ERP for defense audit compliance

02ERP for defense audit compliance

• In Norway, the Contract Audit Branch reports audit results to the HQ Defense Command Norway

• Many countries operate collaborative projects or have reciprocal agreements with the United States DoD, and in these cases DCAA audits may also affect these overseas defense organizations and contractors

Any business performing work for a ministry or department of defense will need to comply with audits from their government customer. For the United States, these audits are performed by the Defense Contract Audit Agency (DCAA), part of the Department of Defense (DoD).

In other countries, different agencies are responsible for auditing defense contracts, but the steps necessary for audit preparation are similar.

• In the United Kingdom, audits may come from the Review Board for Government Contracts, Defense Equipment and Support and the Directorate of Pricing

• tIn France, audits are completed by the Service for the Investigation of Armament Costs (SECAR)

• In Spain, the Costs Evaluation Group, part of the Directorate General for Economic Affairs in the Spanish Ministry of Defense (MINISDEF) is responsible for audits

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Allocability

A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship—if it is incurred specifically for one contract, benefits both the contract and other work, or is necessary to the overall operation of the business.

Reasonableness

A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of competitive business.

My experience is primarily with DCAA—in fact, my mother worked for DCAA in human resources, and I have a more favorable feeling for the organization than many of those submitting to an audit. With the following guidance, I hope to leave you feeling more positive about the prospect of being audited and more prepared. Some of that preparation will require you to make the most of the capabilities of enterprise resource planning (ERP) software optimized for defense manufacturing and contracting. But a lot of the preparation has to do with your mindset. Remember that this audit likely means that the government is qualifying you to take on more work for your defense agency customers. This is a vote of confidence, and excellent performance can put your company on the fast track towards increasing revenues from defense contracts.

A rigorous approach to wrongdoing and delivery improvement

Defense audits have multiple goals, including the prevention of malfeasance, pricing irregularities and graft. The DCAA works closely with the U.S. Department of Justice (DoJ) to prosecute infractions of contract law that rise to the standard of criminal behavior. DoJ for instance has launched a Procurement Collusion Strike Force, focused on "deterring, detecting, investigating and prosecuting antitrust crimes, such as bid-rigging conspiracies and related fraudulent schemes . . ."

But not every audit is aimed at uncovering malfeasance. Audits can also identify opportunities to improve performance against contract requirements. According to the DCAA’s strategic plan, one of its key accomplishments between 2011 and 2015 was a 30 percent improvement in meeting agreed-to dates. That is in addition to the $19.7 billion savings and a doubling in the number of expended dollars examined for things like compliance with Defense Federal Acquisition Regulation Supplement (DFARS).

At a high level, the DCAA audit of a contract or expenditure will focus on three variables:

Allowability

The cost is allowable when it is reasonable, allocable and complies with Federal Acquisition Regulation (FAR) 31.205, CAS (Cost Accounting Standards), laws and regulations, and the terms of the specific contract.

Audits can identify opportunities to improve performance against contract requirements."

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ERP for defense audit compliance

04ERP for defense audit compliance

Getting ERP right

As the system of record, ERP is the central tool used to support an audit, and to ensure through centralization of business processes that the business is auditable and compliant with contract requirements and government regulations. But exactly how does ERP software support these auditability requirements? Are certain ERP packages “approved” or compliant out of the box? What features in ERP are necessary for DCAA compliance? How should a manufacturer or contractor go about selecting and implementing ERP for DCAA compliance?

One thing that anyone involved in the defense contracting or manufacturing space will see from time to time is marketing materials that suggest that a given enterprise software package is DCAA compliant. But this may be a gross oversimplification that borders on misrepresentation.

An enterprise application like ERP can usually be configured to conform to DCAA audit requirements. It may be configured so only allowed costs accrue against a given contract, for instance. It could just as easily be configured to allow inappropriate costs to accrue against a contract. What this means is that no ERP product is, by itself, DCAA compliant. A great deal rests on implementation, the knowledge and skills of the implementation team and a rigorous and disciplined approach to government project accounting.

The information to determine compliance with these requirements comes largely from within an ERP application or other accounting system of record. This accounting system must also be approved, pre-contract. According to a DCAA checklist, an approved accounting system must be in full operation and provide for:

• Proper segregation of direct costs from indirect costs.

• Identification and accumulation of direct costs by contract.

• A logical and consistent method for the allocation of indirect costs to intermediate, and final cost objectives. (A contract is a final cost objective.)

• Accumulation of costs under general ledger control.

• A timekeeping system that identifies employees’ labor by intermediate or final cost objectives.

• A labor distribution system that charges direct and indirect labor to the appropriate cost objectives.

• Interim (at least monthly) determination of costs charged to a contract through routine posting of books of account.

• Exclusion from costs charged to government contracts of amounts which are not allowable in terms of FAR 31, Contract Cost Principles and Procedures, or other contract provisions.

• Identification of costs by contract line item and by units (as if each unit or line item were a separate contract) if required by the proposed contract.

• Segregation of preproduction costs from production costs.

• Financial information required by contract clauses concerning limitation of cost (FAR 52.232-20 and 21) or limitation on payments (FAR 52.216-16).

• Support for requests for progress payments.

• Records maintained in such a manner that adequate, reliable data are developed for use in pricing follow-on acquisitions.

05ERP for defense audit compliance

Do the due diligence

Selecting and then implementing ERP for DCAA, therefore, requires a high degree of due diligence during the selection cycle and a sound methodology for implementation.

The right integrated application will make compliance easier. The government appreciates full access to information in an efficient and effective way. Features that can help deliver this include:

Actual costing. In many implementations, actual costing is desirable as it is the DCAA’s preferred method for most programs and contractors. Other methods like standard costing may be workable, but it is hard to argue that the DoD’s preferred method should not be the goal contractors strive for.

Fully integrated functionality. Data to support a thorough DCAA audit can come from any number of places. A fully integrated suite of software will make it easier to collect data from various sources including customer orders, purchase orders, shop orders and government property records.

Broad project accounting functionality. It is not uncommon for DCAA to audit overall finances of a project. And when they do, they will want to drill down to associated objects, such as purchase orders, that confirm the costs in the general ledger. This means transactional data should be organized by project or program, so during an audit you can drill down and supply DCAA with information specific to that project from any number of data points.

The right integrated application will make compliance easier."

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06ERP for defense audit compliance

A project with a similar scope and level of effort can be identified and used to establish a historically reasonable cost for labor.

Apart from tracking cost, ERP for DCAA must account for borrow-payback. This means ERP must be organized around specific contracts, accounting for the degree to which inventory from the project can be borrowed by other projects and to what extent they can borrow from other projects. Some contracts forbid borrow-payback. And those that allow it carry requirements regarding the cost at which borrowed inventory is replaced. Must the borrowing contract pay the price at which the material or inventory was originally purchased by the contractor, or at the price the government pays for the material or inventory? The government is naturally concerned with such things as they do not want to loan material to another project only to find they have to pay a higher price to replace it. ERP for DCAA compliance must facilitate initial approval by the government customer of the borrowing of material as well as the ensuing cost transfer and payback.

Perhaps you are building a test setup for a project, and you need to purchase some laptops. Normally, those would be considered an indirect cost or overhead, and depreciated as a capital expense. But if these laptops are going to be consumed exclusively on behalf of this government program, they would be an allowable cost. The ability to tie expenditures like this firmly back to a project is of particular importance in the cost-plus environment, where extraneous expenses that cannot be charged can easily put a contract in the red.

An ERP system properly configured for government audit compliance will include bid solicitation functionality. The system will then document the bidding process, the criteria for selection and the ultimate supplier selection. So, in proving reasonableness, you can source data from what bids were received. It is not necessary to prove that you selected the lowest bid, but rather document reasons for making the selection decision that you did. Reasonableness of labor costs must also be documented. This can be done by reviewing the history of labor cost on similar projects.

07ERP for defense audit compliance

8 advanced tips for selection and implementation

1. Look for a well-integrated ERP system versus a collection of best-of-breed solutions. The amount of time and effort required to bring a collection of best-of-breed solutions together in a way that will channel and track costs in a reliable and auditable fashion is considerable.

2. No ERP software is certified out of the box for DCAA compliance. But you need to ask your ERP vendor if they have customers running the software in a DCAA compliant environment.

3. Watch for industry-specific process models that can streamline implementation for DCAA compliance. The existence of these process models will indicate that a vendor has long experience in a DCAA compliant environment, which reduces risk.

4. As early as the initial screening of vendors, start thinking about how you need to present data to a government auditor, how you distribute cost and how you define cost, traceability of information. Build these considerations into a demo script vendors must take you through.

5. Consider all of the elements that go into actual costing. In today’s environment, auditors are more likely to conduct a full-blown audit of a given project or contract, and take deep dives into related documentation. So, you will need to consider how easy it is to drill down from a project or the general record into the supporting documentation for each expense.

6. Remember that actual cost can be hard to pin down. In order to deliver reliable actual costing, an ERP application just goes beyond cost at receipt. The invoice often reflects a slightly different cost than what was understood when materials are delivered. So, ERP must be able to re-cascade costs based on any changes that come to light in accounts payable.

7. Ask a lot of questions about borrow-payback logic. In order to comply with DCAA audits, some companies find they must also adhere to traceability of material transfer for borrow payback logic. Optimal enterprise software must include a process for netting groups that define how different groups of contracts can interact.

8. Realize that in a cost-plus environment, as much indirect cost as possible must be allocated to projects or contracts. A lot of cost would traditionally be considered overhead, but in a cost-plus environment, as much cost as is feasible needs to be allocated to projects.

Conclusion

Defense agency audits of their contractors may be something that must be done to avoid cost and negative repercussions of failure to comply. But you can also see them as a way to demonstrate the value you are delivering to your defense agency customer and win more work. The right ERP software will help you create solid, auditable business processes, preferably with predefined, template process flows. It will allow you the flexibility to document, in great detail, the validity of your invoices. And it will automate a lot of the extremely complex requirements that inspire confidence in your business.

Matthew Medley, IFS Industry Director, Defense

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