4, tab 16 at 261-62, tab 6(a) at 79-80; tr. 1/130-31, 2/58). Mr. Fletcher testified on TSI’s behalf that it generally did not seek pre-approval for its actions because it had found it difficult to contact the ACO (tr. 2/135-36).

After DCAA identified the subcontracts that had not received prior approval and recommended their complete disapproval, ACO Cuellar requested that it attempt a post hoc justification of their prices (tr. 11250-51, 271 ). She allowed the cost for one of the questioned subcontracts because DCAA was able to perform an analysis that demonstrated the prices to be fair and reasonable (id., tr. 1/269). For the others, however, DCAA and the ACO felt themselves unable to perform such a post hoc justification of the costs with the information provided (tr. 11271-73 ). These costs were in the amount of $2,661 under contract 0236 (R4, tab 16 at 261) and $28,568 under contract 0340 (id. at 262).

In December 2008, after it became clear that approval of subcontracting costs would be an issue in the audit, Mr. Benton reached out to DCMA ACO, then, Ms. Sandee Murray, and requested retroactive approval of some the subcontract awards (R4, tab 6(f)). There was no apparent government response to this letter, and, in 2014, Mr. Benton reached out to a number of people seeking support for the subcontract costs. The record includes emails from Mr. Timothy Devin, Mr. Adam Cascioli (project officer for contract 0340), and Mr. Brian Almquist (the contracting officer’s technical representative (COTR)) (app. supp. R4, tab 156, at 3-4, tab 157 at 1-2). All of these email correspondences indicate that the subcontracts “were in support of the [statement of work]” (e.g., app. supp. R4, tab 157 at 1), but none of them venture to provide an opinion regarding the reasonableness of the prices charged (see tr. 2/51-52). We have no reason to doubt that the subcontract prices were allocable to the contract, and so find here, but there is no evidence elsewhere in the record with respect to the reasonableness of the subcontract charges, except the earlier statement that the ACO was able to independently confirm the reasonableness of the cost of one subcontract (tr. 11269).

It appears that both DCMA and DCAA worked with the contractor to approve these costs by working on a retroactive approval of the subcontractors, with some success. The efforts stalled where they were unable to determine the pricing was fair. Of course if the contractor had built a pricing case before entering into the subcontract, this might have worked.

Often we can argue and win cost arguments with DCAA based on the ability to clearly demonstrate the work was done (and we will see examples of this later in this same case). These efforts fail in the face of a specific contractual or FAR requirement. You will notice the FAR even bends over backwards and allows the ACO to specifically exempt identified subcontracts from this clause; however, barring this, the clause stands and the approval is needed.

Other lessons:

  • There is a bit of a break for fixed price subcontracts if they are under the simplified acquisition threshold (I believe the current number is $150,000 but it changes) or 5% of the total estimated price of the contract. I encourage clients to utilize fixed price subcontracts where possible but to always build a price case.
  • It has to be the ACO that the contractor notifies, not the government program officer, not the branch or agency contracting officer (unless this person is the ACO). In my experience, I have always found DCMA accessible.
  • Most small business contractors have not been around long enough to remember the days when small business subcontracting regulatory environment allowed for the exploitation of small business members by major contractors acting as subcontractors. Much of the current regulation arose out of those issues. In addition, the government want to make sure the pricing is fair. Build a price case. To simplify what can be a bit of a complicated process: get three bids, or create a white paper showing why the subcontractor is the only available resource, or create a white paper supporting the subcontractor’s pricing.

 

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Some of Those Pesky Questions Surrounding Timekeeping

With DCAA’s announced return to audit functions other than incurred cost proposals (Annual Report of Congress 2015), contractors need to dust off those policies and procedures and ask themselves a couple of questions. Let us start with labor, timekeeping, and payroll:

How do you control where staff are allowed to charge their time?

DCAA holds to the belief that contractors should authorize employees to on a project and restrict their ability to charge without authorization. Implicit in this is the concern that if Jane, assigned to work on Project A, does not have anything to do on project A, the government does not believe she should wander over to Project B and lend a hand without someone planning for this.

How do you address idle time?

There can be a couple of subtle levels to this question. The first level is literal; how do you address idle time. The correct answer is by charging overhead or G&A.

The second level is: when is idle time too much? When does it become unreasonable and thus DCAA might see the idle time as unallowable?

The old joke about auditors comes to mind – “Definition of an auditor: someone who shows up after the battle and bayonets the wounded”.

I once had a 622% overhead rate approved by the government based on idle time, but not without a fairly extensive fight with the DCAA auditor. The rate arose out of five engineers charging overhead 100% of their time for a few months. The story that won the approval actually involved the Princess of Wales and robots. How could you not win with such a cast? We attributed the idle time to a conflict between a DOD agency and an Army field commander. First, DOD sent these engineers into a foreign area as a perfect place to test their emerging technology. When they got there, the Army field commander informed them that the location was not a laboratory but a combat zone and wanted to know what the heck the paratroopers were going to do with the civilian engineers. DCAA then raised the allegation that the contractors turned the time into a vacation while DOD hashed it out as The engineers sat around charging overhead until the field commander finally sent them home.

I told the DCAA auditor, with a straight face, that I believed the engineers should have charged the project direct and not overhead; but since it was a single contract division it did not really matter.

The point is that idle time is often a reality of government contracting and is not always the contractor’s fault. Addressing idle capacity often calls for hard decisions and the contractor needs to prepare to defend those decisions when tax dollars are involved.

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