Cost And Accounting, Running Your Business

Tom Price and Indirect Costs

articles_moved_notice

Tom Price, Secretary of Health and Human Services, seems to hold a limited understanding of cost accounting and the necessity of indirect costs. I guess he is one of those guys who believes that organizations can exist without administrative costs.

Both the House and the Senate rejected the change this week.

“Tom Price, the secretary of health and human services, said the government

could achieve huge savings next year without harming lifesaving research by paring

back payments to universities for overhead — the “indirect costs” of research

financed by the health institutes.

 

These include the cost of utilities, internet service, data storage, the construction

and upkeep of laboratories, disposal of hazardous waste and compliance with federal

rules protecting human subjects of clinical research.

 

“About 30 percent of the grant money that goes out is used for indirect

expenses, which, as you know, means that that money goes for something other than

the research that’s being done,” Mr. Price said.”

New York Times April 3, 12017

 If you are uncomfortable with the press reporting on this issue, feel free to watch the testimony on the House’s site. If you think that is fake new, I cannot help you.

Standard
Accounting System, Cost And Accounting, DCAA Relations, Incurred Cost Proposals

DCAA and the Myth About Return on Investment (ROI)

articles_moved_notice

Return on Investment (ROI) always proved a concept of limited value and extreme abstraction in government.  How does one measure the ROI associated with a paratrooper sitting on the ground at the green ramp waiting to deploy in harm’s way?  How is the ROI measured on a nuclear missile resting in its silo?

Several years ago, DCAA adopted ROI as one of its main arguments to defend (or excuse) the quantity and quality of their work to taxpayers.  ROI was an alternative to other measurements such as audit productivity, down to 1.06 audits per year per auditor from 1.5 in 2012.   Additionally, form your own opinion about the fact that DCAA wins only half of the fights that get past the auditors and are made by someone outside DCAA.

Let us not forget that one of DCAA’s critical missions, and long neglected by their own admission, is to prevent or reduce costs associated with cost findings by auditing by approving or disapproving contractor’s business systems. I argue that developing and subsequent auditing of a compliant accounting system is a major return on investment for both the contractor and government. I will point out that DCAA recently developed and launched new tools that make major strides in this area with preliminary checklist forms and new audit programs that I believe will greatly enhance DCAA’s future efforts in this area.

I question how DCAA measures ROI as they include forward pricing ‘savings’ in the calculation. This is a classic example of counting your chickens before the eggs hatch.  If a contractor proposes $100,000 in fringe benefit costs and DCAA only approves $80,000, DCAA counts the $20,000 toward ROI. Unfortunately, when the year ends the contractor may discover the fringe costs proved $110,000 and bill the government for the $30,000 in difference.  To further complicate the issue, the incurred cost submission may propose a different number and the subsequent audit even a fourth number[1].

The irony of all of this is the development of the ROI model contributed to DCAA’s current crisis, the continued replacement of DCAA as incurred cost proposal auditors by outside accounting firms. ROI is now a dangerous temptation in evaluating ‘independent” accounting firms’ “success” in auditing incurred cost proposals.

In recent testimony before Congress, Industry complained that DCAA acted more like a collection agency than auditors. Imagine our response if this becomes formalized as commercial contractors are awarded contracts on their promises regarding return on investment.

www.dcaacompliance.com

DCAA Compliance Logo

 

[1] There is no indication that DCAA follows the potential saving through the entire chain. First, they do not report how they calculated the ‘savings’ and given the incurred cost proposal backlog of years, one would wonder about the practicality of going beyond the simplest and first number.

Standard
Accounting System, Cost And Accounting, Incurred Cost Proposals, Running Your Business

Very, Vary, Variance

articles_moved_notice

Let us take a break from the Technology Services, Inc (TSI) case and talk about a continuing flaw in most small government contractor’s accounting system: tracking variances, specifically those associated with cost type contracts and the associated indirect costs.

Simply put, the variance is the amount the government owes you because your rates ran higher than your billing rates or the amount you owe the government because your rates ran lower than the billing rates.

DCAA’s Information for Contractors discusses the subject in Enclosure 5.

  1. Provisional Billing Rates.
  2. FAR 42.704 provides the CO (or cognizant Federal agency official) or auditor responsible for establishing the final indirect cost rates also shall be responsible for determining the billing rates. The Government allows interim payments, if authorized by the contract, during contract performance by progress payments for fixed-price contracts, or by public voucher for cost-type contracts. Reimbursement of indirect costs for these payments is generally made through billing rates that are established to approximately equal the expected final indirect cost rates for the contractor’s fiscal period, as adjusted for any unallowable costs. These billing rates are used for interim reimbursement purposes until settlement is reached on final rates after the end of the contractor’s fiscal year. Billing rates may be prospectively or retroactively revised by mutual agreement, at either the Government’s or contractor’s request, to prevent substantial overpayment or underpayment. Once the final rates are established, an adjustment is made for any variance between the billing and final rates.
  3. Upon receipt of the certified final indirect cost rate proposal, FAR 42.704(e) provides that the Government and the contractor may mutually agree to revise billing rates to reflect the certified proposed indirect cost rates. The proposed indirect rates will be adjusted to reflect historically disallowed amounts from prior audits until the proposal has been audited and settled. The historical decrement will be determined by either the CO or the auditor responsible for determining final indirect cost rates. If billed costs exceed claimed costs, the contractor must appropriately adjust the next voucher or remit or otherwise credit the Government for the difference.

This government publication points to one of the critical knowledge areas for small business government contractors. If you keep your books and accordingly run your business like the IRS wants their information, your will probably go out of business. If you do the same with regards to DCAA, you will almost certainly go out of business.

The IRS wants to collect information in a manner that makes it easier to assess your tax liability and collect the taxes. They simply have no interest in how your business is doing, your success or failure is not within their job description. DCAA enjoys a theoretical interest in a contractor’s success as it assumes that the contractor’s work is necessary to the government, but their institutional focus has been on the contractor’s expenses in terms of allocability and allowability. Profitability, to DCAA, is, at best, out of their scope of work. At worst, contractor profits can be a focus of suspicion for DCAA.

And variances have a direct impact on profitability and the ability of the contractor to succeed and prosper. Here are a couple examples from my work over the years:

A couple of decades ago, a contractor I worked with secured a $10,000,000 contract with the government and managed to talk them into a $5,000,000 advance payment on the contract. Almost unheard of, even back in those days.

Unfortunately, the owner died tragically just after receiving the advance payment. The company made the IRS happy and paid the taxes on the $5,000,000 and recorded the “revenue” on the books. Properly, the company should have booked the advance payment as Deferred Revenue, a liability, and the money should only have hit revenue as it was earned. This is an excellent example of how you fill out your tax return often should have no influence on how you manage your business.

I am sure you can guess, the contractor spent a lot of the money before they even began serious work on the contract and struggled for a couple of years to do the work without any new money for the work.

In another example going the other way, a client of mine brought me in to work some audit issues on a $27,000,000 contract. As I looked everything over, I asked about any variances and they assured me there were no variances. I looked at the billing for the five years and could not see any variance billing, and asked to take a look at one year to check. After some resistance, they agreed and I found they underbilled the government about $75,000 in the sample year. That justified taking a look at all five years and the amount grew to approximately $900,000 never billed to the government.

The latter one annoyed me a bit as this contractor paid me to help create their policies and procedures. These policies and procedures called on the contractor to track the variance on a monthly basis. Obviously this did not happen.

Other contractors I worked with over the years discovered during the preparation of their Incurred Cost Proposal that they owed the government tens of thousands of dollars they did not anticipate. Another former client never had a variance, his books somehow tied exactly to the billing rate year after year. It is a bit more innocent than it sounds. He actually thought he was contractually obligated to spend to that amount exactly.

And of course I have to mention the major accounting firm that called an emergency conference call because they did not understand why the rates on the incurred cost proposals differed from the billing rates.

Tracking variances is cost accounting 101. No one should be surprised by a variance. Contractors should track the variance on each contract each month. You calculate the variance (actual vs. billed) for the month and post the difference to the balance sheet. If you the variance is up one month and down the next, this method will show the contract-to-date total each month. Putting the variance on the books of record and reporting it on the balance sheet formalizes the process, making it a routine item to discuss at those monthly finance meetings.

After writing the first draft of this article this morning I reviewed standard report from one the popular government contracting system and discovered, to my great annoyance, that the variance was reported as an increase of profits!!!!  How do you explain this to your boss when you have to pay the money back? Maybe it is a setup issue, sigh….

There is some disagreement about where on the balance sheet to post the variance. I prefer to post the balances to an accounts receivable account (“CPFF Variance”) and the offset is to “CPFF Variance Revenue”. Some contractors use an inventory method, posting the variance to an inventory Work in Progress account on the balance sheet and posting the other side to a Cost of Goods Sold account.

Either way, you know where you are each month and there are no surprises.

What do you do if you are caught by surprise? Depending on your circumstances, there are some legitimate methods for addressing variances starting with a thorough analysis of allocability, allowability, and costs.

Both Books graphic

Visit us on www.dcaacompliance.com

Standard
DCAA Compliance Logo
Accounting System, Cost And Accounting, DCAA Relations, Incurred Cost Proposals, Running Your Business

Material Overhead Rate — Off and On

articles_moved_notice

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….

Visit us at www.dcaacompliance.com

Standard
Accounting System, Cost And Accounting, DCAA Relations, Running Your Business

Some of Those Pesky Questions Surrounding Timekeeping

articles_moved_notice

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.

DCAA Compliance Logo

Standard
Accounting System, Cost And Accounting, DCAA Relations, Running Your Business

Part Two – Early Childhood or “How DCAA, Contractor, and Consultant Can Ruin an Audit”: Souring the Milk

When the contractor bid on the Air Force contract they had no written policies and procedures, utilized a popular accounting software package, and operated with an alphabetized chart of accounts (not really, but that is what their outside tax CPA claimed). There was an extensive inventory system that ran through cost of goods sold directly (no capitalized inventory).

Back in 2011, a DCAA audit of an accounting system focused, in theory, on two parts: the mechanics of the contractor’s accounting department (usually audited by field work) and the contractor’s policies and procedures (usually provided to DCAA ahead of the fieldwork). Often, DCAA looked at the proposed rates as part of the accounting system audit, effectively combing two audits into one.

Sometimes DCAA gave the impression that the policies and procedures were more of a checkbox than anything else. Often DCAA confirmed policies and procedures during the fieldwork. You would walk through an area such as invoicing, and DCAA would ask if this was reflected in your policies and procedures. You answered yes and moved on to the next subject.

Thus, it was possible to buy a set of policies and procedures, stamp your name on them, and send them to DCAA without realizing that the purchased policies and procedures did not relate to your business and operations at all and sometimes, just sometimes, get away with this.

When our contractor heard that DCAA was on the way, they hired a consulting firm and the consultant recommend they purchase the canned policies and procedures from still another consultant (still not me, (these cost over five times what mine cost)).

Contractor purchased said policies and procedures, but their name on them, and sent them into DCAA. Of course the purchased set of policies and procedures were geared toward a construction company, not a company developing scientific instruments.

The next recommendation the consultant made was based on the conclusion that the contractor’s accounting software set up was adequate. That it was possible to identify direct and indirect costs, claimed and unclaimed costs, plus government and commercial costs. All of the areas identified in the SF 1408 could be demonstrated and defended. The consultant decided on three indirect pools, Fringe, Overhead, and G&A. The consultant’s analysis indicated that the contractor spent $19.43 in indirect costs for every $13.05 in direct costs. The consultant prepared an incurred cost submission, using DCAA’s current ICE model, reflecting these conclusions.

Policies and procedures in place, accounting system compliant with the SF 1408, incurred cost proposals prepared and sent, and rates determined. The contractor felt ready for a DCAA audit.

DCAA came out in the late spring of 2011 and reached several immediate conclusions they promptly passed on to the contractor:

  • The Policies and Procedures provided by the contractor (purchased on recommendation of the consultant) not only had very little to do with the business operations of the contractor but those few areas, such as timekeeping, were not implemented or followed. For example, the policies called for supervisor approval on all timesheets while in practice all of the timesheets went straight to the bookkeeper for entry and processing.
  • The rates and rate structure found in the contractor’s incurred cost submission could not be replicated or tied to the contractor’s actual books of records. Direct and Indirect costs were confused and merged in several accounts. For example, the incurred cost submission reported a little over $90,000 in direct labor while the contractor’s trial balance reported the amount at about $23,000. The contractor and the consultant could not defend either number and there was some evidence the amount was closer to $600,000. Such problems were found throughout the incurred cost submission and the trial balance. This was not an incurred cost submission audit (thank you, thank you, thank you) but DCAA had properly used the concurrent document to try and figure the simple issue of direct and indirect within the contractor’s books.

As DCAA’s questions seem to multiple and answers seemed to generate only further questions. In response to DCAA comments, the contractor began to make rapid changes during the audit that only made things worse. Specifically, all of the costs that DCAA questioned as unallowable were moved to an unallowable G&A account. I do not know if the consultant was aware of the changes.

DCAA poor reaction to the contractor’s preparation and subsequent results raised alarm with the contractor. The contractor felt that the situation was spiraling out of control. Before the contractor received the statement of proposed findings, they terminated their relationship with the current consultant and engaged me as a replacement.

I literally walked into the middle of a bad DCAA audit without any clear idea about what was going on. I was concerned about the relationship with the former consultant but did not make any immediate decisions about either the quality of the previous consultant’s work or the contractor. I focused more on what I figured, wrongly, was DCAA issues.

I will admit that I have a tendency to blame DCAA in such circumstances, especially during this timeframe. On occasion I had seen DCAA and contractors feed off each other as both tried to figure out just what was going on. I listened to the contractor’s legitimate concerns about DCAA’s claims on rental cars as a classical example of audit confusion.  I just figured the consultant had gotten stuck in the middle and I offered a chance for a reset.

As I looked at it, it became clear that DCAA had done a pretty good job. The proposed findings were actually developed and discussed fully with the contractor before any commitment to writing and there were several proposed findings, nine to be exact. There was some confusion in the proposed findings. For example, one finding confused G&A Base and G&A Pool. Two other findings appeared contradictory until one realized the books were contradictory.

All in all, DCAA proposed nine findings:

  • Inadequate Internal Controls Over Timekeeping
  • Inadequate Segregation of Duties Over Timekeeping
  • Fragmentation of the G&A Base Used To Allocate G&A Costs
  • Failure To Properly Segregate and Accumulate Direct and Indirect Costs
  • Failure To Calculate and Monitor Indirect Rates
  • Improper Recording of Direct Material Costs
  • Noncompliance With FAR 52.232-22(c) Limitation of Funds
  • Use of an Arbitrary Rate to Bill the Government for Indirect Costs
  • Inclusion of Unallowable G&A Costs in the G&A Base

All of the findings were constructed and supported out of references to the Federal Acquisition Regulations (FAR), something the successor auditor failed to do. The last finding was a little confusing, I am sure the auditor meant “Pool” and not “Base”.

Number six, “Improper Recording of Direct Material Costs”, arose out of the contractor utilizing a complicated inventory system but then expensing everything through Cost of Goods Sold. The auditor raised FAR 31.201-2 (a) (3) and pointed to the GAAP Matching principle as the basis for the proposed finding.

Number four, “Failure To Properly Segregate and Accumulate Direct and Indirect Costs”, arose out of the fact that the contractor had hundreds of thousands of dollars in costs (over half a million in labor alone) marked in the job system as commercial contract work but booked to indirect accounts in the general ledger such as “G&A Labor”.

The third proposed finding, “Fragmentation of the G&A Base Used To Allocate G&A Costs”, arose out of the circumstances I described above where DCAA raised the issue early in the audit, the contractor made a change, and DCAA gigged the contractor on the change.

It started when the auditor asserted that the FAR required (and I later confirmed this assertion) that all rental cars had to be compact to be allowable. The contractor found this so unbelievable that the CFO decided to move all rental cars to unallowable G&A. This of course raised another issue and DCAA proposed a finding based on the change. It took me a while to work this through with the CFO. Yes, the auditor was wrong about the rental car position but the issue was now direct versus indirect. It is not just the direct cost of the rental car that is alleged to be unallowable but also the associated G&A costs. That is why the change the contractor made did not work. Since the auditor was careful to support all of the proposed findings with strong regulatory support, it was doubtful the auditor would actually propose a finding asserting that rental cars must be compact, but the auditor had no problem with objecting to the change and creating proposed finding number three.

The first two timekeeping proposed findings, “Inadequate Internal Controls Over Timekeeping” and “Inadequate Segregation of Duties Over Timekeeping” were pretty standard DCAA objections. One, anybody could charge anything. Two, the bookkeeper approved the timesheets.

Findings seven and nine (corrected), “Noncompliance With FAR 52.232-22(c) Limitation of Funds” and “Inclusion of Unallowable G&A Costs in the G&A Base” are pretty standard also. Nine related to using unclaimed costs to calculate the indirect rate for proposing billing rates. The reason why I believe the auditor confused the terms “base” and ‘pool’ is due to the simple fact that unallowable direct costs are required to be included in the G&A base but unallowable G&A costs must be excluded from the G&A pool.

The last two findings, five “Failure To Calculate and Monitor Indirect Rates” and eight “Use of an Arbitrary Rate to Bill the Government for Indirect Costs” relate to the easy conclusion reached by DCAA that the contractor did not employ an accounting system that allowed for consistent, supported, and even clear calculation of rates and management of the associated pools/bases.

How was the consultant involved? Much of this had the consultant’s thumbprints on it. Proposed findings five, eight, and nine arose out of the consultant’s own work and conclusions. The first two findings plus number seven are government contractor compliance 101 and should have been addressed before the audit. As to number four, which the contractor included in the incurred cost proposal with fractional modifications, I noticed problems when I first glanced at the contractor’s general ledger.  I wondered, along with DCAA, about an 18 to 1 ratio of G&A labor to direct labor. I did not even need to ask the contractor, I simply ran a job ledger and saw hundreds of thousands of dollars marked with active jobs but booked to G&A labor. DCAA apparently saw the same data.

You might argue about the matching (proposed finding six), but given the extent and support surrounding the other findings, it would be drowned in all of the valid DCAA arguments.

I can only report what I found and my subsequent experience with the contractor. I continued to work with the contractor years after the events described. They were dedicated, even to the point where they considered compliance their patriotic duty. They understood, committed to, and adopted my recommendations, even though new issues with DCAA arose over the next several years. The last recommendation of mine they finally adopted was to leave government contracting. They were losing money with cost sharing contracts (no fee) and if the government wanted their technology the government could buy it like everyone else.

Next – “Potty Training”

Both Books graphic

Available on Amazon and www.dcaacompliance.com

Standard
Cost And Accounting, DCAA Relations

17-2 Costs Related to Extraordinary Reviews of Unsettled Overhead Costs

One of the probably unforeseen outcomes of DCAA’s decision to spin off Chapter Seven of the Contract Audit Manual (CAM) into a new document SELECTED AREA OF COST GUIDEBOOK: FAR 31.205 COST PRINCIPLES is that it reminds us of some of the more interesting sections of the Contract Audit Manual.

And notice the clever way they seem to present their own thoughts as regulatory by linking their thoughts “Guidebook” to the actual rules “FAR 31.205 Cost Principles”.

Section 17 is lifted up from the CAM and only true regulatory or statutory reliance is the “reasonable and prudent” standard. In other words, DCAA applies the reasonable and prudent standard when they cannot find a law, legal decision, or regulation that supports their decision and decide that the contractor’s actions were not those typical to another contractor in a similar position. This assertion is made by DCAA Auditors whom, the vast majority, have never made a business decision. They have never sweated a payroll, created a set of books, invoiced, or other reasonable and prudent activities.

This aside, the section asserts DCAA’s right to question as unallowable contractor costs associated with reviewing indirect costs.

To your amazement, I have a few problems with this positon:

  • The adjective “Extraordinary” is in itself, extraordinary and subjective. It calls on DCAA auditors to determine if the review of indirect costs are routine or “extraordinary”.

 

Of course DCAA tries to help an auditor with this:

 

This extraordinary effort is often the result of the contractor’s earlier negligence in establishing, maintaining, and/or implementing an adequate system of internal control.

 When the circumstances cited above are encountered and the contractor is incurring or is expected to incur significant costs, the auditor should notify the contractor that the costs associated with such extraordinary reviews of unsettled overhead costs are considered to be unreasonable and will be questioned under FAR 31.201-3, Determining reasonableness. The reasons to be cited are:

  1.  1. The costs are not of a type generally recognized as ordinary and necessary for the conduct of the contractor’s business or the performance of a contract. The costs are duplicative of costs incurred for the same purpose in prior periods. The Government has already reimbursed the contractor for the costs of preparing billings and claims for reimbursement. The fact that this task was not adequately accomplished does not entitle the contractor to additional reimbursement.
  2. The costs are the result of the contractor’s failure to follow the requirements of generally accepted sound business practices and contract terms.
  3. The costs result from actions taken which were not those of a prudent businessman in the circumstances, considering his responsibilities to the owners of the business, his employees, his customers, the Government, and the public at large.

A lot more words they employ here call for professional judgement: negligence, significant, failure, and my favorite: duplicative.

Let us remember that DCAA Auditors are awarded professional judgment by an act of Congress. According to their own report to Congress, only about half of their professional judgements are supported and that is with the majority of contractors not contesting DCAA proposed decisions.

These words are loaded terms without definition. The “guidebook” provides no guidance to define the line between ordinary and extraordinary or any other loaded terms. The DFARS 252.242.-7006 provides some guidance on defining significant but this is not referenced in the guidebook.

2. And speaking of the DFAR regulation, how does this section match up with the requirement for Management Review and/or Internal Audit. When do these required activities become “extraordinary”?

3. Duplicative? Did DCAA forget that good internal controls are often duplicative by nature? When does double checking payroll cross from ordinary to extraordinary? When did taking advantage of the time spent preparing your incurred cost submission to check your costs become unreasonable and not prudent? Maybe DCAA is just trying to create work and success for themselves by discouraging contractors from double checking their work?

I am sorry, but I just have to wonder about this. Many people would argue that double entry is duplicative. Accounting is built on cross checking and rechecking, at least good accounting is.

DCAA, when you spend tax dollars to create something new, such as this guidebook, please create something new.

 

Standard
DCAA Relations, Running Your Business

It is all About Control

One note to my post yesterday “Some of the Strange Things Contractors Say“(https://dcaacompliance.wordpress.com/2016/08/22/some-of-the-strange-things-contractors-say/):

You want to control your business, your bid & proposal efforts, and all interactions with the government. The two cases I quoted yesterday demonstrate the problems that arise when Contractors lose control of the process to the Government.

In the first case the Air Force, with the subsequent support of the appeals board, recalculated the contractor’s fringe rate resulting (in the contractor’s belief) in the lost of the contract award.

The second case presents the opposite problem. Here, the Protester successfully argued that the government failed to evaluate the winning proposal’s rates, the government simply accepted the proposed rates. The Protester demonstrated pretty easily that these rates were inaccurate.

In both cases, the contractor surrendered control of the process to the government and even their competitor by not bidding supportable rates.

All easily prevented by an accurate complete cost accounting system.

Standard
Cost And Accounting, DCAA Relations, Running Your Business

Some of the Strange Things Contractors Say

We Are Doing Fine Without ALL OF THIS. We bid the Rates that Will Win the Contract and Still Make a Profit

I, for one, believe in the common sense I discover time and time again among small business contractors. Actually, without their common sense, my work would prove extremely difficult. They know when they are in trouble and they know when they are not.

Of course, in my humble opinion, backing up this common sense with data makes the small business decisions even more effective.

In almost every single contractor without DCAA activity I work with, the rates they bid are different on every proposal. Sometimes the use of different rates arises out of a perceived change in rates, but many times it is the pressure to feel competitive.

In a world without DCAA, the lack of accurate rate information is beginning to haunt contractors. Two recent GAO appeals (one involving an Air Force contract) illustrate the problem:

Because an agency must base its evaluation upon information contained within the offeror’s proposal, and because we will not consider Quantech’s untimely assertions that it could have substantiated its rates had it been permitted to revise its cost narrative, we have no basis to question the agency’s conclusion that Quantech’s revised indirect rates were unsubstantiated and thus unrealistic. In any event, we find that the Air Force’s adjustments to Quantech’s indirect rates were reasonable. Here, the CPET analyzed an offeror’s proposed indirect rates and cost narrative to determine whether the rates reflected the offeror’s unique business model with regard to allowable and allocable indirect costs, and compared the indirect rates to the offeror’s fiscal year 2015 provisional billing rates established by the Defense Contract Audit Agency (DCAA). While the agency concluded that Quantech’s initial rates were realistic based upon information in its cost narrative, the agency determined that the protester’s proposal provided “no rationale” to substantiate the dramatic reduction in its fringe benefit rate ([DELETED] percent to [DELETED] percent). AR, Tab 7, CPET Report, at 8. On this record, we find that the agency’s adjustments were reasonable, and the agency acted within its discretion in deciding to use Quantech’s initial rate, rather than the unsupported final proposed fringe benefit rate.[20] See CSI, Inc.; Visual Awareness Techs. and Consulting, Inc., B‑407332.5, et al., Jan. 12, 2015, 2015 CPD ¶ 35; Science Applications Int’l Corp., Inc.,supra.

The protest is denied.[1]

 

And this one

Here, we find that the agency’s acceptance of the unsupported G&A rates for eight of the awardees was unreasonable and inconsistent with the solicitation requirements. The RFP required that the proposed G&A rates would be evaluated using a cost analysis “based upon verification of the offerors’ cost submissions for their G&A rates and confirming that the submissions are in accordance with the contract cost principles and procedures described in FAR Part 31.”RFP, Tab 3 at 33.The protester, whose proposal complied with the solicitation requirements and whose G&A rate was supported by its certified financial statements, was prejudiced by the agency’s actions as follows: one offeror did not comply with the requirement to submit certified financial statements or a DCAA report; two offerors’ rates could not be verified by the information submitted; and five offerors proposed significantly lower rates than those identified in the certified financial statements they submitted with their proposals.AR, exh. 6, SSDD at 79-84. As a result, these offerors were viewed as offering a lower “price” to the government since the agency was using G&A rates as a proxy for price or cost. There is nothing in the solicitation that informs offerors that the agency would accept a G&A rate that was not supported by certified financial statements or DCAA reports and verified through a cost analysis of the required cost submissions. Accordingly, we sustain this basis for protest.[2]

Since contracting officers can no longer rely on DCAA to verify proposed contractor rates the burden now shifts to the contractor to defend those rates. A good defense arises out of a good cost accounting system.

A good cost accounting system also allows the contractor to defend any proposed changes to the rates. This is common due to the exponential growth experienced by successful small contractors.

I call this the “plumbing argument”. The plumbing costs in building a 2,000 square foot home as compared 5,000 square foot home are not as dramatically different as one would think as the plumbing layout is fairly centralized. Thus, plumbing costs more in a 2,000 square foot home than a 5,000 square foot home per square foot while the total cost of plumbing in the large home is a bit more.

This is also true of G&A costs. You are only going to need one Controller if you employ 100 people or 1,000 people, but she will cost more per employee for the smaller company.

But none of this does you any good if you do not know the costs and cannot do the math.

[1] Matter of:   Quantech Services, Inc. File:  B-408227.8; B-408227.9 Date:  December 2, 2015  http://www.gao.gov/products/D12374# =e-report

[2] Matter of: West Coast General Corporation File: B-411916.2 Date: December 14, 2015  http://www.gao.gov/products/D12409#mt=e-report

 

EXCERPT from  Surviving a DCAA Audit: The Accounting System: For Small Government Contractors Working With the DCAA and Other Government Agencies available on Amazon.

 

Standard
Accounting System, Cost And Accounting, DCAA Relations, Incurred Cost Proposals

Just What is a Subcontractor?

At a recent conference an audience member asserted that the FAR (Federal Acquisition Regulations) did not define subcontractors and she felt free to put the costs wherever she wished on an incurred cost proposal, specifically under Other Direct Costs. I assumed she meant consultants providing direct services on a job or contract, but I did not argue with her and we agreed to disagree.

Subsequent to this, I gave up documenting FAR definitions of subcontracting after the fifth one. All of these included the term “services”.  I will quote, cite, and discuss some of the specific definitions in a bit, but first I want to broaden the issues to the needs of government contractors, especially small business government contractors.

Not only does the FAR define subcontractors, it is an area of intense regulation and receives serious attention from DCAA to include an ever evolving “Schedule J” on DCAA’s model incurred cost electronically (ICE). It is in a contractor’s interest to avoid this greater scrutiny while complying with existing statutes, case law, and regulations (notice I did not say guidance, as in DCAA’s Contract Audit Manual or Information for Contractors).

I will also note that some contractor approaches can lead to unnecessary complications and even visits from the IRS wanting more money.

Traditionally, direct costs are recorded in five broad accounts: Direct Labor, Direct Travel, Materials, Other Direct Costs, and Subcontractors. Over the years. I observed contractors recording what the FAR and I define as subcontractor costs, in all five accounts to include Materials and Direct Travel. There is actually an accounting tax argument for recording subcontractor travel costs under direct travel (see my presentation: Meals & Entertainment Rules – Or How to Avoid Inviting Government Auditors to Your Lunch . I prefer to track subcontractor Meals and Entertainment (M&E) as part of the Subcontractor account, but I acknowledge the argument.

Despite what many DCAA auditors might argue, there is no requirement to use these five main direct cost account groups, but I am going to assume their use because of my vain hope as a taxpayer, that we can reduce costs by reasonable acceptable conventions. Adopting these five major accounts for tracking direct costs is such a convention. Further, these are the five the government cares about.

Subcontractor Definitions

Now to some of the definitions:

FAR 3.502-1

“Subcontract” means a contract or contractual action entered into by a prime contractor or subcontractor for the purpose of obtaining supplies, materials, equipment, or services of any kind under a prime contract.

“Subcontractor” (1) means any person, other than the prime contractor, who offers to furnish or furnishes any supplies, materials, equipment, or services of any kind under a prime contract or a subcontract entered into in connection with such prime contract; and (2) includes any person who offers to furnish or furnishes general supplies to the prime contractor or a higher tier subcontractor.

FAR 4.1.1701

“First-tier subcontract” means a subcontract awarded directly by the contractor for the purpose of acquiring supplies or services (including construction) for performance of a prime contract. It does not include the contractor’s supplier agreements with vendors, such as long-term arrangements for materials or supplies that benefit multiple contracts and/or the costs of which are normally applied to a contractor’s general and administrative expenses or indirect costs.

FAR 52.244-2

“Subcontract” means any contract, as defined in FAR Subpart 2.1, entered into by a subcontractor to furnish supplies or services for performance of the prime contractor a subcontract. It includes, but is not limited to, purchase orders, and changes and modifications to purchase orders.

Subpart 22.801

“Subcontract” means any agreement or arrangement between a contractor and any person (in which the parties do not stand in the relationship of an employer and an employee)—(1) For the purchase, sale, or use of personal property or nonpersonal services that, in whole or in part, are necessary to the performance of any one or more contracts; or (2) Under which any portion of the contractor’s obligation under any one or more contracts is performed, undertaken, or assumed.

“Subcontractor” means any person who holds, or has held, a subcontract subject to E.O. 11246. The term “first-tier subcontractor” means a subcontractor holding a subcontract with a prime contractor.

Discussion

So much for the FAR not defining subcontractors and the definition not covering ‘services’ provided by consultants and other professionals. Having said this, it is critical to remember that FAR definitions typically apply to the section where they are found. For example, the last definition is found in the Equal Employment Opportunity section which is why it further defines subcontract as non employment.

This is where the FAR experts, Contracting Officers, DCAA auditors, and other government employees can spend too much time parsing the FAR in an attempt to twist it into what they mean. A few years ago, a DOE pricing specialist in a vain attempt to prove that the contract was enforceable before the FAR, ended up accidentally accusing the contractor of criminal fraud. Context is critical to pulling out FAR clauses.

But sometimes, the only regulatory guidance is stranded in strange places. The ONLY guidance on how to withdraw an incurred cost proposal properly is found under “Indirect Cost Rates” (FAR 42.7) but under the section about waving penalties (42.709-5)

Now, having said that, the first three definitions appear numerous times in the FAR and could be argued to create a general definition. Let us look at some of the general conclusions we can draw from these definitions:

  • Subcontracts, for government contracting purposes, only apply to direct costs. Many DCAA auditors attempt to apply subcontractor regulations and procedures to costs charged as indirect. Notice one definition specifically addresses this. Professional and consultant costs are covered under FAR 31.205-33. This FAR section seems to assume such charges are indirect; but is not specific about consultants as a direct charge, and not burdening them with the additional definition as a subcontractor.
  • There does not have to be a contract, note the term ‘contractual action’ in the first definition and the inclusion of purchase orders in other definitions.
  • Your weekly trip to Walmart for office supplies does not make Walmart a subcontractor. Any contractual action, to include the right of return, does not create a subcontractor relationship. Again, I am not a lawyer, but I do believe this is a bit of a grey area. A recent example of this was the IRS attempt to force business to issue 1099s to everyone. Fortunately, Congress corrected the situation. Vendors such as Walmart are not subcontractors, but a plumber that provides services on multiple contracts is a subcontractor even if one of the definitions would appear to make this an exception.

As a final look at the regulations, let us look at the requirements reference subcontractors for the contractor’s incurred cost proposal found at FAR 216-7(d) :

(J) Subcontract information. Listing of subcontracts awarded to companies for which the contractor is the prime or upper-tier contractor (include prime and subcontract numbers; subcontract value and award type; amount claimed during the fiscal year; and the subcontractor name, address, and point of contract information).

Complicating Your Life

Now if we are all depressed about the definition of a subcontractor and recovering from our dashed hopes of trying to avoid the extensive subcontractor requirements, let us look at a couple of other common actions small business contractors take with subcontractor costs that can actually complicate their lives.

  • Treating subcontractors as Direct Labor – This is fairly common. For example: Jane, your 1099 ‘employee’ works alongside the regular employees and is invited to all of the parties. Your customer may even require her to fill out a timesheet just like the regular employees. This treatment does presents a couple of challenges.
    1. First, since you treat Jane as an employee and charge her time to Direct Labor; the IRS will decide she is an employee and will send you a bill for her payroll taxes, interest, and penalties. There is now even a section on Jane’s tax return to tell the IRS about this.
    2. Second, as if the first issue was not enough, it makes a bit of a challenge to reconcile your payroll to your labor costs, as required by regulation and on the Schedule L of the DCAA model ICE. If you segregate the 1099 costs in their own account under Direct Labor, you identified them as nonemployee and we are back to the subcontractor identification.
    3. Third, there is the issue of rates and comparative rates in competitive bidding. If you are including 1099 labor in your fringe and G&A base, an appeal could argue that your rates are artificially low and even deceptive. Additionally, we all know how many contracting officers hate paying G&A on subcontracts and will award only a special ‘handling’ or ‘management’ rate for the subcontractor part. I am sure they would be happy to discover what they consider subcontractor costs in Direct Labor.
    4. Fourth, many contracts require contractors to notify the contracting officer about any subcontracts and if a significant portion of your Direct Labor could be seen as actually subcontractors, this could present a problem to include allowability of the costs.
  • Another common approach is to classify all ‘consultants’ as Other Direct Costs. This decision would raise the same issues raised above as to rates and notification. Also, the common sense definition of Other Direct Costs are costs that cannot be easily categorized as Labor, Travel, Materials, or Subcontractors. DCAA might conclude that consultants would fail this categorization as Other Direct Costs.
  • Spreading the Joy – I mentioned the tax argument for segregating the subcontractor M&E costs and some of those engineers might express a desire to separate out the material costs from the subcontractor’s invoice.

These temptations are easily addressed by adding subaccounts to the subcontractor account for travel and materials, if you wish.

Conclusion

Ah, the joy of government contracting. Again, there are excellent reasons why contractors attempt to reduce the government (DCAA) involvement in subcontractor management. Both the regulation and guidance are extensive, to include a requirement to flow down clauses on employee texting while driving. Unfortunately, this is the nature of the beast and any attempts to reduce the government’s involvement in the contractor’s employment of subcontractor needs to be carefully planned and compliant with statute and regulation.

Standard