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INDIRECT-COSTMANAGEMENT GUIDE

NAVIGATINGTHE

SEA OF OVERHEAD

Third EditionOctober 2001

Web edition only (not in print)

PUBLISHED BY THEDEFENSE SYSTEMS MANAGEMENT COLLEGE PRESS

FORT BELVOIR, VA 22060-5426

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For sale by the U.S. Government Printing OfficeSuperintendent of Documents, Mail Stop: SSOP, Washington, DC 20402-9328

Editing and Desktop Publishing: Kathryn E. Sondheimer

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PREFACE

DoD management has become increasingly concerned with broad-based increases in defense con-tractor indirect-cost rates. Many factors have contributed to these rate increases — the major factoris the significant reduction in the business base for most defense contractors due to the decliningdefense budget. As a result, DoD has expanded efforts to strengthen monitoring indirect costs. Ithas become important for acquisition management personnel to thoroughly understand the com-plex and sensitive subject of indirect-cost management.

By teaching various program management classes at the Defense Systems Management College(DSMC), I have found that the subject of indirect cost or overhead is commonly misunderstood andis usually referred to in unfavorable terms. It is thought to be virtually uncontrollable from a gov-ernment program management perspective. In addition, the large number of indirect rates one en-counters in the defense industry significantly contributes to the confusion our students experience.The objective of writing this guide is to demystify what many refer to as the “sea of overhead.” Nosingle published source for the general audience of acquisition personnel provides a complete over-view of indirect-cost management. This guide is intended to fill that void.

From the government perspective, monitoring indirect cost is exceptionally broad in scope; andmany people are involved. So it is essential for acquisition managers to thoroughly understand theinterrelationships of numerous DoD team members and how they improve the monitoring process.

This Second Edition incorporates Navy shipbuilding into government indirect-cost monitoring,describes the major new initiatives undertaken by DCMA and DCAA to accelerate settlement offinal overhead rates, identifies several changes made in various contractor system review require-ments, updates information related to executive compensation and restructuring costs, and elimi-nates prior coverage of functional reviews no longer performed by the DCMA.

To gain background information, I conducted onsite interviews with personnel actively performingindirect-management functions in industry and indirect-cost monitoring functions in the govern-ment. The arrangements were made through contacts with industry and government students atDSMC in our Advanced Program Management Courses. Recognizing that indirect rates are highlyproprietary information, my interest was not in the quantification of indirect-rate data but in thebusiness processes used to manage these difficult-to-control costs. Several contractors and govern-ment offices provided assistance to DSMC. I would like to express special appreciation to bothcontractor and government personnel located at Pratt-Whitney, Sikorsky, Loral Imagining Systems,and Boeing. I would also like to express appreciation to personnel in the DCMA Headquarters Over-head Center and in DCAA Headquarters who provided information relating to current issues andinitiatives in their organizations.

DSMC is the controlling agency for this guide. Comments and recommendations are solicited.

Jack D. CashProfessor of Business ManagementBusiness Management DepartmentDefense Systems Management College

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TABLE OF CONTENTS

PageChapter 1 — Introduction

Objective .......................................................................................................................... 1-1Significance of Indirect or Overhead Costs ..................................................................... 1-1Difficulty of Control ........................................................................................................ 1-4Current Environment ....................................................................................................... 1-5Importance of a Team Approach ...................................................................................... 1-5

Chapter 2 — Essentials for Understanding Indirect CostsIntroduction ..................................................................................................................... 2-1Direct or Indirect ............................................................................................................. 2-1Variable or Fixed Costs .................................................................................................... 2-4Allowable or Unallowable Costs ..................................................................................... 2-7Capitalized Versus Expensed ........................................................................................... 2-7Controllable or Noncontrollable Costs ............................................................................ 2-8

Chapter 3 — Typical Indirect-Cost PoolsOverhead Pools ................................................................................................................ 3-1Service Centers ................................................................................................................ 3-4General and Administrative Expense Pool ...................................................................... 3-4Major Categories of Indirect Expenses ............................................................................ 3-5

Chapter 4 — Allocation of Indirect CostsAllocation of Overhead.................................................................................................... 4-1Allocation of General and Administrative Expenses ....................................................... 4-6

Chapter 5 — Defense Industry Management of Indirect CostsIntroduction ..................................................................................................................... 5-1Planning ........................................................................................................................... 5-2Forecasting....................................................................................................................... 5-7Budgeting ...................................................................................................................... 5-10Control ........................................................................................................................... 5-13Variance Analysis .......................................................................................................... 5-15Ratio Analysis ................................................................................................................ 5-15Trend Analysis ............................................................................................................... 5-17

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Management Metrics ..................................................................................................... 5-18Regression Analysis ....................................................................................................... 5-20Industrial Engineering Analysis ..................................................................................... 5-22Contractor Actions to Reduce Overhead ....................................................................... 5-22

Chapter 6 — Impact of Government Contracting RequirementsIntroduction ..................................................................................................................... 6-1Relevance of Contract Type ............................................................................................. 6-2Federal Acquisition Regulation (FAR) Requirements ..................................................... 6-5

Cost Allowability ................................................................................................. 6-6Reasonableness .................................................................................................... 6-6Allocability .......................................................................................................... 6-6Generally Accepted Accounting Practices ........................................................... 6-7Contract Terms..................................................................................................... 6-7

Selected Costs .................................................................................................................. 6-7Advance Agreements ....................................................................................................... 6-9Certification of Indirect Costs ......................................................................................... 6-9Unusual Indirect-Cost Requirements............................................................................. 6-10

Independent Research and Development/Bid and Proposal Expenses .............. 6-10Cost of Money ................................................................................................... 6-13

Current Issues ................................................................................................................ 6-15Restructuring Costs ........................................................................................... 6-15Executive Compensation ................................................................................... 6-18Expiration of Funds ........................................................................................... 6-19

Chapter 7 — Cost Accounting Standards RequirementsIntroduction ..................................................................................................................... 7-1Applicability .................................................................................................................... 7-2Disclosure Statement ........................................................................................................ 7-3Cost Accounting Standards Relating to Indirect Costs ..................................................... 7-3

CAS 401 .............................................................................................................. 7-3CAS 402 .............................................................................................................. 7-4CAS 403 .............................................................................................................. 7-5CAS 404 .............................................................................................................. 7-6CAS 406 .............................................................................................................. 7-6CAS 410 .............................................................................................................. 7-7CAS 418 .............................................................................................................. 7-8CAS 420 ............................................................................................................ 7-11

Contract Price Adjustments ............................................................................................ 7-12

Chapter 8 — How the Government Monitors Indirect CostsIntroduction ...................................................................................................................... 8-1DCMA Overhead Center ................................................................................................. 8-2Relationship to Program Offices ...................................................................................... 8-3

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Government Team ............................................................................................................ 8-3Procurement Contracting Officer (PCO) .............................................................. 8-3Administrative Contracting Officer (ACO) .......................................................... 8-4Corporate Administration Contracting Officer/

Defense Corporate Executive (CACO/DCE) ........................................... 8-4Defense Contract Audit Agency (DCAA) ........................................................... 8-5Other Team Members .......................................................................................... 8-5

Monitoring Techniques .................................................................................................... 8-5Forward-pricing Rates ......................................................................................... 8-6Billing Rates ........................................................................................................ 8-9Final Rates ......................................................................................................... 8-10Tracking Indirect Costs ...................................................................................... 8-13Contractor Systems Reviews ............................................................................. 8-14

Contractor Purchasing System Reviews (CPSRs) ................................. 8-14Estimating System Reviews (ESRs) ...................................................... 8-15Compensation System Reviews (CSRs) ................................................ 8-15Contractor Insurance/Pension Reviews (CIPRs) ................................... 8-16Material Management and Accounting System (MMAS) Reviews ...... 8-17Earned Value Management Systems (EVMSs) ..................................... 8-17

DCAA Operational Audits................................................................................. 8-19DCAA Systems Reviews ................................................................................... 8-20

Accounting System Reviews ................................................................. 8-20Electronic Data Processing System Reviews......................................... 8-21Contractor Budget and Planning System Reviews ................................ 8-21Labor System Reviews .......................................................................... 8-22Billing System Reviews ......................................................................... 8-22

DoD “Should-Cost” Reviews ............................................................................ 8-22Correction of Problems ...................................................................................... 8-24Program Office and DCMA Relationship .......................................................... 8-24

Summary ...............................................................................................................................Sum-1

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11INTRODUCTION

OBJECTIVE

This guide provides acquisition managementpersonnel, especially personnel who are work-ing in program offices, with an insight into theprocess by which defense contractors manageand government personnel monitor indirectcosts. Although program office personnel arenot involved in indirect-cost management atcontractors’ facilities on a real-time basis, theyneed to thoroughly understand the nature ofthese costs and to know who to contact whenquestions or problems arise. Indirect costs havea significant cost impact upon all weapon sys-tem acquisition programs. Therefore, a primaryobjective of this guide is to explain the rolesand relationships of the many key governmentpersonnel involved with the indirect-cost man-agement process. Further, this guide promotesthe utilization of a team concept and highlightsareas for strengthening the management ofindirect-costs.

The level of detail in this guide is directed tononfinancial personnel because of the variedand broad backgrounds of people working inprogram management. It is not intended as adetailed “how-to” guide for industry or govern-ment functional managers but rather as a com-prehensive overview of basic principles and is-sues related to indirect costs.

The guide is organized to walk the reader throughthe many aspects of indirect-cost manage-ment. This introductory chapter discusses thesignificance of indirect costs, the complexityof managing them, and the necessity for a team

approach. There are chapters that define basicconcepts and terms, explain how indirect costsare allocated to contracts, explore how defensecontractors manage these costs, and discussrecent actions taken by defense contractors toreduce indirect costs. These chapters also ex-plain unique government requirements relatedto indirect costs; define who the various gov-ernment team members are as well as what theydo; and, finally, discuss current managerial is-sues.

SIGNIFICANCE OF INDIRECT OROVERHEAD COSTS

Whether cost is classified as direct or indirectmakes a tremendous difference in defense con-tracting. For example, when there is a diversebusiness base, the government pays 100 per-cent of all direct costs but only a portion of in-direct costs under its negotiated contracts. How-ever, the standard for determining what is adirect and what is an indirect cost is far fromuniversal in the defense industry — or in anyindustry for that matter. But the classificationof direct and indirect costs must be very exactat a specific defense contractor’s plant, and thissubject is presented in considerable detail in alater chapter.

For introductory purposes, indirect costs arethose costs incurred for the general operationof the business and are not specifically appli-cable to any one product line, program, or con-tract. Direct costs are associated with a specific“final cost objective” such as a specific defensecontract; indirect costs are associated with com-

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mon or joint cost objectives such as the work onseveral contracts.

Indirect costs, in the aggregate, represent thelargest class of expense incurred under de-fense contracts. Recent estimates made by theDefense Contract Management Command(DCMA), in conjunction with discussionswith defense contractor top management ontheir DCMA Overhead Initiative, indicate thatindirect costs constitute approximately $90billion of the $170 billion total DoD work inprocess at all defense contractor plants. See“Exhibit 1. Significance of Indirect Costs” fora breakout between direct and indirect costsfor this estimate of work in process. Asshown, the indirect costs of 16 percent in-curred by subcontractors and vendors and the37 percent incurred by prime contractors (in-plant) represented approximately 53 percentof the total cost.

Of course, the ratio of indirect cost to total costvaries significantly among contractors withinthe defense industry because it depends uponmany factors. That is to say, there are numer-ous differences in both workforce and account-ing classifications as to direct or indirect costs,types of products, production methods used,degree to which materials are furnished by thegovernment, extent to which subcontractors areused, and the composition of facilities owner-ship. For these reasons, it is not meaningful toattempt to continuously track an exactindustry-wide ratio of indirect-to-total cost. Butregardless of the many differences betweencompanies, the indirect costs of doing businesswill at least roughly equal the direct costs inmost cases. Since indirect costs are such asignificant portion of current and future totalweapon system cost, program managers and oth-ers in the acquisition community must have a thor-ough understanding of these costs to ensure thatthe costs of weapons systems are kept on target.

At the outset, one should clearly recognize thatthe very nature of defense industry productsoften dictates high indirect costs on a per-unitbasis. The defense industry is critically depen-dent upon tremendous investments in fixed as-sets. The sheer size of some weapons systemsrequires huge buildings, sometimes coveringscores of acres. These large state-of-the-art fa-cilities suggest major depreciation, mainte-nance, property taxes, and other large, fixed in-direct or overhead costs. Large-scale researchand development projects are necessary for acompany to stay competitive in the defense in-dustry; and research and development work,which is necessary to produce a new weaponsystem, normally takes many years to complete.

Because DoD demands more and more techni-cal advancements, a company is often requiredto develop totally new materials in order to stayon the leading edge of technology and to con-tinue to remain competitive. This will mostlikely require new processes, tooling, machin-ery, and personnel. Product testing and evalua-tion is unusually expensive as it often involvesproduction of prototype products. In additionto the research, development, and manufactur-ing efforts of defense prime contractors, theyare responsible for overseeing the work of manysubcontractors and vendors who are producingnew, highly technical products. Defense con-tractors are required to make large investmentsin bid and proposal expenses in response tocomplex government requests for proposals. So-phisticated management control systems are re-quired in order to comply with stringent gov-ernment specifications for engineering,manufacturing, and product support.

Contractual reporting requirements are farmore detailed and expensive than those in thecommercial world. Environmental and safetyrequirements are substantial. Special producthandling and security requirements are char-

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Exhibit 1. Significance of Indirect Costs

DoD Work inProcess

$170.0 Billion IndirectLabor &Fringe

Benefits58%

Depreciation10%

Occupancy10%

ComputerServices

9%

Utilities4%

Supplies,Services &

Travel3%

CorporateAllocations

2%

Miscellaneous4%

Indirect Focus$90 Billion

53% of Workin Process

SubcontractorVendorMaterial

18%

In-PlantIndirect

37%

In-PlantDirectLabor20%

SubcontractorVendorDirectLabor

9%

SubcontractorVendorIndirect

16%

acteristic of defense industry. All of these ex-penses are usually indirect or overhead coststhat must be absorbed by all contracts if thecontractor is to stay in business. In addition,defense contractors normally produce non-standard, tailored, and highly sophisticatedproducts in relatively low volumes. Assemblyis usually an intense, highly engineering-oriented process with small production quan-tities; and a low volume results in high indi-rect rates. This topic is discussed later in thisguide.

The defense budget has been in a continuingstate of decline during the past several years.In particular, the continuous and large-scaledecline in the defense procurement budget andin the research, development, test, and evalua-tion (RDT&E) budget has caused the defenseindustry to incur a steep drop-off in the busi-ness base. As a result, many defense contrac-tors’ indirect rates have increased significantly

as the value of contracts awarded by DoD hasdeclined. The remaining DoD contracts are nec-essarily forced to absorb additional indirectcosts that cannot be quickly eliminated. Dur-ing the 1980s, the indirect rates of most defensecontractors were safeguarded by a nearly con-tinuous increase in the business base. However,the demise of the Soviet Union ended this con-tinuity. During the 1990s, the annual procure-ment budgets of DoD have been essentially cutin half; and significant increases cannot reason-ably be expected in the immediate future.

A fundamental change in defense requirementshas brought about a significant financial im-pact: an increase in indirect rates. These in-creases result not only from the business-basedecline but also from the increase in indirectexpenses. For example, when the businessbase declines, the contractor is forced to layoff large numbers of direct employees; theirseverance pay is an indirect expense. One tech-

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nological factor that drives increases in over-head expenses is the substitution of expensive,computer-operated, and laborsaving machinesfor direct labor in the manufacturing area. Thissubstitution simultaneously increases the over-head expenses (added depreciation and main-tenance charges) and also decreases the allo-cation base if it is direct labor dollars or hours.The financial impact is an immediate increasein indirect rates.

Many indirect efforts are, to a large extent, dis-cretionary in nature and can be reduced or elimi-nated by management if conditions warrant. Soindirect costs demand constant attention if thecontractor is to control them effectively. Froman industry perspective, there is probably noother area of management where the concen-tration of executive talent can be more effec-tive. Defense contractor managers are now tak-ing significant actions to reduce indirect costs.(See Chapter 5.)

From the government’s perspective, where ad-equate competitive market conditions are absent,there is a compelling need for a sound systemfor monitoring indirect costs to ensure that suchsignificant costs are managed efficiently. Thegovernment program manager needs to motivatethe contractors to exercise management controlsthat keep indirect costs at the lowest reasonablelevel and, in future contract prices, to includeonly those indirect costs that are reasonable andproperly allocated to the contracts. It is interest-ing to note that, when the volume of contractsdeclines, a contractor quickly incurs less directcontract costs. But indirect costs may not declineas rapidly since many fixed expenses may re-main in overhead pools, e.g., the leased cost fora building, supervisory labor, power, and prop-erty insurance. Consequently, government pro-gram managers should ensure that companymanagement is reducing indirect costs as rap-idly as prudent judgment allows.

DIFFICULTY OF CONTROL

The management of indirect costs has long beenrecognized as one of the most difficult areas tomanage. There is often no clear-cut relation-ship between these expenses and profit as thereis with direct cost. For example, material andlabor costs are very visible to management andcan be estimated and controlled directly. How-ever, the nature of indirect cost is such that theexpenses are spread over a number of expenseaccounts with various types of expenditures oc-curring sporadically over the year. Most defensecontractors have hundreds of expense accountsin each indirect-cost pool. Many different per-sons are responsible for incurring expenses. Theindirect totals that are reported every month onvarious cost reports are aggregates of hundredsof unrelated indirect expenses. Further increasesin indirect expenses occur more slowly, resultfrom a large number of unrelated actions takenby numerous managers, and may be less ap-parent. Management must constantly be awareof and understand the detailed composition ofsuch costs in order to effectively control them.

Many contractors who produce military hard-ware also produce similar hardware for com-mercial applications within the same divisionof the corporation. This is very advantageousto both the contractor and the government be-cause it enables each to become more effi-cient by capitalizing on significant economiesof scale. Unfortunately, this also creates am-biguity in the allocation of indirect costs be-tween defense and commercial contracts. Theacceptance by the government of what is con-sidered to be a “fair and reasonable” amountfor indirect costs has generated some of themost difficult problems relating to govern-ment contracts. As a result, most governmentcost regulations, which are contained in theFederal Acquisition Regulation (FAR), areassociated with the coverage of indirect costs.A thorough understanding of the regulatory

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provisions, discussed in considerable detail inthis guide, is essential to understanding indi-rect costs.

Government acquisition management person-nel generally view indirect costs as vague andexcessive. They understand very well what gen-erates direct labor, direct material, and subcon-tract costs; but they are much less aware of whatgenerates indirect costs. They generally do notappreciate that indirect costs are generated bythe contractor’s total business volume and notby the volume of any specific contract. Indirectcosts lose their identity when allocated to con-tracts from common-cost pools; and, unlike di-rect costs, they cannot be analyzed on acontract-by-contract basis. Although monitor-ing indirect cost is often time-consuming andcomplex, it is absolutely essential for propervisibility of the weapon system acquisitionprocess.

CURRENT ENVIRONMENT

From a financial perspective, at no time in re-cent history have defense industry and gov-ernment acquisition personnel been faced witha greater challenge. Given the current envi-ronment of less large-scale manufacturing andmore prototyping, indirect rates are expectedto increase in the future, i.e., less productionand less manufacturing direct labor with moreengineering changes result in higher indirectrates. Also during the past few years, DoDhas changed the methods by which it contractsfor research and development. The shift placesa major emphasis on using cost-type contractsas opposed to fixed-price contracts and placesDoD in the position of assuming more costrisk. The results of a significant decline in thedefense business base of a company, alongwith DoD’s shift in how it contracts, places avery high probability for growth in indirect rates.

Schedule delays are frequently encountered onmany defense programs. The delays may becaused by unpredictable technical problems en-countered in research and development pro-grams, engineering changes to take advantageof technology improvements, budgetary uncer-tainties, and political decisions. These extendeddelays may cause significant increases in indi-rect costs.

In a declining business environment, rising in-direct rates generally mean that a contractor’sallocation base for distributing indirect or over-head costs, which are often direct labor hoursor direct labor dollars, is decreasing faster thanthe contractor can reduce indirect costs. Theremay be a delay in reducing indirect costs be-cause the base falls away on a continuous ba-sis, and the indirect budgets are usually deter-mined on an annual or semiannual basis. Again,continued oversight of the indirect-cost man-agement process and cost-containment mea-sures must be maintained.

IMPORTANCE OF A TEAMAPPROACH

From the government’s perspective, the ap-proach to monitoring indirect costs is to moni-tor the contractors management processes, notindividual indirect expenditures, with the ex-ception of samples to test the satisfactory orunsatisfactory operation of the managementcontrol system. The government expects thecontractor to manage its own indirect costs; but,at the same time, the government has a majorrole to play. The government’s objective is toinfluence the contractor’s process and to takeappropriate action before, not after, the costsare incurred. This focus is discussed in detail later(Chapter 8) with the primary emphasis beingplaced on negotiation of forward pricing rates.

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Government acquisition management personnelmust understand that overhead costs relate to allbusiness in the contractor’s plant, not just to oneprogram. Therefore, the responsibility for moni-toring indirect costs necessarily rests with theAdministrative Contracting Officer (ACO), whois the government-responsible person located atthe contractor’s facility. However, the ACO’s jobcannot be performed adequately without assis-tance from program offices. This task requiresteamwork and a close working relationship be-tween the ACO and program managers at buy-ing activities. In particular, major program man-agers should expect the ACOs to depend upontheir input regarding the accuracy of the

contractor’s sales forecasts. At the buying activ-ity, the program manager has up-to-date knowl-edge of specific forecasts relating to programcost, schedule, and technical information. At thecontractor’s plant, the ACO is concerned withensuring that the right types of business processesexist and are being used to support all govern-ment programs at the contractor’s facility. TheACO’s interest in indirect cost is the assurancethat the costs are no higher than necessary andthat the government is not paying more than itsfair share. In order to function as a successfulacquisition team, each team member must un-derstand and support the roles played by theother members.

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22ESSENTIALS FOR UNDERSTANDING

INDIRECT COSTS

INTRODUCTION

Due to the nature of defense business, DoDrequires a detailed knowledge of the internalcost structure of contractors; however, com-mercial customers do not require such knowl-edge. This situation developed because DoDnegotiates the price of many contracts basedupon the contractor’s cost rather than uponprice determined in a competitive market-place. The reader should also keep in mindthat the level of indirect costs is not necessar-ily an indicator of inefficiency. All businesseshave indirect costs, and they are a normal andnecessary part of doing business.

The use of ambiguous terms throughout theindirect cost management process creates realproblems for those uninitiated in governmentcontracting terminology. This is true in bothindustry and government. For example, inpractice, many people in both industry andgovernment commonly use the term “over-head” interchangeably with the term “indirectcost.” We will use the term “indirect cost”rather than “overhead” and will later discussthe differences between overhead and generaland administrative expenses, which are bothindirect costs. Many terms that have the samemeaning as overhead are used interchangeablyin industry: “burden,” “loading,” “add-on,”“management,” and “factory expense.” Thereare several classifications of costs as “either/or.” These costs require a detailed explanation.

DIRECT OR INDIRECT

Understanding details about indirect cost re-quires a regulatory understanding of severalterms. Direct costs must be understood beforelearning about costs. In this chapter, the dif-ference between direct and indirect costs, willbe clarified; and an understanding of the term“final cost objective,” will be provided. Also,examples of the types of direct and indirectcosts typically found in defense contractingare provided. There are many differences ofopinion and disputes about whether certaincosts should be classified as direct or indirect,therefore it is necessary to refer to the FederalAcquisition Regulation (FAR) for key defini-tions.

FAR 31.001 defines a cost objective as a func-tion, organizational subdivision, contract, orother work unit for which cost data are de-sired and for which provisions are made to ac-cumulate and measure the cost of processes,products, jobs, capitalized projects, etc. A fi-nal cost objective is a cost objective that hasboth direct and indirect costs allocated to it.Also, in the contractor’s accumulation system,the final cost objective is one of the final ac-cumulation points. In this guide, a final costobjective is a specific contract.

FAR 31.202 defines a direct cost as any costthat can be identified specifically with a par-ticular final cost objective. Costs identified spe-cifically with a contract are direct costs of thatcontract and are charged directly to the contract.

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All costs specifically identified with other fi-nal cost objectives of the contractor are directcosts of those cost objectives and are notcharged to the contract directly or indirectly.Simply stated, costs are designated as directcosts because they are traceable to, and iden-tified with, a specific contract.

Direct material refers to all material costs thatare used in making a product and that are di-rectly associated with a change in the product.It includes raw materials, purchased parts, andsubcontracted items required to manufactureand assemble completed products. The easewith which direct material can be traced to thefinal product has a great deal to do with whetherthe material is considered as direct material. Forexample, miscellaneous small parts used inmanufacturing aircraft may be considered toosmall and too inexpensive to justify either thecost or time required to keep track of their costapplicable to specific aircraft. For practical rea-sons, they may be classified as an indirect ex-pense.

Direct labor is the labor identified with a par-ticular final cost objective or contract. Engineer-ing direct labor is that engineering work that isreadily identified with the end product, such asdesign, testing, reliability, maintainability, qual-ity, etc. Manufacturing direct labor includes fab-rication, assembly, inspection, and testing re-quired for producing the end product. The em-phasis on direct versus indirect labor in the de-fense contracting environment is significant tothe extent that many companies designate eachemployee as being either a direct or indirectemployee. In an effort to more accurately drivecost to the appropriate contract or project andto reduce indirect costs, some companies mayhave labor that is referred to as “direct distrib-uted,” “prorate,” “program direct support,” or assome other company-specific term. These costs,such as engineering administration, programsupport, scheduling, and engineering liaison, are

of an indirect nature; but they are distributedas direct costs based upon the direct area sup-ported.

Direct costs that are not materials or labor aregenerally referred to as Other Direct Costs(ODC). This cost is one that, by its nature, maybe considered indirect but, under some circum-stances, can be identified specifically with a par-ticular contract. ODC has all of the properties ofdirect material or direct-labor cost, yet it mayor may not be a tangible part of the final prod-uct. As an example, if a consultant providesassistance on several diverse and generalprojects, the cost is considered indirect and isincluded in overhead. However, if the time theconsultant spent benefited only one particularcontract, the cost is charged to the contract onwhich the consultant worked and is classifiedas ODC. Other examples of such direct costscould include special expenses for tooling, testequipment, insurance, travel, packaging, plantprotection, and computer expenses. These“special costs” are direct because they aretraceable to, and identified with, a specificcontract.

From an accounting standpoint, a job or work-order system is normally used by defense con-tractors to accumulate the direct costs of de-signing and manufacturing a company’s prod-ucts or of the performance of services under con-tracts. A separate series of work orders is openedfor each contract, to accumulate costs for vari-ous tasks, such as engineering, tooling, fabri-cation, and assembly. These work orders of-ten number in the hundreds and thousands.

FAR 31.203 defines an indirect cost as any costnot directly identified with a single, final costobjective; but it is identified with two or morecost objectives or an intermediate cost objective.Stated differently, after direct costs have beendetermined and charged directly to the contractor other work, indirect costs are those remain-

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ing to be charged to the several cost objec-tives. The regulation further provides that anindirect cost is not allocated to a final cost ob-jective if those costs that are incurred in similarcircumstances and for the same purpose are in-cluded as a direct cost of that or any other costobjective.

Unlike direct costs, indirect costs cannot be eas-ily identified with one product or service. Be-cause indirect costs are generally plant-widecosts, contractor concern for control is notsolely motivated by any one contract. An ex-ample of such an indirect cost is the cost for heat-ing in a fabrication area that houses the work ofmany contracts. The heating benefits all contractsand cannot practically be identified with a spe-cific contract. Other examples of indirect costsinclude salaries and wages of supervisors, fore-men, and other indirect employees; nonproduc-tive time of direct employees; fringe benefits forall employees; depreciation; insurance; taxes;rent; retirement plan contributions; and corpo-rate management expenses allocated from thecorporate office.

A full understanding of the regulatory aspectscannot be achieved without recognizing that in-direct cost primarily comprises two components:overhead and general and administrative ex-pense. Overhead is that indirect cost related to aparticular part of the company or plant, suchas engineering or manufacturing. General andadministrative (G&A) expense is that indirectcost that supports the company as a whole, suchas the chief executive’s salary. The Cost Ac-counting Standards, which are discussed lateras unique government requirements, distin-guish between overhead and G&A and requirethat certain allocation bases be used in somecases. The differences in overhead, G&A ex-pense, and the various types of overhead costpools that are typically found in defense con-tracting will be discussed in greater depth inChapter 3.

“Exhibit 2; “Components of Contract Price”summarizes the composition of a typical gov-ernment contract. As shown, there are two costcomponents—direct and indirect. Again, di-rect costs are identifiable to a particular con-tract and are categorized as direct labor, di-rect material, and other direct costs. Indirectcosts relate to two or more contracts and areallocated to the appropriate contracts based onsome beneficial or casual relationship. Thetotal cost of a contract, then, is the sum ofdirect and indirect cost allocable to that con-tract. There are many methods for allocatingindirect cost to contracts, which will be cov-ered in Chapter 4. Note that an unusual item,called “cost of money” is also shown as anindirect cost. This very unusual indirect costand the unique government requirements re-lating to indirect costs are addressed later inChapter 6.

It is important to keep in mind that the meth-ods used by individual contractors to classifydirect and indirect cost are very different. Theaccounting method selected by a contractor isinfluenced by several factors, for example, thenumber and type of contracts in the plant, com-petitive environment, personal preferences ofmanagement, and allocation methods used.However, to adequately manage its costs in agovernment contracting environment, a com-pany must set firm criteria for the designationof all costs as direct or indirect. Later, underthe subject of cost accounting standards, moredetails will be provided on how some contrac-tors are required to submit a disclosure state-ment. A disclosure statement is a comprehen-sive document in which the company describes,in detail, how it accumulates and allocatescosts, including the specific identification ofdirect and indirect classifications.

In summary, if the cost is identifiable and if itbenefits a specific contract, it is charged directlyto that contract. If the expense cannot be iden-

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tified with or does not benefit a particular con-tract, it is charged to overhead or G&A ex-pense; and it is allocated to those contractsthat do receive some benefit from it.

VARIABLE OR FIXED COSTS

An important step in the control of indirect oroverhead costs is the breakdown of all costs intotwo groups—fixed and variable. The variousindirect costs do not all behave in the same wayas production volume or business activity in-creases or decreases. One indirect cost may in-crease as a result of a new contract award whileanother may remain unchanged. Knowledgeof cost behavior is, therefore, very importantfor indirect cost forecasting and control. Thereare three broad categories of costs based uponthe criteria of behavior over business volume:variable, fixed, and semivariable costs.

Variable costs fluctuate directly and proportion-ally with business activity, i.e., production vol-ume or level of services provided. Without pro-duction there are theoretically, no variable costs.As “Exhibit 3. Cost Behavior” shows, variablecosts are constantly increasing as productionincreases. Labor, whether direct or indirect, isusually variable. For example, fabrication andassembly hours in the manufacturing area willincrease or decrease with the quantity produced.Any change in manufacturing processes, laborrates, or employee training will affect variablelabor costs. Other typical examples of variablecosts found in the defense contracting environ-ment are direct materials, fringe benefits, em-ployer payroll taxes, royalties, testing, and mis-cellaneous small parts. Production support costsalso are often variable. For example, the costof electricity varies with machine use, which,in turn, varies with the volume of production.Also, numerous miscellaneous factory supplies

Exhibit 2. Components of Contract Price

Cost ofMoney

MaterialHandling

MfgSupport

EngSupport

InterdivisionTransfers

CommercialItems

PurchasedParts

RawMaterials

Subcontracts

MfgLabor

EngLabor

Direct Labor Direct MaterialODC

Direct Cost Indirect Cost

Overhead G&A

Contract Price = Cost + Profit

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and expenses are planned in relation to the vol-ume of direct manufacturing labor hours. Sincevariable costs are directly and proportionatelyrelated to productive activity, they are consid-ered much more controllable than fixed costs.

Fixed costs are relatively constant and, withinreasonable limits of plant capacity, do notvary with changes in production volume inthe short run. As Exhibit 3 shows, fixed costsare charted as a horizontal line; they have thesame total regardless of the volume or othermeasure of business activity. Many fixed-costitems relate to capacity. Some of these itemsare depreciation of buildings and machinery,real and personal property taxes on buildings,equipment and inventories, property and li-ability insurance, and rent. In the future, morecosts can be expected to become fixed ratherthan variable because of increasing use of

machinery as a replacement for manpower.Fixed costs are sometimes called “periodcosts” because they relate primarily to a pe-riod of time. Of course, if the period is longenough, all expenses will become variable.However, in the short run, a capacity cost of-ten cannot be changed and, therefore, is con-sidered to be fixed.

Fixed costs are established by management ona total-plant basis for a broad range of activi-ties, and they will remain unchanged withinthat “relevant range.” Theoretically, the rel-evant range represents the levels of activityover which cost relationships remain constant.That is, if volume increases (decreases), vari-able costs will increase (decrease) proportion-ately; however, fixed costs will stay fixedwithin the relevant range. If volume levels in-crease, capacity may be strained and additional

Exhibit 3. Cost Behavior

VARIABLE FIXED

SEMIVARIABLE

DIRECT LABORDIRECT MATERIALSALES COMMISSIONS

DEPRECIATIONRENTREAL ESTATE TAXESPROPERTY INSURANCEADMINISTRATIVE SALARIES

UTILITIESMAINTENANCE

UNITSUNITS

UNITS

$

$STEP-FIXED

INDIRECT LABOREQUIPMENT RENTAL

UNITS

$

$

2-6

fixed cost capability will be required. Althoughfixed costs are not initially established on acontract-by-contract basis, an award of a largecontract could produce a significant change inproduction volume and in the required level offacilities. Conversely, the loss of a large con-tract could result in idle capacity, which producesserious overhead cost problems.

Fixed costs are often referred to as discretion-ary costs, which indicate that control over theseexpenses rests with top management, who de-termine the amount of corporate investmentin plants, equipment, and organizational size.Two large discretionary costs in a defense con-tracting environment are Independent Researchand Development (IR&D) expenses and Bidand Proposal (B&P) expenses. These indirectcosts may often be increased, even when cur-rent business volume is decreasing. For ex-ample, management’s objective may be to gaina competitive advantage and to increase fu-ture business opportunities. Also, certain keypersonnel involved in research or proposal de-velopment activities might be so valuable tothe company that they would be retained evenif large volume decreases were experienced.It is interesting to note that some fixed costsare more fixed than others. For example, IR&Dand B&P expenses are usually budgeted bymanagement on an annual basis; and theycould, therefore, be considered fixed for theyear. However, these expenses could also bechanged quickly by a management decision.On the other hand, investments in plant andequipment are fixed for much longer periodsof time and cannot be quickly changed.

During production, few indirect expenses be-have as purely fixed or purely variable. A largenumber of expenses contain both fixed andvariable components. As Exhibit 3 shows,these expenses often remain relatively fixedbetween various ranges of volumes and thenadvance or decline in a step-type function as

volume changes occur. An expense of thisnature might be the cost of renting a machinethat, once available, can provide per-unit costsavings by handling a greater volume. Onceits capacity is reached, however, greater vol-ume can be achieved only by renting an ad-ditional machine. Semivariable costs varywith volume but not proportionally. Examplesof semivariable expenses are supervisory la-bor, repairs and maintenance, factory officesalaries, social security taxes, and some utili-ties, such as telephones and electricity. Man-agement control of semivariable expenses isaccomplished by dividing them into fixed andvariable portions and treating them accord-ingly. The fixed portion is considered to bethe necessary expense at the lower level ofthe expected volume, and the difference be-tween this lower level and the higher level istreated as variable.

The fixed and variable analysis of indirect costswon’t be found in published financial reports;but, in all probability, the company will sepa-rate indirect costs into fixed and variable com-ponents for internal decision-making purposes.Most business decisions involve the selectionof alternatives such as whether or not to makeor buy, to accept a special offer at a lower price,or to increase capacity. A fixed versus variableanalysis is needed for making such manage-ment decisions. Although a fixed and variableanalysis should be available internally withinevery company, what is called a fixed cost atone firm may be considered variable cost atanother. The analysis of costs into fixed andvariable components is a powerful tool for ana-lyzing indirect costs. Rarely does the defensebusiness volume remain at one level. The pro-cess of classifying costs according to the be-havior of the costs relative to changes in busi-ness volume leads the decision maker to be-come more knowledgeable about the cost driv-ers of indirect costs within a particular com-pany.

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The relative proportion of fixed and variablecosts is referred to as a company’s cost struc-ture. The more fixed cost in a company’s coststructure, the more volatile will be changes inoverhead rates. This will become more appar-ent when the development of overhead rates isdiscussed in Chapter 4.

ALLOWABLE OR UNALLOWABLECOSTS

Unfortunately for defense contractors, one ofthe most significant factors affecting indirectcosts as well as profitability is the differencebetween allowable and unallowable costs. Thisdifferentiation does not exist in the commer-cial world. From the contractor’s perspective,many normal and necessary expenses, forwhich the government will not pay, exist foroperating a business. From the government’sperspective, there are many expenses that areconsidered unnecessary for government workor contrary to public policy for various rea-sons.

The specific criteria for cost allowability iscontained in FAR Section 31.201. Factors tobe considered in determining the allowabilityof individual items of cost include: (1) rea-sonableness, (2) allocability, (3) CASs pub-lished by the Cost Accounting StandardsBoard or from generally accepted accountingprinciples, (4) terms of the contract, and (5)any limitations in the Federal AcquisitionRegulation (FAR). There are about 50 selectedcost items spelled out in FAR Section 31.205for special consideration as to the allowabilityof the costs on government contracts. Theseselected items, subject to frequent change, arecommonly referred to in practice as the “CostPrinciples.” Both contractor and governmentpersonnel working on negotiated defense con-tracts must have personnel who are very fa-miliar with these rules and regulations.

Due to the recent media attention, many con-tractors have adopted an additional “mediasensitivity” test for allowability: “Before I in-clude this cost in an overhead claim to the gov-ernment, would I want to read about it in thenewspaper in the morning?” As a result of con-gressional interest during the past few years,emphasis has been placed on increasing thetypes of costs that are unallowable. Also, theCongress has enacted statutes providing forstrong penalties if contractors do not complywith unallowable cost provisions. Most recently,Congress has passed limitations on the com-pensation for individuals that can be chargedto defense contracts. Such congressional ac-tions have been highly controversial in indus-try. Since most unallowable-type costs are ofan indirect or overhead nature, they are dis-cussed in more detail and examples are pro-vided in Chapter 6.

CAPITALIZED VERSUS EXPENSED

Whether a particular cost is capitalized or ex-pensed makes a tremendous difference to thegovernment and the contractor. This conceptmust be grasped before indirect costs in thedefense industry can be understood. From anaccounting standpoint, the total costs of itemsthat are acquired for relatively small amountsand for general-purpose use are: (1) typicallyclassified as expenses and (2) placed intoindirect-cost pools for subsequent allocationto many contracts. However, the costs of suchitems for relatively larger amounts are classi-fied as assets and are considered to be capital-ized. In the case of capitalized items, only aportion of the costs is placed into indirect-costpools in the form of a depreciation expenseeach year.

In general, the capital versus expense distinc-tion normally relates to plants, equipment, andother fixed assets. For example, when a com-pany buys a machine that is not intended for

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sale, it generally expects to use the machine overand over again for the benefit of many contractsover a number of years. Therefore, the companyrecords the cost of the machine as an asset andnot as an expense. An asset is simply a valuableitem that is owned or controlled by the company.In each subsequent accounting period when themachine is put into use, an appropriate portion ofthe cost of the machine is written off as an ex-pense based on the estimated service life of themachine. This expense is called depreciation andrepresents the systematic allocation of the cost ofthe asset over its estimated useful life. It also rep-resents the decline, due to wear and tear from useand passage of time, in the useful value of theasset.

As an example, assume that a general-purposemachine to be used in the manufacturing areais purchased by a contractor for $120,000. Theinstallation and checkout costs are $40,000. Fur-ther, assume that the machine has an expecteduseful life of 8 years; has no salvage value; andis placed into use at the beginning of the year.Using a “straight-line” method of depreciation,allow $20,000 ($160,000 divided by 8 years) ofthe total cost of the machine for each year as anindirect expense for depreciation. Recognizethat there are many acceptable ways of depre-ciating assets in addition to the straight-linemethod, but this method is the simplest. Re-gardless of the method of computation, as a gen-eral rule, depreciation expenses for all assetsare indirect or overhead costs. It is importantto note that the entire $160,000 is not classi-fied as an indirect expense in the first year. Thisis particularly important from a defense con-tracting perspective because a contractor canbill the government immediately under a cost-type contract for an appropriate allocation ofindirect expenses. However, the contractor can-not bill for the fully capitalized amount of theasset at the time that it is purchased.

It is important to realize that many companiesfollow a business practice of charging all as-set expenditures of relatively small amountsto expense instead of recording them as as-sets; thus, they avoid excessive accountingwork. Given the large investments in assetsand complexity of the defense business alongwith its many cost-based contracts, very spe-cific rules governing the capitalization andexpensing of assets can be expected. This topicis discussed further in Chapter 7 in the CASssection specifically CAS 404, “Capitalizationof Tangible Assets.”

Amortization, which is similar to deprecia-tion, is a term commonly used in the defenseindustry. Amortization is the periodic write-off or expensing over the estimated life ofcertain, often program related, unique assets,such as special tooling, special test equip-ment, and initial computer programmingcosts. Amortization and depreciation expensesare usually substantial amounts of indirector overhead cost for weapon system contrac-tors.

CONTROLLABLE OR NONCONTROL-LABLE COSTS

Since indirect costs relate to and are allocatedto more than one cost objective, they are muchmore difficult for management to control thandirect costs. To deal with this problem, somecompanies follow an internal practice of break-ing down indirect or overhead-type costs or-ganizationally as either controllable or non-controllable. This classification is based uponthe ability of a given manager to personallycontrol the costs. The concept provides anexcellent managerial tool for relating organi-zational structure and decision-making author-ity to specific activities that caused the coststo be incurred.

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This managerial control technique, sometimescalled “responsibility accounting,” is discussedin further detail in Chapter 5, when the topicon how the defense industry typically man-ages indirect costs is discussed. Bear in mindthat company organizations differ, and thereare substantial differences in how companiesbreak down indirect costs between controllableand noncontrollable elements.

The basic principle of responsibility account-ing is that indirect costs should not be allo-cated to a manager unless the manager can ex-ercise control over costs incurred. The man-ager of a parts fabrication shop, for example,has direct control over and is concerned withthe amount of direct labor, direct material,and other direct costs expended on specificshop orders for building detailed parts to befed into assemblies. In addition, the managermay control over such indirect costs as the la-bor of foremen, training time, overtime, timespent waiting for work, and the call-in ofmanufacturing engineering. However, there areusually other costs charged to the manager’sorganization that cannot be controlled, for ex-ample, depreciation of the building, deprecia-tion of the machinery and tooling used by thepersonnel, or the allocation of costs from ser-vice organizations, such as the computer cen-ter. Such allocated expenses are often sepa-rated from nonallocated or controllable ex-penses in order to focus the manager’s atten-tion on the expenses that can be controlled.

In the short run, there are many indirect coststhat cannot be quickly reduced and, conse-quently, are considered to be uncontrollable.They typically include expenses for taxes, suchas state income, sales, and franchise taxes; lo-cal property taxes; royalties; insurance pre-

miums; employer payroll taxes; and deprecia-tion. However, in the long run, almost all costsare controllable to a certain degree by someonein the corporation. Costs incurred beyond thecontrol of a department manager are uncontrol-lable costs to the department; but generally arecontrollable by a higher manager, such as theplant manager. Examples of these plant-widecosts are employee welfare expenses for suchcosts as operating a company cafeteria, opera-tion of a medical facility, and providing an an-nual summer picnic for all employees. A por-tion of these costs would have to be allocated toall departments.

The costs of service departments may presentmanagerial control problems. For example,the cost of a large computer services depart-ment is the overall responsibility of the com-puter services department head. However, ser-vice costs that can be controlled by operat-ing departments, such as requests for specificcomputer services, should be the responsibil-ity of operating department managers.

Recently, some defense companies have beenmoving away from the classification of costsas controllable and noncontrollable. Some arevery opposed to, and do not allow the useof, the term “noncontrollable cost.” Their ba-sic tenet is that there is no such thing as anuncontrollable indirect cost, and they do notwant their managers to think in these terms.Defense companies want classification to fo-cus on a management philosophy, i.e., all costsmust be controlled at every organizationallevel and any cost that is allocated to their or-ganization should be questioned. This man-agement view is covered further in Chapter 5,when the topic of what defense contractors haverecently done to reduce overhead costs is ad-dressed.

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33TYPICAL INDIRECT-COST POOLS

Establishing separate indirect-cost pools im-proves the visibility of difficult-to-control costsand facilitates the monitoring of similar typesof expenses. Depending on contractor needs forpricing and control, indirect costs are groupedinto logical cost pools relating to major func-tions and activities, types of products, company-specific organizational structure, market, andother considerations. Contractors whose prod-ucts, services, or contracts are substantially dif-ferent naturally require more detailed cost pools.The type or number of indirect-cost pools nec-essary for a contractor’s business segment is notspecified by industry standards or governmentregulations and, consequently, varies signifi-cantly.

Once indirect costs are properly pooled, theyare distributed to cost objectives using a direct-cost distribution base common to all cost ob-jectives to which indirect costs are allocated.The various methods of distributing or allocat-ing overhead costs to contracts is discussed indetail in Chapter 4.

Indirect-cost pools are categorized as overhead,service center, or general and administrative(G&A) expense pools. The primary distinctionbetween overhead and G&A cost pools is thatoverhead costs only benefit a part of a businesssegment, e.g., a functional organization such asengineering or manufacturing, while the G&Aexpense pool benefits the entire organization.“Exhibit 4. Typical Contractor Cost Hierarchy”shows the three broad categories of indirect-cost pools that require assignment or allocationto contracts, i.e., service centers, overhead

pools, and the G&A pool. The contractor’s busi-ness segment has three major contracts and sev-eral independent research and development/bidand proposal (IR&D/B&P) projects; all of theseprojects use direct material, direct labor, andother direct cost as well as four service centers,eight overhead pools, and one G&A cost pool.Of course, if a contractor expects to make aprofit, all costs must be assigned to contractsor final-cost objectives.

OVERHEAD POOLS

It is very common to find separate overheadpools for engineering, manufacturing, materialhandling, and for certain off-site activities, par-ticularly those performed at government facili-ties as opposed to contractor-owned facilities.Yet, it is conceivable that a small contractorcould have only one overhead pool. However,since defense industry products and services areusually complex and are procured under vari-ous types of contracts, defense contractors nor-mally have multiple overhead pools. Generally,the accuracy of cost information and manage-ment visibility are improved by the introduc-tion of additional indirect-cost pools. Again, thetype and number of indirect-cost pools vary sig-nificantly. One contractor may have 8 overheadpools; another may have more than 100. Eventhe same corporation may have totally differ-ent overhead pool structures for various busi-ness segments or separate divisions within thecorporation. More detailed government regu-latory requirements are in the Cost AccountingStandards (CASs) and the Federal AcquisitionRegulations (FARs); these requirements relate

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Exhibit 4. Typical Contractor Cost Hierarchy

(1) Some overhead pools, such as Product A, may not apply to all contracts.(2) A service center, such as computer services, may perform work on specific contracts (as other direct

costs) and support overhead pools, such as engineering.(3) Use and occupancy includes depreciation of the plant and equipment, maintenance, insurance,

taxes, facilities engineering, janitorial services, etc.(4) Operations includes manufacturing planning, production control, quality inspection, graphics,

reproduction, etc.(5) IR&D/B&P expenses are indirect expenses, e.g., direct labor, direct materials, and allowable

overhead, that are collected on a project basis similar to contracts. They are accumulated and thentransferred for allocation as an indirect expense.

TRANSFERRED

TO

G&A

INDIRECT

COST

DIRECT

COST

COMPUTERSERVICES

USE ANDOCCUPANCY (3)

CONTRACT A

DIRECT MATERIALSDIRECT LABOR

OTHER DIRECT COSTS

SERVICE CENTERS (2)

CONTRACT B

DIRECT MATERIALSDIRECT LABOR

OTHER DIRECT COSTS

CONTRACT C

DIRECT MATERIALSDIRECT LABOR

OTHER DIRECT COSTS

IR&D/B&PPROJECTS (4)

DIRECT MATERIALSDIRECT LABOR

OTHER DIRECT COSTS

ENGINEERING PRODUCT A PRODUCT B ASSEMBLY FABRICATION TOOLINGMATERIALHANDLING

OPERATIONS (4) INDUSTRIALENGINEERING

CORPORATE OFFICE EXPENSE ALLOCATIONSEGMENT GENERAL AND ADMINISTRATIVE EXPENSES

INDEPENDENT RESEARCH AND DEVELOPMENT EXPENSESBID AND PROPOSAL EXPENSES

G&A

CONTRACTOR BUSINESS SEGMENT

OVERHEAD COST POOLS (1)

OFF-SITE

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to the criteria for accumulating indirect costsinto cost pools. This topic is discussed in moredetail in Chapter 7.

Most defense contractors have separate over-head pools for engineering and manufacturing.Engineering overhead includes the costs of di-recting and supporting all engineering-orga-nization related activities that cannot be as-signed to specific contracts. Engineeringoverhead typically includes engineering super-vision, engineering policies and procedures, en-gineering buildings and equipment deprecia-tion, software, training, maintenance, supplies,scientific library, and fringe benefits. Manufac-turing overhead, sometimes called factory over-head or factory burden, usually includes allitems of production costs except direct mate-rial, direct labor, and other direct costs. Thecomponent elements of manufacturing over-head typically consist of several major catego-ries of expense, including supervision, admin-istration, time standards engineering,manufacturing research, tool cribs, mainte-nance, indirect supplies (such as small tools),grinding wheels, and cleaning supplies. It usu-ally includes costs associated with factory la-bor fringe benefits, such as social security taxes,leave, group health insurance, etc. It also in-cludes factory-related fixed charges for depre-ciation, insurance, rent, and property taxes.

Manufacturing overhead is often broken downinto several overhead pools rather than one over-all manufacturing pool. This is particularly truewhen several different products require vary-ing amounts of overhead support. For example,separate overhead pools are often found for as-sembly, fabrication, tooling, and quality. Engi-neering and manufacturing overhead pools aresometimes referred to as resource pools becausethey collect or pool the costs of administrativeand other indirect expenses associated with cen-tralized resource organizations that supportmultiple products.

If a contractor’s activities are spread out geo-graphically, the use of separate off-site indirect-cost pools for each geographic location willusually produce more accurate allocations ofindirect cost than the use of in-plant orcompany-wide pools. Overhead pools estab-lished for off-site or remote locations shouldbe based on eliminating indirect costs, whichdo not provide a benefit for the off-site activi-ties, from the overhead pool. For example, oc-cupancy costs would be eliminated from off-site pools for work performed at governmentfacilities because government facilities are usedrather than the contractor’s. If a substantial trav-eling distance is involved, a reduction could alsobe made for management and supervisory ex-penses. Rather than having separate rates foreach site, some contractors have establishedfield service overhead pools to cover all workat customer locations away from the main plant.

Defense contractors sometimes establish prod-uct pools with the objective of increasing thedirect traceability of costs to individual prod-uct lines. Such pools are often established fordedicated program or product engineering, pro-curement, spares, or other elements in order toidentify similar product overhead costs withbenefiting contracts or final cost objectives.Product pools may be established for new pro-grams during the bid phase and discontinuedwhen the effort is complete and all programcosts are recorded. If a program phases downto a small effort over an extended time, the poolmay be merged with another pool. Examplesof product pools are missile systems, electronicsystems, advanced projects, special projects, orspace systems.

Material overhead, commonly called materialhandling, includes the functions of purchasing;receiving and inspection; handling and storage;inventory control; and expediting materials re-quired for contracts. Other examples of sepa-rate overhead cost pools often found in defense

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industry include overhaul and repair, modifica-tion, manufacturing development, subcontractadministration, testing, packing and crating,customer service, product support, and fringebenefits.

SERVICE CENTERS

Service centers are departments or other func-tional organizations that perform specific tech-nical or administrative work for the benefit ofother organizational units. Their costs may beallocated, based on some measure of usage,partially to contracts as direct costs and par-tially to other indirect-cost pools. For example,the cost of the computer service center could becharged directly to contracts or to other indirect-cost pools on the basis of the hours worked byprogrammers.

Programmers could scientifically program aspecific engineering contract, program numeri-cally controlled machines for the manufactur-ing overhead function, update an inventory con-trol system for the material handling overheadfunction, or modify a payroll system for ac-counting, which would be a G&A function. Ofcourse, the programmers could not charge bothdirect and indirect costs for the same task. Eachtask performed must have only one labor charge.Use and occupancy is another example of a verylarge service center commonly found in thedefense industry. This service center is usuallydistributed based upon square footage occupiedby users. It includes the costs for depreciation,maintenance, utilities, leases, security and fireprotection, environmental cleanup, and facili-ties engineering.

From an accounting standpoint, service centersare usually closed out each month by transfer-ring or allocating the cost of operating the ser-vice to the responsible users. “Exhibit 4. Typi-cal Contractor Cost Hierarchy” shows servicecenters for computer services, operations, in-

dustrial engineering, and use and occupancy.“Exhibit 5. Final Overhead Pools” shows howan appropriate amount of these service centercosts might be allocated to various final over-head pools. These amounts are shown at thebottom of the exhibit under the category of“Allocations.” Recognize that some service cen-ter costs will be charged directly to contracts,based upon use.

Other examples of service centers often foundin defense industry are print shops, graphic arts,reproduction services, communication services,motor pools, mail rooms, technical publications,calibration labs, wind tunnels, and corporate air-craft. Some contractors refer to service centersas secondary pools, support pools, or proratedepartments. In government contract accountingterms, they are referred to as intermediate costobjectives because costs are temporarily col-lected in the service center as an intermediatestep before they are later allocated to final costobjectives, such as specific contracts.

GENERAL AND ADMINISTRATIVEEXPENSE POOL

G&A expenses represent the cost of activitiesnecessary to the overall operation of the busi-ness as a whole, but a direct relationship to anyparticular cost objective cannot be shown. G&Aexpenses include the top management functionsfor executive control and direction over all per-sonnel, facilities, and activities of a businesssegment. Typically, G&A expenses include hu-man resources, accounting, finance, public re-lations, contract administration, legal, selling,independent research and development, bid andproposal expenses, and an expense allocationfrom the corporate home office.

A contractor’s selling expenses may be includedin the G&A expense pool or may be accountedfor in a separate cost pool. Selling expenses arethe efforts to market a contractor’s products or

3-5

services and include expenses for advertising,corporate image enhancement, market planning,and direct selling.

Since G&A usually includes executive bonuses,incentive awards, stock options, and businessentertainment expenses, it represents the mostcontroversial area for questioning the reason-ableness of cost allocations to government con-tracts. In this regard, the government does notallow profit on G&A cost when computing itsprofit objective for negotiating flexibly pricedcontracts. Therefore, the defense contractorcould be expected to minimize indirect costclassified as G&A. The government position ofnot recognizing profit on G&A may not be ap-parent when examining a billing submitted bya contractor on a cost-type contract. The profitrate on the billing may be applied to the totalcost incurred, which includes G&A. However,government personnel do not consider G&Aas a profit-bearing cost when arriving at theprofit-rate objective prior to negotiations.

Since G&A costs relate to the operation of thebusiness as a whole, any cost directly distrib-uted to both government and commercial workof the contractor should be removed from G&Aand distributed to the appropriate cost objec-tive, such as a contract or appropriate overheadcost pool. Each contractor business segment hasits own G&A cost pool and, while there can bemany overhead pools, there is only one G&Apool for a business segment. Note in Exhibit 4that a contractor’s business-segment G&A ex-penses usually include major costs for segment-level G&A expenses, an appropriate allocationof corporate home-office expenses, independentresearch and development expenses, and bid andproposal expenses. However, note in “Exhibit5. Final Overhead Cost Pools,” the G&A costpool does not include IR&D/B&P expenses.IR&D/B&P is absent from this exhibit becausethese costs must be handled in a prescribed wayin accordance with government contract re-

quirements. Before the proper treatment ofIR&D/B&P expenses is addressed, it is impor-tant to know how overhead rates are computed.This topic will be revisited in Chapter 4 whenthe requirements for deriving the total cost ofIR&D/B&P projects and then transferring thesevery significant costs to the G&A cost pool isaddressed.

MAJOR CATEGORIES OFINDIRECT EXPENSES

Since each overhead pool normally includeshundreds of individual indirect expense ac-counts, contractors will summarize these ac-counts within each cost pool into major subdi-visions or categories for management controlpurposes. Exhibit 5 summarizes the many in-direct expense accounts into five primary clas-sifications of salaries and wages, fringe ben-efits, supplies and services, other expenses, andservice center allocations. There is no pre-scribed way of doing this, and all companiessummarize as they choose.

Many overhead costs are for personnel, andthese costs usually represent a significantamount of overhead costs. Personnel costs in-clude salaries and wages of indirect labor (thoseemployees needed to run the organization butwhose work bears no direct relationship to anyspecific contract) and fringe benefits for bothdirect and indirect employees. Fringe benefitsare costs associated with labor, such as healthand life insurance, leave, social security taxes,and pensions. It is not unusual in the defenseindustry for fringe benefits to approximate 50percent of labor costs. Supplies and services arethose indirect items, such as lubricating oil, per-ishable tools, nuts and bolts, and calibration,that are not assignable as direct costs to a con-tract; but they relate to all contracts. “Other ex-penses” is a catch-all category that includesmiscellaneous items such as travel, telephone,telegraph, and employee relocation.

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MATERIAL PRODUCT PRODUCT OFFINDIRECT COSTS ENG FAB ASSY TOOLING HANDLING “A” “B” SITE G&A

Salaries & Wages:

Supervision $ 3,701 $ 19,674 $ 6,246 $ 729 $ 4,235 $ 177 $ 301 $ 260 $ 21,982

Indirect Labor 33,310 91,811 28,105 4,666 33,876 694 1,157 1,214 88,636

OTP 925 18,362 4,164 198 42,345 59 141 87 2,836

Training 5,552 1,202 520 255 2,879 231 347 130 2,978

Idle Time 19 219 104 24 85 1 2 3

Total Salaries & Wages $ 43,507 $ 131,267 $ 39,139 $ 5,872 $ 83,420 $ 1,162 $ 1,948 $ 1,692 $ 116,432

Fringe Benefits:

Health & Life Ins $ 29,609 $ 40,768 $ 17,175 $ 4,008 $ 6,288 $ 1,851 $ 3,701 $ 1,388 $ 1,595

Workmen’s Comp 1,851 31,041 12,491 1,093 5,336 116 231 173 4,432

Annual Leave 7,402 8,744 4,164 972 2,287 463 925 347 3,900

Holiday 9,253 10,930 5,205 1,214 1,906 578 1,157 434 2,482

Sick & Pers Lv 3,701 7,651 3,123 559 953 231 463 173 1,773

FICA Taxes 14,804 17,488 8,327 1,943 3,049 925 1,851 694 1,578

Unempl Taxes 1,851 2,186 1,041 243 381 116 231 87 1,064

Retirement Plan 16,655 19,674 9,368 2,186 3,430 1,041 2,082 781 2,570

Savings Plan 3,701 4,372 2,082 486 762 231 463 173 2,322

Total Fringe Benefits $ 88,827 $ 142,853 $ 62,977 $ 12,703 $ 24,391 $ 5,552 $ 11,103 $ 4,250 $ 21,716

Supplies/Svcs:

Operating $ 925 $ 18,624 $ 6,402 1,241 4,235 29 35 106

Maintenance 37 1,093 520 121 898 5 12 21

Perishable Tools 1,110 9,181 4,372 1,020 51 30 8

Cal & Cert 370 656 312 73 34 23 46

Office Supplies 925 874 427 97 728 60 46 1,950

Total Supplies/Svcs $ 3,368 $ 30,429 $ 12,033 $ 2,553 $ 5,945 $ 147 $ 148 $ 2,078

Other Expenses:

Travel $ 7,032 $ 1,749 $ 833 $ 194 $ 8,469 $ 160 $ 319 $ 8,864

Telephone 4,626 1,093 520 121 1,186 289 578 10,016

Busn Meetings 925 66 31 20 593 60 21 1,773

Employee Relocation 555 44 21 5 102 40 81 124

Dues & Subscriptions 370 46 21 8 31 18 35 1,773

Employee Welfare 185 334 159 37 38 23 46 121

Total Other Expenses $ 13,694 $ 3,331 $ 1,585 $ 386 $ 10,418 $ 590 $ 1,081 $ 22,669

Allocations:

Use & Occupancy $ 60,653 $ 98,423 $ 31,705 $ 13,785 $ 27,845 $ 3,860 $ 7,719 $ 31,705

Computing Svcs 22,465 14,145 4,160 2,496 14,145 1,165 1,331 23,297

Operations Svcs 556 33,381 20,665 2,384 18,280 397 636 3,179

Industrial Eng ________ 5,464 2,484 1,987

Total Allocations $ 83,675 $ 151,413 $ 59,014 $ 20,652 $ 60,270 $ 5,422 $ 9,687 $ 58,181

Total Indirect Expenses $ 233,070 $ 459,294 $ 174,748 $ 42,165 $ 184,445 $ 12,874 $ 23,966 $ 5,942 $ 221,076

Exhibit 5. Final Overhead Cost Pools (In Thousands)

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The allocations category represents indirectcosts distributed to the final overhead pool fromexternal organizations, such as service centersor other intermediate cost objectives. Thesecosts usually include the fair share of facilities-related costs, including fixed asset depreciation,repair and maintenance, leased equipment, andutilities. In the allocations category of Exhibit4, service center allocations from use and oc-cupancy, computing services, operations ser-vices, and industrial engineering are included.

Some companies may include fringe benefitsas a part of their direct-labor rate as opposed toclassifying fringe benefits as a part of overhead.Either method is acceptable; however, sincefringe benefits are such a significant amount,they will have a very significant impact uponreducing overhead rates when they are a part ofdirect labor. This item will be discussed laterwhen allocation methods and indirect rate com-putations are examined.

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44ALLOCATION OF INDIRECT COSTS

For numerous reasons, industry requires an ac-curate allocation of indirect costs to final costobjectives, such as commercial products or spe-cific government contracts. From a financialreporting perspective, accurate indirect-costallocation is necessary for the proper valuationof inventories and for the determination ofbusiness-segment profitability. From a manage-ment perspective, it is necessary for controllingcosts and for internal decision-making pur-poses, such as product pricing and capital in-vestment decisions. To do business with thegovernment on a negotiated cost basis, defensecontractor management must provide accuratecost and pricing data necessary for compliancewith government contracting requirements.From a program management perspective, themethod used to allocate indirect costs will de-termine the amount of those costs that will becharged to each contract.

ALLOCATION OF OVERHEAD

For overhead cost allocation purposes, compa-nies view overhead on an annual basis; and it isconsidered to be a “period” expense. The pe-riod used is the contractor’s fiscal year becauseit provides a natural business cutoff for ex-penses. Consequently, this period usually nevercoincides exactly with any government contractperiod of performance. Businesses view over-head on an annual basis for many reasons. Manyoverhead-type expenses will vary significantlyfrom month to month. Changes in business vol-ume from month to month can significantly af-fect overhead rates. Seasonal variations, such

as heating and air conditioning requirements,cause large month-to-month differences.

Month-to-month estimates are required for hun-dreds of indirect expenses in each overheadpool, and they can never be precisely correct.For example, detailed monthly inventories ofthe many indirect materials and supplies can-not be made to determine the actual amountused during a monthly production period. Manyestimates are made because management can-not wait until the end of the year to find outwhat each job costs. Further, many jobs arecompleted before the year ends; and customersare continuously requesting proposals and quo-tations that must include indirect costs. There-fore, overhead is estimated at the beginning ofthe year and applied to each job or productworked on during the year. This approach usesan average estimated overhead cost withoutchanging the overhead rate when costing spe-cific jobs, products, or contracts from day today or month to month. Again, overhead ismanaged in annual increments based upon thecontractor’s fiscal year.

The concept of a predetermined, “applied over-head rate” is used in industry for allocatingoverhead costs, for estimating purposes, and forcosting jobs completed prior to the end of theyear when actual costs will be known. The ap-plied overhead rate is the ratio of estimated in-direct costs for the contractor’s fiscal year tothe estimated business volume for some com-mon, measurable, direct-cost allocation-basefactor for the same period. To correct a com-

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mon misunderstanding, note that, although“forward-pricing rates” are commonly referredto as “applied rates,” they are not the same rates.Forward-pricing rates are used only for govern-ment contracting purposes, and the contractor’sapplied rates are not reduced for many costs thatthe government will not pay. The applied ratesrepresent the contractor’s best estimate of whatthe total costs will be, including any unallowableexpenses. The contractor’s applied rates will al-ways be greater than the rates used for govern-ment contracting purposes. Forward-pricing ratesare discussed later in Chapter 6 after governmentrequirements for allowability of indirect costs areaddressed.

The basic formula for all indirect-cost rates is:

rate = indirect-cost pool expensesallocation base

In computing overhead rates, the estimated in-direct cost in each cost pool is the numerator;and the estimated specific allocation base forthat cost pool is the denominator. The predeter-mined rate should produce an equitable alloca-tion of indirect costs among numerous final costobjectives, such as government contracts. Eachaccounting period, the estimated rate is appliedto the incurred cost on each job on a cumula-tive basis. Of course, there will always be a dif-ference between the overhead costs generatedby applying the predetermined estimated rateand the actual overhead costs. The estimatedoverhead rates are adjusted to actual rates assoon as the actual data are known at the end ofthe accounting period.

Each direct-allocation base is calculated basedon a projection of the forecasted direct activity,which, in turn, is derived from the estimatedsales for the same period. It should be empha-sized that the estimated sales are the total salesfor both government and commercial business.Any significant error in estimating sales will

result in a significant error in the predeterminedrate. Therefore, the accurate development ofthe business base is crucial to the rate-development process. The subject of sales fore-casting, crucial to the management of overheadcosts, is discussed in greater detail in Chapter 5.

The direct-allocation base selected for a givenoverhead cost pool must be common to all con-tracts worked on since it becomes the measur-ing device for allocating joint, indirect costs tocontracts. On a historical basis, the most com-mon method of applying overhead costs hasbeen direct-labor cost. Direct-labor cost hasbeen used because it is readily available frombusiness records and because it has tradition-ally been such a large, common, direct-costcomponent of total costs. The importance ofdirect labor as an allocation base is changing;this change is discussed in more detail later.

“Exhibit 6. Final Overhead Rates” takes a moredetailed look at the computation of overheadrates in a large company. It shows the overheadrates that would apply to the eight overheadpools in this example of a typical defense con-tractor. For educational purposes, direct-labordollars are used as the basis for allocating theindirect cost for all overhead pools. The onlyexception is material handling, where direct ma-terials are considered to be a more appropriateallocation base. Note that indirect rate figuresare usually extended two places beyond thedecimal point. For example, in recovering theindirect costs associated with particular con-tracts during the year, each dollar of engineer-ing direct labor worked on a contract is bur-dened with an engineering overhead of 125.95percent. In addition, the engineering direct la-bor and overhead, plus any added labor andoverhead that may be applicable to work on thecontract from other cost pools, is burdened withgeneral and administrative (G&A) expenses.However, a G&A rate cannot be computed inthe example until total IR&D/B&P expenses

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MATERIAL PRODUCT PRODUCT OFFINDIRECT COSTS ENG FAB ASSY TOOLING HANDLING “A” “B” SITE G&A

Salaries & Wages:

Supervision $ 3,701 $ 19,674 $ 6,246 $ 729 $ 4,235 $ 177 $ 301 $ 260 $ 21,982

Supervision $ 3,701 $ 19,674 $ 6,246 $ 729 $ 4,235 $ 177 $ 301 $ 260 $ 21,982

Indirect Labor 33,310 91,811 28,105 4,666 33,876 694 1,157 1,214 88,636

OTP 925 18,362 4,164 198 42,345 59 141 87 2,836

Training 5,552 1,202 520 255 2,879 231 347 130 2,978

Idle Time 19 219 104 24 85 1 2 3

Total Salaries & Wages $ 43,507 $ 131,267 $ 39,139 $ 5,872 $ 83,420 $ 1,162 $ 1,948 $ 1,692 $ 116,432

Fringe Benefits:

Health & Life Ins $ 29,609 $ 40,768 $ 17,175 $ 4,008 $ 6,288 $ 1,851 $ 3,701 $ 1,388 $ 1,595

Workmen’s Comp 1,851 31,041 12,491 1,093 5,336 116 231 173 4,432

Annual Leave 7,402 8,744 4,164 972 2,287 463 925 347 3,900

Holiday 9,253 10,930 5,205 1,214 1,906 578 1,157 434 2,482

Sick & Pers Lv 3,701 7,651 3,123 559 953 231 463 173 1,773

FICA Taxes 14,804 17,488 8,327 1,943 3,049 925 1,851 694 1,578

Unempl Taxes 1,851 2,186 1,041 243 381 116 231 87 1,064

Retirement Plan 16,655 19,674 9,368 2,186 3,430 1,041 2,082 781 2,570

Savings Plan 3,701 4,372 2,082 486 762 231 463 173 2,322

Total Fringe Benefits $ 88,827 $ 142,853 $ 62,977 $ 12,703 $ 24,391 $ 5,552 $ 11,103 $ 4,250 $ 21,716

Supplies/Svcs:

Operating $ 925 $ 18,624 $ 6,402 1,241 4,235 29 35 106

Maintenance 37 1,093 520 121 898 5 12 21

Perishable Tools 1,110 9,181 4,372 1,020 51 30 8

Cal & Cert 370 656 312 73 34 23 46

Office Supplies 925 874 427 97 728 60 46 1,950

Total Supplies/Svcs $ 3,368 $ 30,429 $ 12,033 $ 2,553 $ 5,945 $ 147 $ 148 $ 2,078

Other Expenses:

Travel $ 7,032 $ 1,749 $ 833 $ 194 $ 8,469 $ 160 $ 319 $ 8,864

Telephone 4,626 1,093 520 121 1,186 289 578 10,016

Busn Meetings 925 66 31 20 593 60 21 1,773

Employee Relocation 555 44 21 5 102 40 81 124

Dues & Subscriptions 370 46 21 8 31 18 35 1,773

Employee Welfare 185 334 159 37 38 23 46 121

Total Other Expenses $ 13,694 $ 3,331 $ 1,585 $ 386 $ 10,418 $ 590 $ 1,081 $ 22,669

Allocations:

Use & Occupancy $ 60,653 $ 98,423 $ 31,705 $ 13,785 $ 27,845 $ 3,860 $ 7,719 $ 31,705

Computing Svcs 22,465 14,145 4,160 2,496 14,145 1,165 1,331 23,297

Operations Svcs 556 33,381 20,665 2,384 18,280 397 636 3,179

Industrial Eng 5,464 2,484 1,987

Total Allocations $ 83,675 $ 151,413 $ 59,014 $ 20,652 $ 60,270 $ 5,422 $ 9,687 $ 58,181

Total Indirect Expenses $ 233,070 $ 459,294 $ 174,748 $ 42,165 $ 184,445 $ 12,874 $ 23,966 $ 5,942 $ 221,076

Allocation Base DL$ $ 185,055 $ 218,597 $ 104,094 $ 24,289 $ 11,566 $ 23,132 $ 8,674

Allocation Base DM$ $ 1,693,812

Overhead Rates 125.95% 210.11% 167.88% 173.60% 10.89% 111.31% 103.61% 68.50% (1)

(1) The G&A rate cannot be computed until IR&D/B&P costs are transferred into the G&A cost pool (see Exhibit 7).

Exhibit 6. Final Overhead Rates (In Thousands)

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Engineering DL$ $ 60,000

Engineering OH 125.95% 75,568

Fabrication DL$ 72,000

Fabrication OH 210.11% 151,279

Assembly DL$ 35,000

Assembly OH 167.88% 58,757

Tooling DL$ 18,000

Tooling OH 173.60% 31,248

Product “A” DL$ 6,000

Product “A” OH 111.31% 6,679

Off-site DL$ 2,000

Off-site OH 68.50% 1,370

Direct Materials 500,000

Material Handling 10.89% 54,447

Total-cost Input $ 1,072,347

Exhibit 7. Contract “A” Estimated Costs

are computed and transferred into the G&Acost pool. The necessity for this transfer be-comes clear later when the methodology forallocating G&A expenses is discussed.

Assume that a defense cost-type contract, in-cluding some Product A input, has the estimateddirect-labor and materials content as shown in“Exhibit 7. Contract ‘A’ Estimated Costs.” Theapplication of the overhead rates to the directcosts is made by multiplying the appropriateoverhead rates by the estimated direct costs.Note that the Product B overhead rate is notapplied to this contract. The overhead rates areapplied only if the applicable direct cost that isused as a base for allocating overhead is usedon that particular contract.

If the estimate of the projected direct-allocationbase is too high, too little indirect cost will beapplied to contracts. If the estimate of the pro-jected allocation base is too low, too much in-

direct cost will be applied. In addition, the ac-tual indirect cost incurred in each overhead poolwill realistically always be greater or less thanestimated costs. Therefore, the actual indirectcosts incurred will always differ from theamount of indirect costs applied to contracts.When actual costs are less than applied costs,overhead is overapplied or overabsorbed. Whenactual costs are greater than applied costs, over-head is underapplied or underabsorbed. If thedifferences are not significant, overapplied orunderapplied overhead is credited or chargedto profit in the current year. However, if theamounts involved are significant, it is assignedto the cost of sales and inventory in the propor-tions in which the costs during the year havebeen assigned to cost of sales and inventory.

The comparison of actual and applied overheadcosts will be discussed later in more detail whenthe subject of how industry uses the techniqueof variance analysis for overhead cost-control

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purposes is addressed. To ensure overappliedand underapplied amounts are kept to a mini-mum, predetermined applied overhead rates arerevised during the year if there are significantchanges in business volume projections or inactual indirect expenses.

Keep in mind that the objective of cost allocationis to logically link the indirect costs in each costpool to the direct-cost allocation base. Thereshould be a high correlation between the direct-cost allocation measure and the indirect costs inthe overhead pool. In order to accomplish a link-age, indirect costs should be allocated in a pro-portionate amount to the job or contract that causedindirect costs to be incurred. Therefore, thedirect-allocation base should be a primary costdriver for the work activity that causes overheadcosts to be incurred. If a causal connection cannotbe made, some other criterion, such as benefitsreceived, should be substituted. Certainly, the al-location of overhead cost is not an exact scienceand the methods of allocation can vary signifi-cantly with contractors; but the method usedshould give an equitable assignment of overheadto the various products produced.

There are many direct-allocation bases that haveproven acceptable for the fair distribution ofoverhead costs. The following are commonlyfound in industry: direct-labor dollars, direct-labor dollars plus fringe benefits, direct-laborhours, direct materials, prime cost (materials andlabor), units produced, machine hours, meter read-ings, floor space, and cubic content. Employeehead count is sometimes used to distribute costs,such as personnel department costs, payroll de-partment costs, cafeteria losses, and medical de-partment costs. Generally, a combination of sev-eral of these acceptable bases is used, dependingon the particular circumstances.

The direct-labor dollars base is typically usedwhen labor rates are relatively uniform andwhen labor costs are significant in relation to

total costs. The direct-labor activity base is mostoften used, because the data are readily avail-able from payroll and labor-distribution recordsand the method is simple and economical. Insome cases, fringe benefits are included asdirect-labor dollars as opposed to being in-cluded in the overhead cost pool. When this isdone the overhead rate is dramatically reduced.For example, in Exhibit 6, if engineering fringebenefits are included in the direct-labor base,the engineering overhead rate is reduced from125.95 percent to 52.67 percent. The numera-tor, or engineering overhead, is reduced by$88,827; and the direct-labor base is increasedby a like amount resulting in a revised engi-neering overhead pool of $144,243 and a re-vised base of $273,882. Although the overheadrate has been dramatically reduced, total costshave not changed.

Direct-labor hours are a commonly acceptedbase for allocating overhead costs when the em-ployees are interchangeable — a situation some-times found in manufacturing operations. Forexample, if assembly overhead was based ondirect-labor hours instead of direct-labor dol-lars, as shown in Exhibit 6, and the number ofdirect-labor hours estimated to be worked in as-sembly for the next year was 5,500,000 hours,the assembly overhead rate would be $31.78per direct-labor hour. If the skills required onvarious contracts within a manufacturing op-eration vary significantly, the direct-labor hourmethod may not be appropriate.

The use of machine hours as the basis for allo-cating manufacturing-related indirect costsmight be appropriate when machinery is heavilyutilized in production operations. The currentmanufacturing trend toward the use of roboticsand numerically controlled production equip-ment significantly increases the use of machineson the factory floor. Unfortunately, for use inallocating overhead costs, machine hours havenot been as readily available as direct-labor

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hours have been in the past. However, manage-ment attention is given to this area throughoutindustry; and an increasing use of machinehours is becoming an acceptable allocationbase. If machine hours are used as the basis ofallocation for fabrication overhead, as shownin Exhibit 6, and 38 million machine hours areforecasted for the year, the fabrication overheadrate is $12.09 per machine hour. Thus, futureincreases would be expected in the use of ma-chine hours as an overhead allocation base,given the increased level of automation with anattendant reduction in direct labor as a signifi-cant cost of production. Some companies, par-ticularly in the electronics manufacturing area,experience this reduction to such a degree thatdirect labor now represents less than 5 percentof product cost.

Material-handling costs may be allocated basedon the physical quantity of direct materials asopposed to the dollar value of the material. Also,more than one material-handling rate is oftenfound, particularly when high-value materialsor subcontracts require procurement processesseparate from those required for lower-priced,high-volume materials. The average-cost orunits-produced method is one of the simplestmethods of overhead cost allocation as it merelydistributes the costs equally to each unit of aproduct produced during the period. However,if products vary in size, weight, and dimensionsor if they require different amounts of materialor time to produce, this method results in aninaccurate allocation of overhead costs. For gov-ernment contractors, the method of allocationmust be consistent with the Federal Acquisi-tion Regulations (FARs) and the Cost Account-ing Standards (CASs). This will be discussedfurther when specific government requirementsaffecting the allocation of indirect costs areaddressed. Again, the primary objective, whenselecting a base, is to use the method that mostequitably allocates costs to all work, both gov-ernment and commercial.

Although good accounting practices promoteconsistency, changes still may be required af-ter accurate allocation bases are selected. If thenature of an indirect-cost pool or allocation basechanges substantially due to circumstances suchas the introduction of new products, manufac-turing processes, or organizational structurechanges, the existing methods of allocating in-direct costs may require reevaluation andchange.

ALLOCATION OF GENERAL ANDADMINISTRATIVE EXPENSES

Cost allocation, as it relates to G&A expenses,accounts for one of the major differences be-tween commercial and government contracting.In the commercial world, G&A expenses aretypically not allocated to contracts; they areconsidered to be period expenses that are writ-ten off to the cost of sales each year. However,for government contracting purposes, con-tractors would be unable to recover their ac-tual total cost, even on cost-type contracts, ifthey did not allocate G&A expenses to con-tracts. It is important to note that G&A iscalled out as a separate line item on govern-ment cost-performance reports (CPRs), whichrelate to specific contracts.

Since G&A, by definition, represents the ex-penses for the general management and ad-ministration of the business segment as awhole, the G&A cost-allocation base shouldrepresent the total activity of the businesssegment. If an expense included in G&Adoes not relate to the total activity of thebusiness, then a question is raised as to whyit should not be taken out of G&A and allo-cated separately. The most commonly usedbase for allocating G&A is total-cost input.Total-cost input, a term seldom used outsideof the government-contracting world, is de-fined as all costs except those in the G&A costpool.

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“Exhibit 8. Computation of the G&A Rate”shows how the total G&A cost pool is deter-mined after a transfer of IR&D/B&P expenseshas been made to the G&A cost pool.IR&D/B&P projects must be accounted for onthe same basis as if the work was being doneunder contract. That is, the projects must havea fair-share allocation of all applicable overheadcosts added to the direct costs of the projects.The total direct and indirect costs for IR&D/B&P projects are then added to the G&A costpool. The G&A rate, thus determined and basedon total-cost input as shown in Exhibit 8, wouldbe 12.24 percent. Applying this rate to “Exhibit9. Contract ‘A’ Estimated Costs,” the appropri-ate allocation of G&A to the contract would be$131,262. The logic of including IR&D/B&Pin the G&A cost pool is that this cost, like G&Aexpenses, relates to the operation of the busi-ness segment as a whole. In other words, IR&Dand B&P expenses are not G&A expenses butare indirect expenses that must be allocated onthe same base as G&A. Many defense contrac-tors choose to have a separate IR&D/B&P costpool. If so, it must be allocated on the samebasis as the G&A pool.

Bases often used for allocation of G&A ex-penses include total-cost input, value-added costinput (total-cost input minus direct materialsand subcontracts), and the single element ofdirect labor. Although the cost of goods sold orcost-of-sales base is often used in some busi-nesses for allocating G&A-type expenses, thisbase cannot be used for government contrac-tors subject to CAS requirements. There arevery stringent requirements regarding the ac-counting for G&A expenses for governmentcontracting purposes; these requirements willbe discussed further when CAS 403, Alloca-tion of Home Office Expenses, and CAS 410,Allocation of General and Administrative Ex-penses, are addressed. Again, the accounting forG&A represents one of the most controversialareas in government contracting.

The term “wrap rate” is sometimes used bydefense contractors to indicate the total cost or“all-up” rate including overhead and G&A. Forexample, assume that direct labor dollars is theallocation base for engineering overhead andtotal cost input is the base for G&A. If the en-gineering overhead rate is 125 percent and theG&A rate is 25 percent, the wrap rate or “all-up” rate for engineers with an average hourlyrate of $25 would be $70.31. Contractors oftentrack wrap rates from year to year for competi-tive analysis and management-control purposes.Wrap rates usually do not include direct mate-rials, subcontracts, and materials handling sincethe content of these costs may be highly vari-able for a given contract.

Although overhead and G&A rates of differentcompanies are often compared as an indicatorof efficiency, any such comparison is of ques-tionable value. A high rate no more indicatesthat indirect costs are necessarily out of con-trol than a low rate indicates efficiency. In fact,a high overhead rate could be the result of acontractor having the latest and most efficientmanufacturing processes in the plant versus acontractor who is operating with antiquatedequipment and, consequently, is using an ex-cessive amount of direct labor. The excessiveuse of direct labor could cause the overhead rateto be low if the rate was based on a direct-laborallocation base. As previously discussed, anoverhead rate merely represents the relationshipbetween two numbers — one number is the in-direct-cost pool and the other is the selected al-location base. Although the numerator is alwaysexpressed in dollars of indirect costs, the typeand number of indirect-cost pools vary signifi-cantly by contractor; and the allocation basesalso vary. For example, one contractor may in-clude the receiving and inspection functions inthe manufacturing overhead pool; and anothermay include similar functions in the materials-handling pool. The overhead-allocation basecould include fringe benefits for one contractor

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G&A Cost Pool:G&A Expenses (Exhibit 4) $ 221,076

IR&D/B&P Projects:

Engineering Direct Labor $ 69,600

Engineering Overhead 125.95% 87,658

Fabrication Direct Labor 3,900

Fabrication Overhead 210.11% 8,194

Tooling Direct Labor 1,450

Tooling Overhead 173.60% 2,517

ODC 543

Direct Materials 3,625

Material Handling 10.89% 395

Total IR&D/B&P Costs $ 177,883

Total G&A Expenses $ 398,959

G&A Allocation Base—Total-cost Input:Total Less TotalCost IR&D/B&P Cost Input

Engineering Direct Labor $ 185,055 $ 69,600 $ 115,455

Engineering Overhead 233,070 87,658 145,411

Fabrication Direct Labor 218,597 3,900 214,697

Fabrication Overhead 459,294 8,194 451,099

Assembly Direct Labor 104,094 104,094

Assembly Overhead 174,748 174,748

Tooling Direct Labor 24,289 1,450 22,839

Tooling Overhead 42,165 2,517 39,648

Direct Materials 1,693,812 3,625 1,690,187

Material Handling 184,445 395 184,050

ODC 31,450 543 30,907

Product “A” Direct Labor 11,566 11,566

Product “A” Overhead 12,874 12,874

Product “B” Direct Labor 23,132 23,132

Product “B” Overhead 23,966 23,966

Off-Site Direct Labor 8,674 8,674

Off-Site Overhead 5,942 5,942

Total $ 3,437,173 $ 177,882 $ 3,259,291

G&A Rate 12.24%

Exhibit 8. Computation of G&A Rate

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Engineering DL$ $ 60,000

Engineering OH 125.95% 75,568

Fabrication 72,000

Fabrication OH 210.11% 151,279

Assembly DL$ 35,000

Assembly OH 167.88% 58,757

Tooling DL$ 18,000

Tooling OH 173.60% 31,248

Product “A” DL$ 6,000

Product “A” OH 111.31% 6,679

Off-Site DL$ 2,000

Off-Site OH 68.50% 1,370

Direct Materials 500,000

Material Handling 10.89% 54,447

Total-cost Input $ 1,072,347

General & Admin Expenses 12.24% 131,262

Total Costs $ 1,203,609

Exhibit 9. Contract “A” Estimated Costs

while such costs are included as overhead foranother.

Contractors differ in the type of products theyproduce, ownership of facilities, tooling andequipment used, amount of government fur-nished equipment, the number and types ofgovernment programs, company-make versusbuy programs, and organizational structure. Allof these differences will significantly impactoverhead and G&A rates.

Another complicating factor that makes thecomparison of overhead rates an almostmeaningless exercise is that many companiesfollow a practice of prorating or directlydistributing certain types of costs as direct costs;

other contractors may consider the same coststo be overhead. For example, administrative orindirect labor in engineering may be distributedto jobs based upon the pure engineering direct-labor hours worked by the supportedengineering organization. This practice has atremendous impact upon reducing overheadrates. The numerator is reduced because indirectlabor is taken out of the cost pool; and, at thesame time, the denominator is increased as thedirect-cost allocation base is increased. Thereis tremendous flexibility in accounting systemsand in direct versus indirect classifications.Before any meaningful analysis of overheadcosts is undertaken, one must thoroughlyunderstand each contractor’s accounting andindirect-cost-allocation methods.

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55DEFENSE INDUSTRY MANAGEMENT

OF INDIRECT COSTS

INTRODUCTION

To understand indirect costs, it is essential torealize that they are extremely difficult to con-trol. A great deal of management attention,structure, and a disciplined business process isnecessary to effectively control them. The es-sential elements for developing all overheadrates (the direct allocation base and the indirectexpenses for each cost pool) are developed byindustry in a very disciplined manner as an in-tegral part of the corporate-business planningprocess. This planning process is initiated andcontrolled by the top level of the corporation.Defense-contractor managers strongly empha-size that a thorough understanding of the plan-ning process is essential to grasp the develop-ment and use of indirect rates in industry.Essentially, the approach sets out specific quan-tified objectives and then follows a disciplinedmanagement decision-making process to deriverigorous budgetary data, including data neces-sary for managing indirect costs.

The business planning process represents topmanagement decisions that focus on how thecorporation plans to be successful. The corpo-ration addresses a broad range of very signifi-cant issues including:

• goals and objectives of the corporation• manpower targets• engineering-load projections• make-versus-buy decisions• investments in capital equipment,• facility requirements,

• manufacturing schedules,• inventory levels,• discretionary bid and proposal (B&P) levels,• independent research and development

(IR&D) expenditure levels,• and financing needs.

To demonstrate the importance of this corpo-rate planning process, many top company man-agers make no outside commitments during theimportant phases of business planning. Thebusiness planning process results in the prepa-ration of a mathematical model of the total cor-poration; therefore, the specific allocation basesand indirect expenses for all overhead rates, ineffect, “fall out” of this decision-making pro-cess.

The control system for managing indirect costsmust be viewed within the framework of thecorporate organizational structure and mustencompass the levels of responsibility withinthat structure. Defense contractors use differ-ent terminology to designate various organiza-tional levels within their corporation. For ex-ample, a branch or division could represent thetop manufacturing organization in one companybut a much lower level in another company.However, there are three common organiza-tional terms, which are referred to as “centers.”These centers are used generically in industryto designate responsibility levels. The corpo-rate office is an “investment center” with re-sponsibility for making major decisions, suchas product line or facility investment. A majordivision or business segment of the corporation

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is a “profit center” with responsibility for con-trolling price, volume, and cost for specificproducts. A “cost center” is the lowest levelwithin a business segment, where a manager isheld responsible for controlling the cost of spe-cific activities.

For example, a machine shop may be a depart-ment within the fabrication division of a largedefense manufacturing contractor. The machineshop may contain various groups of machines,such as lathes, punch presses, and milling ma-chines. Each group of machines has a separatecost center and a supervisor. The supervisor ofthe cost center is responsible for minimizingcosts in that cost center. Typically, a large de-fense contractor may have more than a thou-sand cost centers at one plant location within agiven business segment. Although costs areidentified to specific cost centers, the manage-rial focus on developing and controlling indi-rect rates is usually at the business-segment or“profit-center” level.

The output of the business-planning process,at the profit-center or business-segment level,is a specific set of managerial documents thatprovides a logical sense of direction for thebusiness segment. These managerial documentsalso provide a basis for guiding and evaluatingthe corporation’s accomplishments. See “Ex-hibit 10. Business Planning Process Outputs”for an example of typical managerial controldocuments. These documents are producedduring the planning process and are a part ofthe operating plan for a business segment. Thenames used by defense contractors for operat-ing plans vary — profit plans, blue books, mas-ter budgets, management budgets, and annualoperating plans. The generic term, “operatingplan” is used in this guidebook.

The corporation performs four processes in alogical and disciplined fashion — the planningprocess, the forecasting process, the budgeting

process, and the control process. These pro-cesses lead to managerial control of indirectcosts through the development of the operatingplan.

PLANNING

The first step in the planning process, whichis a high priority task for top management, isthe development of the corporation’s strategicor long-range plan. Strategic planning refersto the process of developing goals and objec-tives for each business segment and the strate-gies to be used in attaining them. Strategicstudies are often made by the corporate officein cooperation with its business segments. Out-side consultants, who have certain criticalknowledge of products and markets, may beused to assist management. The strategic planprovides general directions for a 5- to 10-yearperiod. In some corporations the time span islonger. The strategic plan forms the basis fora more detailed operating plan that encom-passes a shorter period.

Due to the lengthy developmental nature andcomplexity of defense products, long-rangeplanning is very prevalent in the aerospace/defense industry. Sound business practice re-quires future products to be carefully targetedfor investment. Production often requires thedesign and construction of new, large facili-ties. Long lead times are often required for thedevelopment of raw materials and componentsthat are pushing the state of the art. In addi-tion, due to product improvements resultingfrom engineering modifications, it is not un-usual for defense products to have product lifecycles of a decade or more. Therefore, defensecontractors must carefully select their prod-uct areas and map out a long-range plan toassure success. Management must be continu-ally assessing and evaluating what the corpo-ration is currently doing in relation to its dy-namic operating environment. During this

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Exhibit 10. Business Planning Process

assessment, managers ask the following im-portant questions:

• What do we want to be in the 21st century?• Where are we now, and where are we going?• What are our core competencies?

• What is needed in order to expand into ourcore-relative markets?

• What future threats are out there, and how dowe overcome them? What happens if we don’t?

• What competitive advantages do we have orneed to develop?

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• What are reasonable objectives for us toachieve?

• What is in the way?

Essentially, strategic planning requires research-ing and identifying the right businesses to en-sure future growth by developing and market-ing the right products.

Long-range planning by defense contractorsrequires an integrated team comprised of manybusiness disciplines, including marketing, en-gineering, manufacturing, quality, logistics,human resources, finance, and research. Thegoals, objectives, and strategies for attainingthem must be consistent across all functions andprovide a clear sense of direction. A typicallong-range plan will contain information onpredicted sales and profit trends. This informa-tion includes major product lines, new productlines, new acquisition plans, diversificationplans, planned new facilities, manpower re-quirements, and research and developmentplans. Strategic planning is a continuous pro-cess. As significant developments occur, theyare incorporated into the long-range plan. Manycompanies formally update or revise the planon an annual basis. One year is dropped eachyear, and a new year is added. The result of thelong-range or strategic planning process is theestablishment of a planning baseline fromwhich near-term operating plan projections arederived — essential for effective managementof indirect costs.

Each year, prior to the start of the corporation’sannual planning cycle, the corporate office orinvestment center establishes a uniform plan-ning framework. It also issues instructions aboutthe format and content of each planning docu-ment to be included in each of the business-segment or profit-center operating plans. Toachieve corporate objectives, the corporate of-fice or investment center ensures that each ofthe business segments fits into the overall plan.

Also, to obtain consistent inputs from all busi-ness segments on a timely basis, a calendar ofevents is normally prepared by the corporateoffice. See “Exhibit 11. Business Planning Pro-cess — Typical Defense Contractor” for a con-ceptual example of the corporate andbusiness-segment responsibilities. Exhibit 11also shows the sequential flow typically foundin formulating the business-segment operatingplan. Detailed planning for the next fiscal year,which in this case is the calendar year, actuallybegins 8 months earlier with the assessment ofcurrent performance and the recommendationof goals, objectives, and strategies. The corpo-rate office issues guidelines to the various busi-ness segments, and there is considerable in-volvement in planning. Recommendationscome from the heads of the business segmentsand their key managers.

Industry program managers are typically veryinvolved in the business-planning process, andthey are key suppliers of data relevant to theirweapons systems for business-planning pur-poses. The planning process includes consider-able negotiation with corporate management.Both corporate and business-segment manage-ment want to ensure that the operating plan islogical and achievable. It should also be chal-lenging and should promote the maximum uti-lization of corporate resources. Final approvalof the plan by the top corporate managementoccurs before the start of the fiscal year. Onceapproved, the details of the operating plan be-come the basis for measurement of manage-ment’s performance against its objectives.

Defense contractors usually prepare operatingplans for each business segment for at least a3- to 5-year period. A typical 5-year operatingplan covers the forecasted sales and profits pro-jected monthly by the business segment for thefirst 12-month period. The next year is pro-jected by quarter, and the last 3 years are pro-jected by year. The plan states goals in quanti-

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Exhibit 11. Business Planning Process — Typical Defense Contractor(Prior to Start of Business Plan Year)

Corporate

BusinessSegment

May Jun Jul Aug Sep Oct Nov Dec

StrategicMeetings

ExecutiveManagement

CouncilMeeting

Prepare "Preliminary" Plans:

OperationalSalesMajor ProjectMaster Delivery ScheduleProductionEngineeringManpowerMarketingFacilitiesIR&DB&PCapital InvestmentFinancial

Contains:

Strategic Planning,Set Initial Targets,Goals, Objectives,

Strategies

Issue Guidelines,Assumptions,

ResourceConstraints

ExecutiveManagement

Analysisand Review

FinalCorporateApproval

AssessCurrent

Performanceand

RecommendGoals,

Objectives,Strategies

IncorporateChanges

Prepare "Final"Operational Plans

Business-Base Forecast

OverheadExpenseForecast

OverheadRates

tative terms and sets specific frames for accom-plishment.

The importance of the business-planning pro-cess for the management of indirect cost can-not be overemphasized. While business-seg-ment goals can sometimes be broad andphilosophical in nature, business-segment ob-jectives are very specific and measurable. Forexample, goals may cover such things as thebasic mission or purpose of the organization,breadth of the product line, product quality,growth expectations, responsibly to sharehold-

ers, and social responsibilities. Other goals maybe to fix, sell, or close any business segmentthat is not first or second in their market. Busi-ness-segment objectives bring the goals intosharper focus by quantifying the goals, desig-nating responsibility, and establishing specifictime dimensions for attaining them. Examplesof these objectives might include:

• achieving sales of $1 billion in Year 2;• increasing profit by $18 million in Year 1;• achieving an investment rate of return of 14

percent in Year 1; or

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• reducing the manufacturing-overhead rate by15 percent by the end of the second quarterof Year 1.

Targeted “affordability” rates for overhead aresometimes set by top management during theplanning process, and they often become spe-cific objectives. While a strategic plan is broadand general in nature, the operating plan is de-tailed and specific; for it becomes the budgetor control tool for managing overhead in thenear term. Further, management compensationis often tied directly to business-segment ob-jectives, which often include overhead reduc-tion targets. Consequently, the objectives havevery strong motivating power.

After basic goals and objectives are determined,the next step is to map the detailed, integratedstrategies for achieving objectives. Several dif-ferent types of strategies are required for thebusiness-planning process. They include mar-keting, manufacturing, research and develop-ment, human resources, and financial strategies.Each strategy is highly interrelated with otherstrategies; it is critical to the success of a busi-ness plan that each strategy be consistent withother strategies.

A market strategy addresses these issues:

• Who are our target customers?• What products will we sell to them?• What will be the types of contracts and pric-

ing methodologies?• Will we enter the foreign military sales market?• Will we participate in teaming arrangements

with other contractors?• Will we lower price to increase business volume?

A production strategy addresses the following:

• What process and technology will we use todesign, develop, produce, deliver, and supportour weapons systems?

• How will we meet the requirements for ma-terials, equipment, and production skills?

• Will we make or buy certain components?• Will we make improvements in our weapons

systems to increase capabilities?• Where will we locate our facilities?• What level of capital investment will be nec-

essary?• What are our “best practices” from across the

corporation?

Because of rapid, frequent, and expensivechanges in technology, research and develop-ment costs are very significant costs, whichcontribute to high indirect-cost rates in the de-fense industry. Consequently, defense contrac-tors place a heavy weight on the research anddevelopment strategy; and they must carefullyplan expensive research and developmentprojects. This strategy addresses these issues:

• What are the essential areas that must bemaintained or expanded in order to have acompetitive edge?

• What investments in technology are neces-sary to maintain or expand the competitiveedge?

• Will we collaborate with others through jointventures in order to share development costs?

• Will we purchase certain data rights to en-able us to enter a given market?

A human-resource strategy addresses the fol-lowing issues:

• Do we have the necessary talent, or will weneed to recruit?

• How will we train the workforce to be prop-erly certified to perform new manufacturingoperations?

• How will we negotiate wage rates with theunion?

• How will we provide research personnel todevelop new materials within the requiredtime frame?

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• How will we conduct salary and wage re-views?

• How will we structure our fringe benefits forprofessional employees in order to be com-petitive?

• Will we need to lay off personnel; and, if so,will we make employee severance payments?

A financial strategy addresses these issues:

• How will operating and investment-fund re-quirements be generated?

• Will we lease or purchase facilities?• What will be our financing structure — debt

or equity?• How will we generate a reasonable return on

our investment?• How will we minimize our investment in

total assets?• How will entering foreign markets affect

taxes?• How are we going to contain health-care

costs?• Will we have an employee stock-owned plan?

The development of a financial strategy be-comes a highly interactive process with the de-velopment of other business-plan strategies be-cause any change or modification in other areaswill necessarily have a financial impact.

It should be emphasized that the developmentof the operating plan for the business segment,“Exhibit 11. Business Planning Process —Typical Defense Contractor” is a highly itera-tive process. Business-segment managementrecommends certain tentative goals and objec-tives, which are based on guidelines along withcertain assumptions and conditions developedby the corporate office. After considerable re-view and analysis, the plan is satisfactory, or itis not. For example, if forecasted sales do notcover estimated production and operating costs,sales goals may be adjusted upward; or indi-rect cost-cutting actions may be planned. If still

unsatisfactory, the iterative process begins againuntil an acceptable plan is developed. Each busi-ness segment’s objectives and strategies vary,but the operating plan for each segment hasspecific terms for the performance objectivesof the segment. In addition, it provides a clear,overall indication of how the objectives will beaccomplished.

Summarizing and integrating all elements ofcorporate- and business-segment planning intoone document, the operating plan is the writtenend product of the business-planning effort; andit has both internal and external uses. Internally,it is used to communicate clear performanceexpectations to management and staff. In addi-tion, the operating plan and the process of de-veloping it are used to educate and motivate keymanagers in the corporation. An operating planalso has several uses in relation to significantparties outside the firm. Since an operating plancommunicates planned actions, it can be usedto assist in securing funding from outsidesources, either creditors or stockholders. It isimportant to note that the operating plan con-tains highly proprietary data; and any decisionto release it, or any parts thereof, to parties out-side the corporation is a decision of top man-agement. Management often limits the numberof copies and closely controls distribution. Gov-ernment personnel who have access to the datain a contractor’s operating plan, such as fore-casted indirect rates, must be aware of the highlyproprietary nature of the information containedin the plan.

FORECASTING

There is probably no other business processperformed within a company that is more im-portant to the control of indirect costs than thatof the forecasting of future sales. It is absolutelyessential for a company to have an accurate andwell-disciplined process for estimating sales,as this process leads to the projection of the all-

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important business base. The projection of thebusiness base is the starting point in preparingthe details of the operating plan, and it is theprimary driver in establishing indirect-cost re-quirements. Since indirect-cost pools includevariable and fixed costs, indirect costs are vari-able to the business-base projections. Conse-quently, an erroneous sales forecast can causea company to incur serious indirect-cost con-trol problems.

Once the sales forecast is complete, the direct-allocation bases and the indirect expenses foreach overhead pool can be estimated. How-ever, a reasonable attempt cannot be madeto estimate indirect expenses in each pooluntil a solid estimate is made of the businessbase. Usually, detailed indirect-pool expensesare not estimated until approximately a monthafter the sales-forecasting process is com-plete.

In order to understand indirect-cost manage-ment in the defense industry, how defense con-tractors establish the sales forecast must beunderstood. The sales forecast is the total salesdollar volume, which includes both commer-cial and government sales. Arriving at a salesforecast is a difficult task, typically involvinginputs from hundreds of people in a large com-pany. The process is similar to a large pro-posal effort and requires very close coordina-tion and control. A “bottoms-up” approach isoften necessary due to the highly varied na-ture of the products and services marketed.The sales-forecasting process is usually man-aged by the vice president of marketing or thevice president of finance, with guidance pro-vided by top management. Industry programmanagers routinely provide certain baselineinformation relating to their programs, suchas estimates at completion, head-count fore-casts, and time-phased expenditure plans. Thisinformation is valuable for use in developingsales forecasts.

The sales forecast, formulated through the se-quential analysis of data, indicates the expectedperformance in the following areas: economy,industry, corporation, business-segment, prod-uct line, individual products, and contracts. Sev-eral mathematical techniques are often used inestimating sales. These techniques include trendextrapolation, simple and multiple regression,and expected-value analysis. Due to the vola-tile nature of the defense business, managementjudgment plays a very significant role in esti-mating sales for defense contractors. Since his-torical weapons-systems data is often not rep-resentative of the future, mathematicalforecasting techniques are not as widely usedas in a large commercial marketplace. Conse-quently, a bottoms-up approach, with a heavyemphasis on the judgment of certain key man-agers, is predominantly used in the defense busi-ness for forecasting sales. At the present timedefense contractors have exceptionally difficultproblems in forecasting future sales becausethere are so many unknowns in the currentdownsizing environment. Even though contrac-tors deal with many program offices, in effectthe U. S. Government is the defense contractor’ssole customer. Consequently, political consid-erations often play a major role regardless ofthe general economic and industry forecasts,e.g., current debates on missile defense andsubmarines.

Using a bottoms-up approach, defense contrac-tors typically develop their sales forecastthrough an analysis of their backlog along withprojections based on managerial experience andjudgment. For contractors engaged primarily inlarge-scale manufacturing, the buildup of themaster production schedule is essential becausethe key ingredients for the sales forecast are thenumber of items to be delivered and when theyare to be delivered.

One method used in near-term projections is tostratify the estimate into firm, near-firm, antici-

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pated, and potential business. Firm businessconsists of commercial contracts or purchaseorders and government contracts that have beenfunded and committed to planned production.Firm business orders are referred to as “back-log.” Near-firm sales volume, under normalconditions, can be expected to come to the com-pany; but this volume is subject to further ac-tion by the customer. Examples of near-termbusiness include priced government options andcommercial options in existing contracts, con-tracts negotiated but not signed, and any pur-chase orders subject to contingencies. The salesforecast also includes certain anticipated busi-ness that the company expects to perform basedon prior history. An example is follow-on spareparts for supporting military products where thetotal requirements of specific programs or prod-ucts have not yet been defined. Most commer-cial products fall into this category, as they usu-ally have a history of large continuous sales.Identified new business includes sales that maybe expected to result from outstanding B&P.Many companies use historical statistics to de-termine the percentages of “wins” that willprobably occur against a known number of pro-posals being submitted.

When forecasting sales on very large programs,some companies use a discounting concept onanticipated future contract values based upon“go” and “win” factors. A probability of “go”is assigned after identifying key issues of a po-litical or funding nature that affect the successof the program. In assigning probabilities, man-agement considers factors including budgettrends, national need, congressional support,and user acceptance. A probability of “win” isassigned based on factors such as the company’sstrengths and advantages relative to its competi-tors, technical capability, price competitiveness,and experience. The resultant sales forecast forsuch large programs will be extremely impor-tant in establishing overhead rates for futureyears.

The sales forecast is refined through a seriesof senior management reviews. Since the ac-curacy of management judgment is so criticalto sales forecasting and a tremendous amountof detailed planning is dependent upon thesales forecast, management must thoroughlytest the accuracy of the forecast against meet-ing assigned objectives. While a large numberof people are involved in the sales forecast, avery small number of top management peopleare involved in actually determining the finalnumber that will represent forecasted sales vol-ume.

With experience, top management learns howto modify the sales forecasts of lower-levelmanagers. If some program or division manag-ers are always overly optimistic in their fore-casts, this should be taken into account whenpreparing the business-segment sales forecast;the opposite type of adjustment is made for in-puts from more conservative individuals. Dueto the crucial importance of the sales forecastand uncertainty in forecasting, top managementwill often use outside consultants to provide anindependent assessment of certain forecasts,particularly on large, costly developmental pro-grams. Once the sales forecast is complete (pri-marily through the use of historical statisticaldata and engineering estimates), the translationof the sales volume into direct-cost allocationbases for computing overhead rates is accom-plished.

During the year, sales forecasts are continuouslyassessed for the impact of changes to the busi-ness base or indirect-expense forecasts. Actualresults are usually compared to the sales fore-casts on a monthly basis. Thus, monthly or quar-terly sales-forecast revisions commonly aremade in conjunction with quarterly corporatereviews. This provides management with thelatest projections of current business volumeand strengthens the planning and controlling ofindirect costs.

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It should be emphasized that sales forecastinginformation is highly sensitive, private data thatcould be very damaging if obtained by some-one outside of the company. Typically, infor-mation is closely controlled by the companyand is given out to a very limited number ofpersonnel who have an absolute “need to know.”Government personnel with access to sales fore-casting data must ensure that it is closely pro-tected.

BUDGETING

The detailed indirect-cost-budgeting processcommences when the sales forecasting processhas been completed and tentatively approved.Key to the development of reliable indirect ratesis the establishment within the company of arigorous budgetary control system with maxi-mum participation by company managers. Gen-erally, the responsibility of forecasting overheadexpenses resides with a designated overhead-pool manager with lower-tier expense budgetsdeveloped at the functional-manager level.Commitments are then made to the overhead-pool manager to manage within the budgetedamounts. This process ensures ownership of theoverhead budget at the lowest level of the orga-nization.

Typically, overhead-pool managers are mem-bers of upper management. They are often ata vice-presidential level and are responsibleto the president of the business segment forthe control of overhead rates (i.e., the vicepresident of engineering is responsible for en-gineering overhead, the vice president of op-erations is responsible for assembly overhead,etc.). Generally, the president is responsiblefor general and administrative (G&A) ex-penses. Also, due to the large dollar amountsand discretionary nature of the expenses, thepresident is often responsible for IR&D andbid and proposal expenses.

At the outset, top management occasionallyfurnishes “overhead target” rates with business-base projections. These target rates must becompetitive with others in the marketplace. Thistechnique is called a “top down” managementapproach. Subsequently, by implementing thecompany’s budgetary process using a “bottoms-up” approach, detailed overhead budgets are es-tablished within each pool at the lowest orga-nizational level. The detailed budgets, whenfinalized at the functional and manager levelsin each overhead pool, constitute the primarycontrol mechanism of the overhead process.

Budget planning and control systems varyamong companies and among business seg-ments within a company. Hence, the systemsare broadly addressed so they will be applicableregardless of the differences among organiza-tional structures and accounting systems ofcompanies. The process used by defense con-tractors to establish detailed organizationaloverhead budgets typically comprises five sepa-rate phases: the budget call, budget submissionfrom organizational units, a negotiation phase,a senior management review phase, and theperformance-measurement phase.

The top official in the financial function, whois ordinarily the vice president for finance, usu-ally will have responsibility for coordinatingvarious budget efforts. Within the financial func-tion, it is customarily the responsibility of abudget-control group to generate budget pro-posals and coordinate the process for the de-velopment of overhead budgets for each orga-nizational element. But the budgetary processconstitutes a general management decision-making process and is not solely a financialfunction.

The annual budgeting process usually beginswith a meeting held by the budget-controlgroup, and it is attended by a representative from

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each department. At that time, departments arepresented an overview of the budget process andits relationship to other business segments andcorporate plans. Each department is given abudget package to help it develop a budget re-quest. Typically, the information in the pack-age includes a detailed schedule of the budgetprocess and the estimating parameters to befollowed. These parameters include:

• sales forecasts,• business-base forecasts,• labor rates,• annual merit-increase percentages,• fringe-benefit rates for hourly and salaried

employees,• year-to-date actual overhead expenses by ac-

count,• year-to-date head count,• direct-employee versus indirect-employee tar-

gets, and• company-unique pro forma budget-input

sheets to be used.

Each departmental manager is tasked to pre-pare a proposal of its annual budget needs.

In effect, subordinate managers estimate andrequest the resources required to support theforecasted level of sales. Budgets are preparedfor every unit of authority down to the lowestlevel of budgetary accountability, commonly atthe department level. Again, this level of au-thority can vary by company. Until approvedby top management, budgets are considered tobe only requests.

It should be noted that the control of indirectcost is usually the responsibility of theorganizational-unit manager for whom the costis budgeted. Such allocated indirect costs as de-preciation, taxes, insurance, and fringe benefits,rarely can be controlled by an operating depart-ment; hence, they are usually not held respon-

sible for the budgets allocated to their depart-ment. So the assignment of cost responsibilitymay not always agree with cost allocations. Forexample, the cost responsibility (industrial en-gineering, data processing, print shop, etc.) ofservice departments is the responsibility of thedepartment heads.

Budgeting for those service costs that the oper-ating departments can control, e.g., volume ofdata processing services used, is the responsi-bility of the operating department managers.But they are not responsible for the amount ofindirect materials used by the service depart-ments. As an additional example, the indirect-labor cost of the payroll department is control-lable by the supervisor of that department. Thiscost is commonly considered to be a noncon-trollable cost in the case of the factory supervi-sor, who is charged with a prorated amount ofthe payroll department’s costs.

Indirect expense or overhead forecasts are madeby responsible managers or their staff. They usevarious estimating techniques, such as projec-tions from actual experience, trend analysis,comparative analysis, manpower factors,change analysis, “grass roots” buildup usinganalysis of required tasks, and base variabilityanalysis. Of primary importance in forecastingindirect expenses is an analysis of indirect la-bor. An evaluation of the necessity for each in-direct employee through an analysis of the tasksto be performed should come before any evalu-ation of the cost to perform the function.

Each organizational manager prepares anddocuments estimates of all indirect expenses.These documents have details necessary to sup-port a reasonable and complete forecast of over-head by month, year, and major indirect-costelement. Since the subordinate managers werevery involved in the decision-making process,the “bottoms-up” overhead forecasting process

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results in a strong commitment to achieve thebudget and a willingness to accept the results.

Overhead-pool managers, with the assistanceof their staff, are responsible for assessing thereasonableness of the overhead estimates re-quested by the various organizational manag-ers who are inputting indirect cost into theiroverhead pool. An assessment is made byoverhead-pool managers to understand cus-tomer requirements, significant cost drivers,optional resource assignments, and optimal re-source use. The assessments made byoverhead-pool managers enable them to exer-cise the necessary control of costs and to haveevery opportunity to achieve or out performbudget targets. Their assessment will also iden-tify management reserves and challenges.

Typically, once all budget requests are receivedby the budget group in the finance function, acompany overhead distribution system is con-ducted to “roll up” the proposed budgets and todevelop preliminary budgeted-overhead rates.The budget group then makes an independentassessment of the budgetary estimates. Concur-rent with the organizational estimating process,the budget group has usually developed its ownoverhead projections using various statisticaldata. The purpose of these independent esti-mates is to challenge the soundness of the vari-ous budgetary requests. It ensures consistencywith other planning and forecasting assump-tions and conditions and ensures linkage withother key plans, such as the sales forecasts,manpower plan, and capital plan. Some con-tractors have found the use of budget reviewcommittees very useful in strengthening thebudgetary process. In effect, subordinate man-agers are required to present and justify theirbudgetary requests to a committee comprisedof senior company managers.

As a result of independent reviews and chal-lenges, negotiation with managers is conducted.

Changes are made when appropriate, and rec-ommendations are made to senior managementfor acceptance of the forecasted indirect ratesto be used by the company. If differences can-not be resolved through the internal negotiat-ing process, the matters are referred to top man-agement for a decision. If the budgetary processworks as intended, the recommendations to topmanagement represent a joint effort of the op-erating organizations and the financial function.

Top management reviews the recommendedindirect rates to ensure affordability and to ob-tain a definite commitment from overhead-poolmanagers. Management wants to ensure that theforecasted rates are competitive. They also mustreflect maximum cost-containment measuresand include significant challenges for each func-tional area. The next step is the most impor-tant: If management is not satisfied that the ratesare competitive, the forecasted rates are notapproved; and subordinate managers are di-rected to cut overhead costs. Thus the processstarts over again. In some cases, managementplaces upper limits on the rates to ensure com-petitiveness. To achieve reduced rates, eachfunctional area must find new, different, andmore efficient ways to perform its tasks. Con-sequently, more often than not, the budgetaryprocess for establishing overhead rates consti-tutes both a bottoms-up and a top-down ap-proach.

After approval by top management and inclu-sion in the business-segment operating plan, theestimated-business base and indirect expensesbecome the basis for overhead-budget alloca-tions to the operating organizations. The bud-get allocations are flowed throughout the com-pany to the lowest level of managerial controldesired by the overhead-pool manager.Overhead-pool managers may establish a re-serve to ensure that results are achieved withinthe budget. Such a technique is sometimes referredto as “motivational budgeting” — management

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sets very tight overhead budgets to motivatebetter performance and encourage cost reduc-tions.

The detailed allocated budget becomes the pri-mary control mechanism in the overhead pro-cess as it, in effect, constitutes the delegatedauthority to incur overhead expenses. Budgetsare time-phased by month and broken down byspecific indirect-cost accounts for each depart-ment. By planning at this level of detail, eachmanager has a tool to measure and control as-signed responsibilities. Overhead rates are sub-sequently monitored continuously and revisionsmay be made at any time that a significantchange occurs in either the forecasted-businessbase or in forecasted indirect expenses. Thistopic is discussed later.

The indirect-cost data developed in the budget-ary process is highly proprietary data and usu-ally is distributed only to executives and top-level managers. Lower-level managers usuallyreceive only budgetary data for which they areresponsible. However, this data may be sharedwith government customers for their evaluationof indirect rates used for government-contracting purposes. Government involvementin estimating indirect rates is addressed laterunder the subject of forward-pricing rates,where a large number of government rules comeinto play.

CONTROL

Once actual work begins, the business enters anew phase: the budget becomes the tool forcontrolling indirect costs. So the managementof indirect cost requires the contractor to planin advance what the costs should be. The con-tractor must hold actual costs in line with theplan or justify any differences. This controlrequires discipline, and management must es-tablish a highly disciplined cost-control envi-ronment. People, not reports, control indirect

costs. Typically, any specific indirect cost re-quires the advance approval of a responsiblemanager or supervisor. When the budget limitis reached, no further costs may be incurredunless a higher level of management authorizesit. Most large companies set up a detailed sig-nature-authorization matrix system to ensurethat all indirect expenses are approved by theappropriate level of management before the ex-penses are incurred. The financial function, usu-ally on a routine basis, verifies the appropriate-ness of approval levels and authenticity ofsignatures.

The company’s management-control systemshould provide a tracking capability for com-parison of actual performance with forecastsand interpretation of variances by responsiblemanagers. It also proves a system that willreadily communicate performance data to ap-propriate management levels. Given the largenumber of indirect costs in a variety of over-head pools with many managers authorizingoverhead costs for their respective organiza-tions, it is critical that common, standardizedreporting systems be administered to ensure theconsistency and integrity of the total reportingsystem. Significant data relationships must bemaintained in order to have organizational “roll-ups” to higher levels of management. Also, itis essential that indirect-cost-control reports besubmitted promptly because they are of littlevalue if received too late for corrective action.

Although overhead-pool managers are respon-sible for indirect-cost performance, the report-ing of actual indirect costs occurs at all lowerlevels of the business segment or wherever bud-get accountability is assigned. In effect, eachorganizational manager is responsible for theexpenditure of resources to accomplish assignedoverhead tasks and to ensure that the assignedtasks are accomplished within specified and au-thorized spending limits. Management and con-trol of costs within those limits are supported

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by frequent and timely reporting of indirectcosts as they are incurred. These reports are thencompared to targets that have been establishedfor that reporting period. This reporting enablesmanagers to measure performance, to make thenecessary mid-course corrections, and to adjustfuture spending to offset any adverse trends orunanticipated overruns. Consequently, reportsmust be in sufficient detail to reach the lowestlevel of indirect-cost responsibility. Thus, per-formance reporting provides overhead-poolmanagers, organizational managers, and topmanagement with timely visibility on progresstoward committed targets. Reports to the upperlevels can eliminate some of the detail that isnecessary for supervisors, but the reports mustbe detailed enough to determine which organi-zational unit had variances.

Indirect costs are usually reported monthly,except for certain overhead costs, such asIR&D and bid and proposal expenses, whichare often reported weekly. These two large costsare “burned up” quickly if they are not con-trolled in a highly disciplined manner. Indirect-cost reporting is usually done on both a current-month and year-to-date basis, with anassessment of any “at-completion” impacts.Pool managers and responsible organizationalmanagers usually hold monthly indirect-cost-management meetings. Often, monthly man-agement councils or committees are formedsolely to review indirect costs each month. Usu-ally, at a minimum, indirect-cost reviews areheld with members of top corporate manage-ment on a quarterly basis to review the statusof indirect costs.

The specific format for indirect-cost control re-ports is different for each contractor, based onthe perception of information necessary to un-derstand progress made toward achieving estab-lished overhead-rate commitment and budgettargets. But generally, contractors provide man-agers with three primary reports that show, on a

monthly and year-to-date basis, a comparison ofthe planned and actual overhead rates, overheadexpenses, and direct-allocation bases. “Exhibit12. Rigorous Monthly Overhead Variance Analy-sis” gives an example of the type of informationthat would be shown on a typical overhead re-port. This data is often shown graphically formanagement presentation purposes.

The chart is shown at the overhead-pool level.This same comparison information is reportedto each lower-level organizational managerwithin the overhead pool, with each of the hun-dreds of separate indirect expenses separatelyidentified. Individual cost-center managers arethen called upon to justify variances fromplanned costs. In addition to the reporting ofspecific overhead expenses, the reporting of thedirect-cost, allocation-base data is essential tomonitor overhead-rate performance. Althoughoverhead-pool and organizational managershave control of specific overhead expenses in-curred in their organizations, they do not nec-essarily control the base over which their over-head costs are absorbed. For example, the headof the engineering calibration department maycontrol the level of indirect employees in thedepartment, but the head of the engineering testdepartment may control the number of piecesof equipment requiring calibration as well asthe timing and availability of equipment. Thissplit in responsibility can lead to loss of con-trol and enormous “people problems” unlessmanagement follows a tough cost-control phi-losophy. Quick management action may be re-quired to adjust spending levels to respond tochanges in the allocation base, which can sig-nificantly affect the overhead rate.

Usually the computerized indirect-cost-controlsystem is processed monthly; but indirect la-bor in each overhead pool is typically so sig-nificant that head-count information may belooked at weekly, or even daily, on a “by name”basis. The importance of closely monitoring

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indirect head count cannot be overemphasizedin controlling overhead costs.

VARIANCE ANALYSIS

Once the work is well under way, organizationalmanagers have a continuing responsibility toprovide the overhead-pool manager a justifica-tion of the variances of actual performance frombudget targets. An essential component of theoverhead-control process is a variance analysisof numerous cost drivers and cost elementswhen performance reporting reflects out-of-tolerance conditions. Variance analysis providesa more in-depth understanding of differencesbetween planned and actual performance andenables management to better forecast futureperformance. These assessments also enablemanagement to direct corrective action plansthat compensate for past or future adverse per-formance to budget targets.

The total variance in overhead costs for a monthhas several variances — some favorable, someunfavorable. Variances are termed favorablewhen actual costs are less than budgeted costs;they are unfavorable when actual costs aregreater than budgeted costs. Managers analyzesignificant variances to determine the cause andto take appropriate corrective action. The crite-ria for “significant variances” varies by com-pany. A rather common criteria at the overhead-pool level seems to be a cumulative dollarvariance for each overhead expense account ofmore than $100 thousand or more than 5 per-cent of the budgeted amount. Written explana-tions are usually required by management toexplain these significant variances.

Variance analysis probes the reasons behinddifferences between performance targets orspending plans and the true incurrence of cost.Many reasons exist for these variances, such aschanges in activity scheduled, resources re-quired to accomplish the original plan, and re-

source costs (labor rates, travel costs, materialcosts, etc.) versus planned resource costs. Ananalysis of an unfavorable variance in indirectengineering labor worked, for example, mayshow that the variance was caused by a combi-nation of overtime worked at premium pay, alarger number of on-board workers thanplanned, and the use of workers in a higher la-bor category than planned.

An unfavorable variance in indirect materialsin the assembly area may be analyzed to showthe cause of the variance. It may be due to theuse of excessive quantities of material by newemployees, the purchase of inferior material,or the purchase of material priced above thebudgeted amount. This information must becommunicated quickly, and a continuous follow-up must be undertaken before the unfavorabletrends or tendencies develop into large losses.If overhead-rate variances are very significant,the overhead-pool budget may require revision.Quite often, this will be the case when the com-pany experiences a major fluctuation in the fore-casted business base.

RATIO ANALYSIS

Defense contractors typically use numerousratios as managerial tools in analyzing and con-trolling overhead costs. Such ratios are math-ematical relationships of indirect- or overhead-type costs that can logically be related todirect-cost drivers or total costs. For example,a manager may know, based on experience in aparticular manufacturing operation, that the“utilization ratio” for direct-labor employeesshould be approximately 78 percent of total la-bor for both direct and indirect. In other words,the employee (in a direct-labor capacity on theproduction floor) is expected to work directlyon jobs 78 percent of the time. The employee isalso expected to perform various indirect oroverhead functions (not directly traced to spe-cific jobs or contracts) 22 percent of the time.

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Exhibit 12. Rigorous Monthly Overhead Variance Analysis

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Such indirect or overhead-labor charges couldinclude training; union activities; idle time;medical exams; and various leave charges dueto sickness, vacation, military obligations, andjury duty.

In many cases, the corporate office looks atvarious ratios as control tools and uses them toset targets for overhead-management purposes.For example, a corporate objective for the busi-ness segment may be to improve the utilizationratio of direct labor from 78 percent to 82 per-cent in Year 1. The ratios used may be based onthe prior year’s business-segment experience oron data from other business segments in the cor-poration.

Recognizing that overhead is made up of liter-ally hundreds of different types of indirect ex-penses, these overhead control devices are usu-ally not developed as engineered standards thatuse expensive industrial engineering methods,as one typically finds for direct labor and directmaterial costs. Usually, they are based on in-ternally developed historical data for each com-pany.

To deal with the large number of relatively smallindirect charges and to facilitate analysis by ex-amining ratios, contractors often summarizetheir overhead expenses by combining similargroups of accounts.

The overhead classification and summariza-tion process is unique to each company. Forexample, contractors may use terms such as“facilities support services,” “shop support ser-vices,” and “management support services.”These terms sound similar; but they are, in fact,quite distinct. Large overhead cost classifica-tions in one company, such as “unrestrictedparts,” “perishables,” and “miscellaneoussmall parts,” may not exist in other compa-nies.

In effect, each company has an overhead busi-ness language of its own. Therefore, some ra-tios developed to control overhead cost in onecompany would probably be of little or no valuein another. In actual practice, some ratios usedto control overhead costs may be based onmanagerial experiences of key personnel whohave found that certain ratios have proven prof-itable and efficient in the past. However, the his-torical database may be personal in nature, mayhave originated when the individual worked atanother company, and may not be documentedanywhere.

TREND ANALYSIS

Trend analysis greatly facilitates the analy-sis of overhead costs. One of the principaluses of this technique is to identify early de-partures from historical patterns over time.Trend analysis enables one to detect unfavor-able trends or correlations; and it allows at-tention to be focused on certain, more sig-nificant indirect-expense accounts ororganizations that appear out of control. Forexample, if an indirect cost, such as the useof miscellaneous small parts in the assemblyarea, has been found to vary proportionatelywith assembly direct labor in the past, cur-rent use of these items can be expected to bearthe same or similar relationship. A more de-tailed investigation is then required to deter-mine the specific causes of any departurefrom normal operations. For example, inex-perienced employees, who were recently“bumped” into certain assembly jobs as a re-sult of compliance with union contract re-quirements, could cause an increase in themiscellaneous small parts usage ratio. Infe-rior quality parts that are bought from a newvendor could cause an increase as well. Byisolating indirect costs that need special ex-amination, a means for improving overheadcontrol is provided.

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Another important use of trend analysis is fore-casting overhead costs. Such forecasts assumethat relationships observed in the past will con-tinue in the future. They are most likely reli-able when they are within the general range ofthe historical data. If changed conditions or cir-cumstances, such as operating efficiencies orchanges in plant location, are predicted, histori-cally based overhead projections may requireadjustment to reflect the related changes in ex-pected costs.

As discussed earlier, overhead expenses areoften divided into fixed- and variable-costcomponents based on the pattern of behaviorof the costs over production or volume. Froman overhead-cost-control standpoint, a com-parison of the dollar amounts for fixed costsincurred over time may prove beneficial. Theseexpenses should remain about the same fromone period to the next. As an example, the costof depreciation charged to the fabrication shopand the equipment within the shop usuallywould not be expected to vary by much sim-ply because the company forecasts an increasein fabrication work for the coming year. Thedifference in the forecasted cost of deprecia-tion and the prior year’s depreciation could bedue to factors, such as asset purchases and re-tirements, differences in depreciation rates, ororganizational changes. It is possible that therecould be few or no differences if straight-linedepreciation was used and no new equipmentwas installed. This kind of comparison can of-ten identify errors made in forecasting and re-cording overhead costs. Dollar comparisonsfrom 1 year to the next are a useful tool toevaluate other overhead costs, particularlycapacity-related costs such as rents, leases, in-surance, real estate taxes, and property taxes.However, if contractors make significantchanges in fixed assets, a detailed fixed-assettracking system is usually required to ensureoverhead costs are properly accounted for andcontrolled.

MANAGEMENT METRICS

According to personnel actively involved in ana-lyzing overhead costs in the defense industry,several overhead management indicators ormetrics effectively identify overhead controlproblems.

Indirect labor is ordinarily one of the largestcost elements categorized as overhead in mostoverhead cost pools, i.e., engineering, fabrica-tion, assembly. The ratio of indirect-labor coststo total overhead costs in each cost pool is acommon overhead metric, and it often accountsfor 25 percent or more of all overhead costs.Many believe that, if you can control indirectlabor, you control overhead. Consequently, inmost companies, the authority for hiring anynew “indirect employee” is controlled at a highmanagement level.

Contractors often compute various factors fordirect and indirect labor. These are oftenunique to a company. But a rather commonmethod to compute a utilization factor is tocompute the ratio of indirect labor to directlabor after subtracting vacation and leave time.Some contractors also compute effectivity fac-tors of total indirect labor divided by total di-rect labor. Overtime charges often contributein a major way to overhead and are closelymonitored using a ratio of overtime percent-age worked for both direct and indirect em-ployees. Idle, waiting, or nonproductive timeis closely monitored by the ratio of such timeto total direct labor.

Indirect-labor charges are numerous and highlyvaried in nature. If a detailed cost analysis ofthe charges is required, these costs must be bro-ken down into logical components. For ex-ample, the compensation of managers, secre-taries, supervisors, lead personnel, and variousadministrative-support personnel in each over-head pool may be found in indirect-labor

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charges. Such costs must be identified by laborcategory and functional organization, and thenthey are analyzed in relation to variable andfixed components. The ratios of each categoryto the overhead allocation base, such as direct-labor dollars, can thus be computed and com-pared with similar historical ratios used for over-head forecasting.

The analysis of head-count information isthought to be extremely important and is widelyused by defense contractors to control overheadcosts. Contractors commonly provide monthlyand weekly reports to management, which cov-ers all aspects of manpower status. Overhead-cost-control information that is typically sup-plied includes:

• ratios of management to nonmanagement em-ployees,

• professional to total employees,• indirect to direct employees,• hourly to salaried employees,• contract or purchased employees to total em-

ployees, and• lead personnel to production workers.

The current status of any newly hired employ-ees is closely monitored, often on a daily basis.

Fringe benefits for both direct and indirectemployees are usually included in overheadcost. A separate analysis of fringe-benefitcosts is made for hourly and salary employ-ees because they often have different benefitpackages. These costs are significant and mayaccount for as much as half of the regular payfor all employees. For overhead cost analy-sis purposes, contractors typically breakdown fringe benefits as a percentage of totalsalaries and wages with a separate cost ratiocomputed for: health care, workers’ compen-sation, pensions, life insurance, sick pay, va-cation pay, holiday pay, savings plans, andsocial security taxes.

Capacity- or facility-related overhead costs,such as depreciation, maintenance, insurance,and property taxes, are often monitored basedupon a ratio of cost per square foot of occu-pied space. Other typical management toolsinclude:

• square foot occupancy per employee,• telephone lines per employee,• repair and maintenance per machine hour,• power cost per operating hour, and• equipment downtime per operating hour.

Overhead metrics in the materials overhead area(often called materials handling) include:

• total people working in the materials handlingfunction as a percentage of total company em-ployees,

• materials-handling cost per unit shipped orreceived,

• freight cost per unit shipped or received,• shipping and receiving per ton handled,• number of people in purchasing as a percent-

age of total materials purchased, and• purchasing costs per purchase order.

Examples of other significant overhead coststhat are monitored using metrics are:

• quality assurance as a percentage of produc-tion,

• computing cost per employee,• training costs per employee,• travel cost per employee,• consumable supplies per direct-labor hour,• perishable tools per direct-labor hour,• office supplies per employee, and• graphics cost per employee.

In analyzing G&A expenses, several ratios areused because of the broad nature of this expensepool. Examples are G&A expenses as a per-centage of sales; personnel classified as G&Aas a percentage of total company personnel; and

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employees in contracts, accounting, legal, andhuman resources as a percentages of total em-ployees. Certain large administrative expensesare tracked with ratios such as personnel costper employee hired, billing cost per invoiceprocessed, and payroll costs per employee ser-viced. Selling and marketing expenses are of-ten broken down into direct selling and salesadministrative or support expenses. These ex-penses are separately monitored as percentagesof sales or profit. Order processing is some-times reviewed based on cost per order pro-cessed. IR&D and bid and proposal expensesare large indirect-type expenses. They are usu-ally classified as G&A expenses and aretracked based on ratios, such as cost as a per-centage of sales or profit, cost per product sold,cost per value of new contracts received, orcost per employee.

To inform managers, contractors frequently pre-pare graphs to identify overhead-cost trends andto show departures from historical patterns.Typical graphs include both estimated and ac-tual plots over time of monthly and cumulativeoverhead rates, overhead-expense dollars, andoverhead-allocation bases. Other graphs (oftenprepared monthly because of the significant dol-lars involved) show estimates and actual plotsfor IR&D expenses, bid and proposal expenses,indirect labor, and employee head count.

The use of various overhead ratios or metrics,along with trend analysis, provides a ready meansof focusing attention on those costs that deviatefrom experienced trends and those that requiresome degree of special investigation. It shouldbe emphasized that overhead metrics cannot beused blindly. Often other factors may have sig-nificant meaning when comparing ratios, suchas changes in production methods or processes,organizations, employee classifications (direct orindirect), certain unusual or nonrecurring costs,inflationary factors, and accounting.

REGRESSION ANALYSIS

The statistical technique of regression analysisis sometimes used to manage indirect costs. Adetailed mathematical explanation of the tech-nique is beyond the scope of this guidebook;however, a brief summary of how it may beapplied in the analysis of overhead costs is pro-vided. Regression analysis is concerned withderiving mathematical equations that expresscertain functional relationships among vari-ables, such as the relationship of an indirect cost(a dependent variable) to a direct-cost alloca-tion base (an independent variable). Statistical-correlation data provides information for evalu-ating how closely dependent and independentvariables are related. Commercial softwarepackages are now available to perform regres-sion and correlation analysis computations.

Simple regression analysis, so named becauseit has only one independent variable and onedependent variable, is sometimes used to fore-cast overhead costs. The independent variablecould be any direct cost, such as direct-labordollars, direct-labor hours, or machine hour; andthe dependent variable could be overhead costs.As an example, the overhead forecast in a manu-facturing overhead pool could be expressed bythis mathematical equation derived through re-gression analysis:

$1M (Fixed cost)+ ($2.6) (Forecasted Machine Hours)Forecasted Overhead

The $1 million of fixed-overhead cost wouldoccur at zero machine hours, while the coeffi-cient of ($2.6) would be derived from the slopeof the regression line that was computed basedon historical statistics.

Multiple regression analysis is often more ac-curate than simple regression analysis. It evalu-ates the relationship between a dependent vari-

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able, such as overhead costs, and two or moreindependent variables. It is used when thecause-and-effect relationship based on a singleindependent variable is insufficient. Multiple re-gression analysis could be used to forecastmanufacturing maintenance hours based uponthe variables of production direct-labor hours,machine hours, and square footage of produc-tion floor space serviced by maintenance per-sonnel.

Regression analysis can be used to test the rea-sonableness of estimated-overhead rates fore-casted many years into the future. Overheadrates vary in response to numerous causes; but,because many overhead costs are fixed (as dis-cussed in Chapter 2 involving cost behavior),the level of predicted operations is very sig-nificant. Overhead rates are lowest when a fa-cility is operating at capacity, and they increasesubstantially when operating levels are re-duced. This relationship becomes significantin forecasting overhead costs for large pro-grams that involve performance over long pe-riods. In these cases it is necessary to predictoverhead rates many years in advance on thebasis of operating levels projected for theseyears.

Regression analysis is also used to determineif it is reasonable to use a certain direct cost,such as direct-labor hours or machine hours, asthe basis for allocation of overhead to cost ob-jectives. The direct-cost-allocation base shouldbe a primary cost driver or an activity that causesthe overhead cost to be incurred. In other words,there should be a strong causal relationship be-tween the direct-cost-allocation base used forallocation of overhead and the overhead costsincurred. Although there will probably never bea perfect correlation between any overhead pooland any direct-cost allocation base, some allo-cation bases provide a higher degree of corre-lation than others.

One of the statistics provided by regressionanalysis, the coefficient of determination, mea-sures the extent of the relationship between twovariables. The value of the coefficient of deter-mination is always between zero and one. Thecloser the value is to one, the stronger the rela-tionship between the two variables. The higherthe correlation, the stronger the linkage of in-direct costs is to direct cost; thus, a more accu-rate allocation of overhead is provided.

Some industry personnel, actively involved inmanaging overhead, find that regression analy-sis is not used extensively for forecasting de-fense contractor overhead due to the volatilenature of the business. The use of regressionanalysis assumes that overhead costs will be thesame in the future as the past. If a change incost behavior of an expense is foreseen, regres-sion analysis applied to historical data will notprovide useful results; and some other methodof forecasting should be used. In other words,what is known about the future is far more im-portant than historical data.

Statistical techniques are quite valid for char-acterizing prior history, but they cannot predictthe future. There are constant changes in thedefense business. They include large swings inthe business base, technological changes, manu-facturing process changes, creation of new func-tions, transfers of functions between overheadpools, reorganizations, and acquisitions. Inter-viewed industry personnel stated that constantchanges in the defense business make it diffi-cult to obtain meaningful overhead-forecastingresults with regression analysis. Consequently,judgment and experience, combined with ananalysis of future program requirements, are farmore valuable than statistical techniques forforecasting overhead. Thus, in practice, regres-sion analysis is used mostly for testing the rea-sonableness of other forecasts developed bymanagement.

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INDUSTRIAL ENGINEERINGANALYSIS

One of the largest costs included in all over-head pools is indirect labor. Such costs are sosignificant that they warrant special study. Oneof the best ways to analyze and controlindirect-labor costs is to use the industrial en-gineering staff, assuming that the benefitsclearly outweigh the costs. Industrial engi-neers can analyze the indirect tasks performedin various indirect functions similar to the waydirect tasks are examined on the productionfloor. With the objective of improving the ef-ficiency of operations and activities, defensecontractors sometimes use industrial engineer-ing techniques to study various indirect andproduction processes.

Industrial engineers use scientific methods, suchas time study, work sampling, and standard data,in evaluating specific indirect-labor functionsperformed by various departments. The analy-sis is output-oriented, with an emphasis on theidentification of nonvalue-added activities. Es-sentially, industrial engineers determine if cer-tain indirect functions are necessary, desirable,or simply nice to have. They are also concernedwith analyzing how the functions are currentlybeing performed and whether the most efficientmethods are being used. The engineering analy-sis of indirect- or overhead-type functions couldlead to savings by:

• combining certain functions,• simplifying work processes,• eliminating administrative bottlenecks,• eliminating unnecessary equipment,• reducing reporting requirements,• introducing automation, and• deciding to purchase rather than buy ser-

vices.

A fresh, independent, and objective look at over-head is desirable because indirect functions are

sometimes originally staffed based on meetingpeak workload requirements. Consequently, in-direct employees may not be efficiently usedwhen normal operations are resumed, or whenoperational requirements are reduced.

CONTRACTOR ACTIONS TOREDUCE OVERHEAD

Research shows that defense contractors arevery concerned about increasing overhead rates.Generally, there has been a severe deteriorationof the business base, which naturally causes asignificant increase in overhead rates. Contractterminations and major quantity reductions thathave occurred in the last few years have sig-nificantly affected overhead rates, and remain-ing contracts have been forced to absorb addi-tional overhead costs. As previously discussed,this is a standard occurrence for indirect or over-head cost allocations. Current defense contrac-tor management is concerned that high over-head rates will cause additional increases inweapons systems costs and result in further pro-gram reductions in the future. Each of the con-tractors interviewed has faced severe problemsin managing indirect or overhead costs. Over-head costs, often linked to capital assets, sim-ply cannot be eliminated quickly. It takes timeto vacate leased space; consolidate functions;and sell land, buildings, and equipment. Largedefense-oriented facilities often do not havemultiple uses, and a marketability problem usu-ally exists because defense program cutbacksimpact local economies.

Defense contractors realize that overhead costsmust be reduced for them to be competitive,and they are serious about cutting these costs.Each contractor interviewed has made toughdecisions involving people, many of whom haveworked for them for decades. It is not uncom-mon for a defense contractor to lose half of thepersonnel and half of the business base withinthe past few years.

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To deal with the critical overhead problem,defense contractors set up special projectteams to study how to reduce these costs. Spe-cial efforts ensure that the teams are inter-disciplinary in nature, with all organizationalelements and functional areas represented.Generally, teams include lower-level manag-ers (or those being burdened with overhead)and upper-level managers. Efforts are madeto encourage team members to get out of a“stovepipe mentality” and take an objective,fresh look at the problem from a total-com-pany perspective. In some cases, teams aregiven specific targets by top management re-garding certain overhead cost reductions thatneed to be achieved.

Recent approaches used by defense contractorsto cut overhead costs have been genuinely in-novative. Some contractors instruct their over-head study teams that a totally new way ofthinking about overhead costs is required. Someexamples of insights offered follow:

• There is no such thing as uncontrollable cost!If operational managers cannot control over-head, who can?

• There is no such thing as a fixed cost! Noth-ing is fixed — it can be eliminated.

• There is no such thing as an allocated over-head cost that you must accept! The controlof overhead cost is the responsibility of theperson charged with it!

Lower-level operational managers receive thefollowing instructions:

• No cost is free, and overhead is not peanutbutter to be spread out.

• If any overhead cost allocation is not worththe amount allocated, approach the allocat-ing organization and try to reduce or elimi-nate the cost!

Essentially, management directs project teamsto challenge every indirect function performedand to recommend collective alternatives to cutoverhead; these goals are to be achieved usinga bottoms-up approach.

The focus of the detailed studies of overhead isto dissect the hundreds of indirect expenses andto identify why the cost is incurred. Efforts iden-tify indirect function “core competencies” andeliminate any non-value-added functions oractivities. Loral Imagining Systems went a stepfurther and analyzed overhead functions to pin-point, for management’s awareness, those spe-cific indirect tasks that would no longer be per-formed if cost-cutting targets were met.

Some contractors make concerted efforts to ex-amine the various overhead or indirect-cost-oriented business processes within their corpo-rations with the objective of identifyingsimilarities, differences, and efficient or ineffi-cient practices at various business segments. Forexample, the Boeing Defense and Space Group,as part of its overhead study efforts, conducteda rigorous review of internal practices to iden-tify the “best in class” for certain functionswithin its five major divisions. They analyzedfunctions, such as manufacturing support, ma-terials handling, quality assurance, inventorycontrol, billing, scheduling, and the businessprocess used for managing overhead. The “bestin class” analyses have resulted in significantproductivity improvements and overhead-costreductions. In addition, wide-scale efforts havepromoted management objectives of standard-ization, consistency, and continuous improve-ment.

Special projects to study overhead in many com-panies resulted in management decisions topurchase certain services traditionally per-formed in-house. Examples of such servicespreviously performed as overhead functions butnow partially or totally purchased at lower cost,

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are data processing, travel management, insur-ance claims processing, legal services, photog-raphy and graphics, janitorial services, groundsand roads upkeep, cafeteria operations, andguard services. The initiative to purchase suchservices from outside sources also gives defensecontractors greatly increased management flex-ibility by converting large, fixed-cost overheadelements into a more variable cost. In somecases, the requirement for security guards iseliminated entirely with the installation of au-tomated security systems.

Numerous efficiencies and reductions in over-head costs result from overhead study team ef-forts to consolidate various operations. Consoli-dation and reorganization efforts have resultedin the sharing of resources through the com-bining of support functions, such as transpor-tation, facilities engineering, security, procure-ment, finance, and human resources. Markedreductions have taken place through the elimina-tion of indirect employees as a result of reduc-tions in supervisory and management personneland other indirect functions, such as staff and ser-vice activities in engineering and manufacturing.

Indirect labor is considered to be the initial tar-get for overhead-cost reduction, since it is sucha large cost driver. Contractors consolidatedcomputer and data-processing centers to effectoverhead-cost savings. In addition, various data-processing functions within engineering, opera-tions, and finance, which operate independently,are now consolidating to become less costly andmore efficient. Combining computer centers hasresulted in the reassignment and release of com-puter equipment, thus reducing depreciationcost. Boeing experienced large savings in over-head by closing or consolidating numerous en-gineering laboratories. Sharing resources andconsolidating efforts resulted in reducing thenumber of labs by more than 60 percent in a 4-year period.

A concentrated effort has been made to iden-tify and eliminate facilities that are not opti-mal. For example, Sikorsky made certain con-solidations in their feeder plants, transportation,and warehousing activities that significantlyreduced their square footage requirements formateriel functions. They also substantially re-duced the number of indirect employees intransportation functions. Concerted efforts havebeen made to eliminate leased space, transferbuildings to corporate commercial segments,and to sell some facilities. As an example ofthese efforts, Pratt & Whitney has reduced theirleased space by more than 50 percent withinthe past few years.

Contractors have also effected overhead costsavings and increased the utilization of assetsby vacating buildings. The result is the reduc-tion of costs for heating, air conditioning, andmaintenance expenses until the space is reuti-lized, subleased, or until the leases are termi-nated. In addition to vacating numerous build-ings, contractors are also reducing individualspace allocations for their employees.

Further consolidation efforts to reduce overheadand increase efficiency could include the con-solidation of overhead pools. A future problemmay develop in manufacturing overhead-relatedpools because large-volume defense productionwork has been significantly curtailed. Recentdefense contractor acquisition and merger ac-tivity will probably increase major consolida-tion efforts between, as well as within, compa-nies.

Efforts to reduce overhead cost often resultin staff cuts. Companies offer incentives forearly retirement, reduce the number of indi-rect employees by increasing the span of con-trol of supervisors and managers, eliminateovertime pay for salaried employees, deferor lengthen the period for pay increases, andeliminate some holidays. To reduce overhead

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and retain key experienced employees, Pratt& Whitney furloughed certain employees,particularly in the test areas, for a period ofseveral months. Sikorsky was able to reducefringe benefits by introducing flexible-ben-efit plans. These plans provide a frameworkwhereby an employer can control or cap costgrowth by limiting the allowances providedto the employees to purchase benefits, whilegiving the employees some flexibility to tai-lor benefit packages to their own individualcircumstances. Often, the flexible-benefit al-lowance doesn’t totally cover benefits pur-chased under the flexible plan; and the em-ployee contributes to the costs throughpayroll deductions.

Defense contractors have made many efforts toreduce overhead costs through better manage-ment of employee medical expenses. Most sig-nificantly, efforts have been made to increaseemployee contributions through payroll deduc-tion, increase deductible amounts, increase co-payment amounts, encourage employees to shiftto lower-cost HMOs, require second opinionsfor some surgeries, and give employees incen-tives to choose preferred providers with theirless-expensive, negotiated rates. In one case, atthe suggestion of employees on special over-head study teams, onsite doctors and nurseswere eliminated to cut overhead costs.

Other overhead-cost containment measureshave included substantial reductions in travelexpenses, training, perishable tools, and outsideservices. Also overhead costs have been reducedby using voice mail to reduce secretarial sup-port, eliminating executive dining rooms, in-creasing use of teleconferencing, eliminatingcopiers and telephones, and conserving energy.As a result of overhead study team recommen-dations, special management approval is nowoften required before incurring certain overheadexpenses.

There has been a strong effort by defense con-tractor management to constrain capital spend-ing to reduce overhead costs. It was not unusualfor defense contractors to cut capital spendingby 50 percent or more within the past few years.It may be difficult to get a large capitalizedproject approved in the current environment;often, it must be for asset replacement or forsafety reasons. At best, defense contractors ex-pect capital spending to remain flat for the nextseveral years.

To cut G&A expenses, most defense contrac-tors have significantly reduced their IR&D andB&P expenses. Since new programs and bidopportunities are minimal, there is a strong con-servation of IR&D and B&P discretionaryfunds. Companies are now focusing on coretechnologies and pursuing projects in only thoseareas. It is getting much tougher to get newprojects approved; and, generally, they must berelated to an existing product line. For example,the Loral Imaging Systems Division recentlyset up a “strategy board” to review each projectin detail prior to approval. Since IR&D andB&P expenses are usually included in the G&Aexpense pool, the president of the company isoften the person responsible for reducing thisoverhead cost.

Defense contractors are now making significantefforts to identify more costs by reclassifyingemployees from indirect to direct to providemore visibility and control. Examples of suchfunctions being changed in some companiesfrom indirect- to direct-charging functions areprogram management and administrative sup-port, earned value, engineering administrativesupport, industrial engineering, expediting, dis-patching, and certain production liaison func-tions.

Of course, companies differ significantly as tohow they individually classify these functions.Some companies move fringe benefits from

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indirect cost to direct cost for salaried, hourly,and contract-job shop employees. The shiftfrom indirect to direct has a significant impacton reducing overhead rates because the laborwill be in the cost-allocation base (or denomi-nator) rather than in the indirect overhead costpool (numerator). As we have previously dis-cussed, such shifts from indirect to direct donot reduce total cost; but defense contractorsfeel that it improves the accuracy of cost allo-cations.

According to upper levels of management, spe-cial project, large-scale study efforts are verybeneficial because they produce many cost cut-ting ideas. The study team approach was alsoinstrumental in educating employees about theimportance of controlling the many indirectcosts and of establishing a sense of responsi-bility for overhead at lower operational levels.After the special projects were completed, manyemployees continued to volunteer overheadcost-cutting ideas; but, while the bottoms-upspecial-project team approach was useful, itsimply did not cut overhead enough.

Although actions to cut overhead costs throughthe bottoms-up approach are ambitious and ag-gressive, a top-down approach is necessitatedby the urgency to make major overhead costreductions. DoD budgetary forecasts call foradditional reductions in the business base; and,given this downturn, defense business segmentsare receiving increasing pressure from the cor-porate office on profitability concerns.

To be competitive, each of the contractors in-terviewed had to iteratively cut overhead costsand reduce rates. For this reason, overhead-costreduction was placed directly before top man-agement. Given the limited opportunities forwinning additional business, top managementcapped overhead at certain rates deemed nec-essary to maintain competitiveness during ex-pected future lean times.

To maintain a strong emphasis on reducingoverhead and to elevate the sense of urgency ofcompetitive overhead rates, most contractors setup highly visible “control rooms,” which aregiven attention-getting names, such as “Break-through Room,” “Room X,” “Engineering Over-head Control Room,” or “Management ControlRoom.” These control rooms are established toconduct overhead reduction team meetings andto post a myriad of data relating to cost control.Typically, contractors post large charts on thewalls of the control room on a monthly basis.These charts show the current month and year-to-date overhead performance for each overheadpool.

The Boeing Defense & Space Group (D&SG)took particularly strong steps to firmly estab-lish accountability for managing overhead costsby designating specific executives responsiblefor each of its many overhead cost pools. Theirview is that, once executive responsibility foroverhead is clearly established, more positivesteps can be taken to improve the effective uti-lization of indirect activities. Each overheadpool in the Defense & Space Group organiza-tional structure has an “owner.” The owner isthe designated pool manager, normally a vicepresident, but always a senior operational man-ager, who is responsible for managing the pooland achieving the committed performance levels.

It is interesting to note that pool managers areoperational personnel and not financial person-nel. This indicates that a significant change hasoccurred — senior operational managers, notfinancial personnel, are required to explain vari-ances in overhead to top management. The abil-ity to manage overhead costs is a significantfactor in evaluating management performanceand in determining incentive pay. Financialpersonnel help each of the overhead-pool man-agers interpret and explain accounting systemsand data; but operational managers are the onesaccountable. An “Overhead Pool Responsibil-

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ity Matrix” is maintained by D&SG to ensurethe proper assignment of responsibility for poolmanagement, and an individual called a “fi-nance focal point” is designated to assist theoverhead-pool manager by providing account-ing support.

Each overhead-pool manager is accountable tosenior D&SG management for conformance tointernal organizational overhead budgets and iscommitted to achieving the overhead rates.Overhead-pool managers and finance focalpoints are responsible for documenting and sup-porting the accuracy, currency, and complete-ness of their overhead forecasts and for provid-ing justification for the various calculations andvalues contained in rate computations.

Involving operational personnel in overheadmanagement is exceptionally beneficial, sincesuch a large number of indirect costs are dis-cretionary in nature and considerable manage-ment judgment is required. When making toughdecisions, senior operational managers have theknowledge and experience that financial per-sonnel lack.

Recently, the concern for “affordability” ofoverhead rates has lead to a relatively new man-agement philosophy regarding the control ofoverhead costs. The new concept is referred toby some as the “100 percent variability of over-head rule.” In this concept there is no such thingas a fixed cost, and overhead does need to becarried if the business base declines. Stated dif-ferently, all overhead costs should be viewedas variable costs; and, if the business base de-clines by 20 percent, overhead cost must alsobe reduced proportionately by 20 percent to“hold the rate.”

The concept represents a top management di-rection that overhead-pool managers must becommitted to maintaining a constant overheadrate so the company can be competitive. In other

words, they cannot afford for overhead rates togo any higher. If the business base is reduced,overhead-pool managers must find ways to cutoverhead costs a sufficient amount to keep therates from increasing. For example, suppose thecurrent manufacturing overhead rate is 200 per-cent (derived by the indirect manufacturingoverhead expenses of $400 million divided bya direct-labor dollar base of $200 million). Theindirect overhead expenses are made up of fixedcosts of $160 million and variable costs of $240million. Therefore, the variable overhead is$1.20 for every $1 of direct labor or $240 mil-lion divided by $200 million. Consider that thecontractor loses a major contract and the busi-ness base is reduced by $60 million for a 30percent reduction in the direct-labor burden.Traditionally, the new forecasted manufactur-ing-overhead rate would normally be expectedto jump to 234 percent, which is derived bydividing the new forecasted overhead costs of$328 million by the new direct-labor base of$140 million. The new base would be 70 per-cent of $200 million or $140 million. The newoverhead-pool expenses would consist of a fixedoverhead of $160 million plus the revised vari-able overhead of $168 million (revised base of$140 million times the variable overhead rateof $1.20 per direct-labor dollar). However,under the concept of the “100 percent variabil-ity of overhead rule,” the overhead rate must beheld constant at 200 percent to be competitive.This means that fixed costs must be cut sub-stantially to make this happen; in fact, fixedcosts would have to be cut by $48 million, aformidable task. However, the ultimate goal ofmanagement is to treat fixed costs and semi-variable costs as totally variable costs.

Although there can be approved exceptions tothe rule in some circumstances, it is clear thattop management expects overhead-pool man-agers to think in terms of 100 percent variabil-ity of overhead costs. Previously, overhead-poolmanagers were held responsible for only over-

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head expenses. Now they are responsible formaintaining the overhead rate, which meansthey are responsible for the business base aswell as overhead expenses. Some contractorsreport favorable results with this concept. Forexample, if the business base declines, manag-ers must consider what can be done to offset it.Also, if costs go up in one area, they must ad-dress what can be done to cut or trim overheadcosts in other areas. In the past, managers tendedto manage by direct-labor hours; now they man-age to a rate; and as a result, an increased em-phasis must be placed on overhead. “Holdingthe overhead rate” has been incorporated intomanagement score cards. Whether this conceptis achievable remains to be seen; however, itcertainly creates tremendous pressure on man-agers to focus on overhead-cost control.

Some contractors report a cultural change indealing with the government in connection withmanaging overhead. They are working moreclosely with the government on the joint objec-tive of avoiding any major surprises involvingincreasing overhead costs. In some cases, gov-ernment personnel from the local Defense Con-tract Management Agency cognizant office meeton a regular basis with overhead-pool managersat the company’s monthly overhead meetings todiscuss reasons for cost variances. Previously,the contractor would mail certain overhead re-ports to the government for review. A signifi-

cant improvement in maintaining currency re-garding overhead problems has been noted bygovernment personnel, and a more open, trust-ing relationship between the two parties seemsto exist. In addition, contractors report that gov-ernment employees seem more focused on un-derstanding their business processes as a meansof monitoring overhead costs rather than rely-ing on reports previously created for their use.

In summary, it is apparent that defense contrac-tors are concerned about the significant prob-lem of a drastically declining business base andthe resultant impact on overhead rates. If notaddressed by management, the problem couldresult in increased costs to program offices onflexibly priced contracts and spiraling, noncom-petitive, overhead rates for defense contractors.Contractors have studied and continue to studywhat can be done. They are cutting overheadcosts, reducing their workforce, eliminatingexcess capacity, and consolidating operations.Significant reductions are being made in dis-cretionary spending through cuts in capitalspending on plants and equipment, machineryand tooling, IR&D, and bid and proposal ex-penses. Concerted efforts are being made tostreamline operations by examining the best andlowest-cost business practices in numerousfunctions throughout the corporation.

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66IMPACT OF GOVERNMENT CONTRACTING

REQUIREMENTS

INTRODUCTION

Significant differences exist in the way pricesfor products and services are determined in thecommercial versus government contractingmarketplaces. In the commercial environment,the price paid by the customer is usually alwaysdetermined by the demand for the product inan open, competitive marketplace. In pricingproducts for that market, commercial compa-nies initially estimate the direct material anddirect labor required and apply all related indi-rect rates; and then they add a margin to coverthe expenses of marketing, sales, research, de-velopment, and administrative expenses. Theinitial pricing estimate is compared with com-petitive prices, and market price adjustments arethen made.

The costs of marketing, sales, research, devel-opment, and administrative expenses are viewedas “period costs,” i.e., those costs are writtenoff in a lump sum against profit on the finan-cial statements for each fiscal period. Typically,these period costs are not allocated in any wayto specific products or contracts. Customers inthe commercial marketplace are interested onlyin the price they are paying and not in the break-down of the direct and indirect costs within theproducing company.

Furthermore, even if there is an interested cus-tomer in a product-cost breakdown, the cus-tomer has no legal right to see the cost data.However, in the acquisition of weapon systemswhere competitive prices do not exist, the break-down of the cost becomes very important.

Under a cost-based pricing methodology, whichis used extensively in weapons systems procure-ment, a price must be negotiated with each cus-tomer for each contract. Under cost-based pric-ing, the contractor must assign all costs aslogically as possible to each contract using a“full costing” concept. The full cost of a con-tract is the sum of the direct costs plus a fairshare of all applicable indirect costs, includingthe period costs of marketing, sales, research,development, and administrative expenses.

Therefore, for the DoD as a customer, thecontractor’s cost allocation methods play amajor role in determining the price of not onlycost-reimbursable contacts but also any nego-tiated fixed-price contracts. The type of con-tract used is important to the government’s rightof access to information on the contractor’s in-direct costs. Later in this guide, the types ofcontracts used in defense contracting and howthese contract types affect indirect rates are dis-cussed in detail.

When there is a mix of negotiated governmentcontracts and commercial business in acontractor’s facilities, a need for more accuratecost-allocation methodologies (as compared tothe commercial business environment) is readilyapparent. DoD’s concern is that indirect-costallocations should be no more than necessary,and the government should pay no more thanits fair share. Therefore, considerable involve-ment by government personnel should be ex-pected in the monitoring of indirect-cost allo-cations. An accurate allocation of indirect costsis important because incorrect allocation can

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result in charging defense contracts fornondefense-related costs or in one contract sub-sidizing other contracts through the allocationof a disproportionate share of indirect costs.However, in the interest of working with con-tractors in a constructive “win-win” manner, thecontractor’s methods of allocating indirect costsshould only be contested if there is a materialdifference in costs that would result from usingdifferent allocation methods.

Because of significant differences of opinionabout the proper allocation of indirect costswhere material differences do exist, numerousgovernment regulations have resulted. Essen-tially, the government cost regulations relatedto indirect costs are contained in the FederalAcquisition Regulations (FARs) and the CostAccounting Standards (CASs). The cost prin-ciples in the FAR apply to contracts, subcon-tracts, and modifications when the price is ne-gotiated on the basis of analysis of thecontractor’s costs. The cost principles determinecost reimbursement, negotiation of indirectrates, and other cost determinations or negotia-tions required by a contract. Requirements ofthe FAR are discussed in greater detail later.

The rules governing the applications of CASsfor the allocation of indirect costs are consid-ered by many procurement-acquisition profes-sionals to be very complex. Nevertheless, un-less specifically exempted, all negotiatedgovernment contracts or subcontracts of morethan $500,000 are subject to modified CAScoverage. Full CAS coverage applies if thecontractor receives a single negotiated awardof $50 million or more or had $50 million inCAS-covered net awards during the preced-ing cost-accounting period and at least one ofthem exceeded $7.5 million. Exemptions fromCASs apply to contracts with small busi-nesses, sealed bid awards, commercial items,and contracts with foreign governments.Greater details regarding CAS requirements

that influence indirect costs are provided inChapter 7.

Currently, one major initiative of the DefenseContract Management Agency (DCMA) ismonitoring defense contractor indirect costs.DCMA is concerned with the large amount ofcosts tied up in overhead in the defense mar-ketplace where contracts are often awarded ona noncompetitive basis. DCMA is also concernedwith large reductions in the defense businessbase, which will naturally cause indirect rates togo up. In addition, during the past few years, achange has occurred in the way DoD contractsfor research and development work. This changeplaces a major emphasis on using flexibly pricedcontracts instead of fixed-price contracts. There-fore, DoD is placed in a position of assumingmore risk for indirect costs.

RELEVANCE OF CONTRACT TYPE

Because of the complexity of contractual ar-rangements, the management of indirect costsis far more complicated for firms engaged ingovernment contracts than it is for firms en-gaged in commercial business. In the commer-cial environment, contracts are basically allfirm, fixed-price agreements. This is not the casein the defense environment. To recognize theimpact that changes in indirect cost rates haveon both the defense contractor and the govern-ment, it is vital to understand the various typesof contracts used in government work. In somecases, increases in indirect costs are totally or par-tially paid by the customer — the government.

The type of contract used, generally a matter ofnegotiation, may vary significantly based on thedegree of responsibility assumed by the con-tractor for the costs of performance, includingthe allocation of an appropriate amount of in-direct cost. A large assortment of contract typesprovide the flexibility necessary to acquire thelarge variety of products and services the gov-

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ernment requires. The objective is to negotiate acontract type that results in reasonable contrac-tor risks and provides the contractor with the great-est incentive for economical performance.

It should be noted that the type of contract usedon a given program will often change over time.For example, in the course of a weapons sys-tems acquisition program, changing circum-stances may make a different contract type moreappropriate later than the one used at the be-ginning of the program. Government contractsare broadly classified as being either in the cost-reimbursement or fixed-price family of contracttypes. Between these two basic families, nu-merous incentive arrangements share cost re-sponsibility between the government and thecontractor.

A cost-reimbursement contract is used when thecost of contract performance cannot be pre-dicted with accuracy, such as in the develop-ment of weapons systems. This is especially truewhen research and development work is re-quired, performance uncertainties exist, or en-gineering changes are likely. These situationsmake it difficult to estimate future costs, andthe contractual scope of work cannot be de-scribed adequately enough for the contractor toguarantee performance at a fixed price.

Though the government generally prefers notto use cost-type contracts, using them permitsthe government to contract for complex workthat would otherwise present too great a costrisk to contractors. An estimate of total cost,including an appropriate allocation of indirectcosts, is necessary under cost-type contracts forthe purpose of obligating funds and establish-ing a ceiling that the contractor may not ex-ceed. If the contractor exceeds the estimate oftotal costs, he does so at his own risk. The esti-mated total cost is also very important for ne-gotiating the fee on the cost-type contract. Ofcourse, estimated indirect rates are used in ne-

gotiating cost-type contracts to give the partiesan idea of the likely indirect rates that will berealized during contract performance. There areseveral varieties of cost-reimbursement con-tracts.

Under a cost-plus-fixed-fee (CPFF) contract,the contractor is reimbursed for his actual cost,subject to certain government requirements re-garding allowability, plus a negotiated fixed fee.The large numbers of costs, which may be un-allowable and are generally of an indirect- ratherthan a direct-cost nature, will be discussed later.

The fixed fee is negotiated at the beginning ofthe contract and does not change regardless ofthe amount of actual cost incurred. The fee maybe adjusted later, however, as a result of modi-fications to work performed under the contract.Since the contractor is paid actual costs for us-ing the best efforts to accomplish the workwithin the specified time, the CPFF contractprovides the contractor with only a minimumincentive to control costs. Therefore, this typeof contract results in the government assumingall of the cost risks, since the final price is de-termined after the work is performed and afteractual costs are known.

A cost-plus-incentive-fee contract (CPIF) is acost-reimbursement contract that provides fora fee that is adjusted by a formula according tothe relationship of total allowable costs to tar-get costs. The target cost, target fee, minimumand maximum fee, and the fee-adjustment for-mula are negotiated at the outset. The fee paidto the contractor is negotiated after contract per-formance and final actual costs are determined,using the formula and the minimum and maxi-mum fees. A cost-plus-award-fee (CPAF) con-tract is a cost-reimbursement contract with spe-cial fee provisions. The fee has two parts, a fixedportion and a variable portion, to be awardedbased on the caliber of performance in specificcontract areas. These include quality, schedule,

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creativity, and cost effectiveness, as determinedby the government. Recently, some program of-fices place a great deal of emphasis on estab-lishing award fee factors to help regulate thecontractor’s ability to control indirect costs.

From the government’s perspective, a cost-reimbursement contract is used only when thecontractor’s accounting system is adequate fordetermining costs applicable to the contract andwhen appropriate government surveillance dur-ing performance will provide reasonable assur-ance that effective cost controls are used. Undercost-reimbursement contracts, the contractor, inthe final analysis, is reimbursed for actual, notestimated, indirect costs.

From the contractor’s perspective, if a large in-crease in indirect-cost rates between the initialpricing of the contract and the negotiation offinal actual indirect rates is experienced, thenegative financial impact would only be a re-duction in fee under a CPIF arrangement. Thegovernment pays the cost of the increase in in-direct rates. Therefore, from the government’sperspective, the higher the value and percent-age of cost-reimbursable contracts, the greaterthe need for review of the contractor’s manage-ment controls over indirect costs. Final indi-rect rates are discussed in Chapter 8, where in-direct rates contractors use in dealing with thegovernment, forward pricing, billing, and ac-tual rates are discussed.

The fixed-price contract is suitable for acquir-ing commercial products or for acquiring sup-plies or services. Suitability is determined onthe basis of reasonably definite functional ordetailed specifications when the contracting of-ficer can establish fair and reasonable prices atthe outset. The fixed-price family of contractsmay provide for a firm-fixed price or an adjust-able fixed price. The firm-fixed-price contractprovides for a price that cannot be adjusted be-cause of the contractor’s cost experience in per-

forming the contract. However, the fixed-pricecontract, with an economic price-adjustmentprovision, leaves the contract open for a lateradjustment of contract price. This adjustmentis based upon the occurrence of contingenciesspecifically defined in the contract. This typeof contract is applicable to circumstances whereuncertainty exists as to the stability of marketor labor conditions, e.g., inflation or cost-of-living adjustments.

The fixed-price-incentive (FPI) contract is afixed-price contract. The price of the FPI is ad-justed by a provision that changes profit accord-ing to a formula based on the relationship offinal negotiated total cost to target cost. In anFPI contract, the following items are negotiated:target cost, target profit, price ceiling, and aformula for establishing final profit and price.

After performance of the contract, final costsare negotiated; and the contract price is estab-lished by using the formula. If the final costsare less than the target costs, the final profit ismore than the target profit. On the other hand,when the final cost is more than the target cost,application of the formula results in a final profitthat is less than the target profit; or it may evenresult in a loss. If the final negotiated cost ex-ceeds the price ceiling, the contractor absorbsall costs above the ceiling as a loss. It is impor-tant to note that, even under the FPI contractwhere there are cost overruns, the contractor ispaid his final allowable actual costs, includingan appropriate share of indirect costs up to thenegotiated ceiling amount.

However, from the contractor’s perspective, themanagement of the indirect cost estimating pro-cess is more stringently tested with the fixed-price family of contracts. Under fixed-pricecontracts, the contractor develops indirect-costrates that reflect greater risk to the contractorfor both cost and performance. This type of con-tract provides maximum incentive for the con-

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tractor to perform efficiently and to control indi-rect costs. It also imposes a minimum adminis-trative burden on both the government and thecontractor. Therefore, from the government’sperspective, fixed-price contracts are preferredwhen contract costs can be estimated with rea-sonable accuracy and when performance re-quirements are reasonably certain.

In summary, under cost-type contracts, the gov-ernment absorbs all increased costs that resultfrom indirect-rate increases occurring duringcontract performance and that are over the ratenegotiated at the time of contract award. Underfirm-fixed-price contracts, the contractor ab-sorbs all increased costs due to indirect-rate in-creases during contract performance. Of course,the opposite would be the case if indirect-costrates decrease. Under cost-type contracts, thegovernment receives the benefit through de-creased cost. However, under firm-fixed-pricecontracts, the contractor receives the benefitthrough increased profits. For a more detaileddiscussion of contract types, see Part 16 of theFederal Acquisition Regulation.

FEDERAL ACQUISITIONREGULATION (FAR) REQUIREMENTS

As briefly discussed in Chapter 2, one of themost significant influences on indirect costs indefense contracting is the category of unallow-able costs established by the FAR. For variousreasons, the government will not pay manycosts; for example, it will not pay interest cost,even though it is commonly recognized as nor-mal and necessary. In fact, interest expense issuch a significant amount that it is separatelycalled out as a major expense on published cor-porate financial statements. But from the gov-ernment perspective, paying for interest costsamounts to favoring those companies that fi-nanced their business with debt, as opposed tostockholder equity. The company could simplypass on the interest charges under negotiated

contracts to the government, whereas the com-pany that financed with stockholders equitywould not incur any interest costs.

Other common business expenses that are un-allowable are contributions made to charitableorganizations. If the government paid for con-tributions to charities by defense contractors,in effect the contractor rather than the govern-ment would be deciding which charities shouldreceive taxpayer dollars. The allowability ofcosts can always be expected to present a prob-lem for defense contractors because the busi-ness is often too complicated to perform on anybasis other than some type of negotiation basedon costs.

The rules governing the allowability of costsfor defense contractors are contained in the FARPart 31, and in DoD Federal Acquisition Supple-ment (DFARS), Part 231. In practice, theseregulations are referred to as the “cost prin-ciples”; but they are equally applicable to thepricing of fixed-price contracts whenever theprice is based upon cost data.

Within the past few years, Congress has becomevery involved in setting rules for the allowabilityof contract costs. The basis for new or changedcost principles often originates with legislativechanges. For example, changes occurred in theFARs after the infamous “dog kennel charges”claimed by a General Dynamics executive (dis-closed during congressional hearings) and afterthe Navy “Ill Wind” investigation into the ac-tivities of defense consultants. These horror sto-ries brought about legislation that resulted inmore complex regulations governing indirectcosts, more unallowable costs, and arequirement for contractors to certify their indirect-cost claims. As a consequence, contractors arenow at risk of being assessed severe penalties,such as the doubling of the amount of unal-lowable costs taken out of their indirect-costclaims.

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Cost Allowability

The criteria for the allowability of costs is definedin FAR 31.201-2, which lists factors to be consid-ered in determining whether a cost is allowable.These factors include the following items:

• reasonableness• allocability• cost accounting standards, if applicable (oth-

erwise generally accepted accounting prin-ciples and practices)

• terms of the contract• limitations established by FAR subpart 31.2,

“Contracts with Commercial Organizations,”which discusses selected costs and numer-ous unallowable costs

Reasonableness

In practice, applying the reasonableness crite-ria, as defined in FAR 31.201-3, is not easy. Whatis reasonable depends on many considerationsand circumstances involving the nature andamount of the cost in question. What is reason-able to one person may be completely unreason-able to another. From the government’s perspec-tive, reasonableness of specific costs is of particularconcern in connection with contracts awardedwithout competitive forces present. Judgment isrequired to determine the reasonableness of a givencost. Consideration should be given to the fol-lowing questions:

• Is the cost generally recognized as ordinaryand necessary for the conduct of thecontractor’s business or for contract perfor-mance?

• Is the cost acceptable in terms of sound busi-ness practices, arm’s-length bargaining, andfederal and state laws and regulations?

• Would a prudent businessman make this de-cision in competitive circumstances?

• Are there significant deviations from the es-tablished practices of the contractor?

When the government questions a cost, the bur-den of proof is upon the contractor to establishthat the cost is reasonable. An example of howthe government can question an indirect costbased on reasonableness would be a case inwhich a contractor charges for the use of its owncorporate aircraft when commercial flights areavailable at a lesser cost.

Allocability

Allocability means that each contract shouldreceive only its fair share of all costs. Someconnection must be shown between each con-tract and any costs that are assigned to it. Theallocability of indirect costs is an extremelysensitive area, particularly when a mix betweengovernment and commercial products exists, orwhen there are different contract types. Thegovernment’s aim is to avoid paying costs in-curred primarily for the benefit of a contractor’scommercial contracts.

Detailed regulatory guidance relating to allo-cability is provided in FAR 31.201-4. A cost isallocable if it is assignable or chargeable to oneor more cost objectives on the basis of relativebenefits received or other equitable relation-ships. Subject to the foregoing, a cost is allo-cable to a government contract if it is:

• incurred specifically for the contract;• beneficial to both the contract and other work

and is distributable to them in reasonable pro-portion to the benefits received; or

• necessary to the overall operation of thebusiness, although a direct relationship toany particular cost objective cannot beshown.

It should be noted that the FAR cost principlesrefer in some cases to the required use of cer-tain CASs. Cost accounting standards containsignificantly more guidance related to alloca-bility than the FAR. The many requirements of

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the CASs that affect indirect costs are coveredin more depth in Chapter 7. Briefly, all con-tracts subject to CASs must meet more restric-tive requirements concerning how costs are al-located to contracts. However, even under theCASs, the contractor still has considerable op-tions in determining the methodology for allo-cating indirect costs. Since each contractor al-locates indirect cost under his own accountingsystem, government personnel must evaluatewhether the allocation bases used by the con-tractor for the allocation of indirect costs areequitable.

Generally Accepted Accounting Principles

Generally accepted accounting principles(GAAP) provide the overall framework for allaccounting. They provide guides for acceptablefinancial reporting, but detailed cost-accountingpractices are not covered. Financial reports areprimarily for stockholders, investors, and othersinterested in the financial results of the corpo-ration as a whole. To assure that profits andlosses are fairly stated for each year, such finan-cial reporting principles focus only on cost al-locations between fiscal years.

The GAAP do not delve into the acceptablemethodologies for allocating indirect costs tospecific cost objectives, such as defense con-tracts. In fact, one of the primary reasons forthe creation of the Cost Accounting StandardsBoard (CASB) was the inadequacy of GAAPto define the criteria for acceptable bases forcost accounting related to defense contracts. Al-though GAAP is defined in the FARs as a re-quirement for allowability of contract cost, theprinciples are of very limited value in estab-lishing allowability.

Contract Terms

Some costs may be specifically listed in a con-tract as unallowable by mutual agreement be-

tween the contractor and the government at thetime the contract is negotiated. The contract mayalso provide specific criteria that must be metbefore a cost is considered allowable, or it mayspecify certain limits that cannot be exceeded.For example, a contract may state that cer-tain large-scale employee relocations must beapproved by the contracting officer before thecosts are incurred; or it may state that suchcosts are allowable only up to a specificamount for each employee or a specific totalamount.

Some contracts, particularly those involvingcost-sharing arrangements, may containindirect-rate ceilings that are incorporated intothe contract. Indirect-rate ceilings may alsobe incorporated into contracts when the con-tractor is a new supplier, and there is no pastrecord of incurred indirect costs. In addition,an indirect-rate ceiling may be incorporatedinto a contract when the contractor has a re-cent record of rapidly increasing indirect-costrates.

When would the government want to incor-porate indirect rate ceilings? When a contrac-tor seeks to enhance its competitive positionin a particular pricing decision, it may baseits proposal on indirect-cost rates that arelower than those that may reasonably be ex-pected to occur during contract performance.Of course, two parties are required for a con-tract; and the contractor may not agree to suchrate ceilings.

SELECTED COSTS

FAR 31.205, “Selected Costs,” provides substan-tial guidance on the allowability of 49 major clas-sifications of costs. Some of the costs discussedin the regulations are unallowable. Some are par-tially unallowable, and some are fully allowable.A very careful reading of the FARs is required todetermine which costs are unallowable.

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Examples of costs, considered totally unallow-able, include these items:

• alcoholic beverages• bad debts• contingencies• contributions or donations• entertainment• fines and penalties• interest and other financial costs• losses on other contracts• organization costs• goodwill• executive lobbying• asset valuations resulting from business com-

binations

Examples of costs that may be partially unal-lowable follow:

• public relations and advertising• compensation for personal services• employee morale, health, and welfare• idle facilities and idle capacity• independent research and development• bid and proposal expenses• legislative lobbying• patent costs• professional and consultant services• recruitment costs• relocation costs• rental costs• selling costs• taxes• travel costs

To demonstrate why careful reading of the FARsis required to determine the allowability of cost,let us examine the first FAR provision for se-lected cost, FAR 31.205-1, “Public Relationsand Advertising.” Each of these major costs aredefined, then particular items are specified asallowable or unallowable. Public relations in-cludes all functions and activities dedicated to

maintaining, protecting, and enhancing the im-age of a concern or its products. It also includesmaintaining or promoting a reciprocal under-standing and favorable relations with the gen-eral public or with any segment of the public.

Advertising is the use of media to promote thesale of products or services. Advertising mediainclude, but are not limited to, the following items:

• conventions• exhibits• free goods• samples• magazines• newspapers• trade papers• radio• television

The only allowable advertising costs are thosethat are used to:

• fulfill specific contract requirements;• recruit personnel required for the contract;• acquire scarce items for contract performance;• dispose of scrap or surplus materials acquired

for contract performance; and• promote the exportation of products that are

usually sold to the U.S. Government. (Thisincludes trade shows and items that requirea significant effort to sell outside of theUnited States.)

However, such costs do not include costs ofsales promotion or memorabilia items, such asmodels, souvenirs, and gifts. Sales-promotioncosts are unallowable. Physical facilities thatare primarily used for entertainment rather thanfor product promotion are also unallowable.

The only allowable public relations costs arethose used to:

• fulfill specific contract requirements;

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• respond to inquires about company policiesand activities;

• communicate with the public, press, stock-holders, creditors, and customers;

• conduct general liaison with news media andgovernment public relations officers;

• participate in community service activities,such as blood drives, savings bond drives,charity drives, etc.; and

• conduct plant tours, keel layings, and aircraftrollouts.

Both the contractor and the government musthave personnel who are very familiar withthese regulations working in the indirect-costarea.

While the guidance provided in the FARs issubstantial, the discussed “selected costs” donot cover every situation. The failure to ad-dress any item of cost in the FAR is not in-tended to imply that it is either allowable orunallowable.

ADVANCE AGREEMENTS

Since the allowability of costs may be subject tovarious interpretations, FAR 31.109 recommendsthat certain controversial costs be part of an ad-vance agreement between the contractor and thegovernment. Advance agreements are stronglyrecommended for companies that do substantialbusiness with the government on the basis of ne-gotiation. Advance agreements may be negoti-ated either before or during a contract but shouldbe negotiated before incurrence of the cost in-volved. The agreements must be in writing, ex-ecuted by both contracting parties, and incorpo-rated into applicable current and future contracts.

Examples of costs for which there may be dif-fering interpretations relating to reasonablenessand for which advance agreements may be es-pecially beneficial include the following:

• precontract costs (costs that are incurred be-fore the effective date of a contract and thatmay be necessary for meeting the deliveryschedule)

• compensation for personal services, includ-ing, but not limited to, allowances for off-site pay, incentive pay, location allowances,and cost-of-living differential

• use charges for fully depreciated assets• independent research and development ex-

penses• bid and proposal expenses• selling and distribution expenses• travel and relocation costs• costs of idle facilities and idle capacity• plant reconversion• general and administrative (G&A) expenses

in some cases, e.g., corporations with foreignsubsidiaries or government-owned andcontractor-operated plants (GOCOs)

• public relations and advertising expenses• training and education expenses

Advance agreements help avoid controversiesand disagreements in the treatment of costs thatarise. But an advance agreement is not an ab-solute requirement, and the absence of an ad-vance agreement on any cost should not effectthe reasonableness of the cost.

CERTIFICATION OFINDIRECT COSTS

Contractors are required to submit their finalindirect cost claim for each fiscal year to thegovernment within 6 months after the end ofthe year. Contractors must maintain adequatecontrols for identifying unallowable costs andensuring that such costs are not included in pro-posals, billings, or indirect-cost claims submit-ted to the government. DoD now requires con-tractors to certify their final indirect-cost claimwith the execution of a “Certification of Indi-rect Costs” (Exhibit 13). Industry personneloften call this the “Weinberger Certificate”; it

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states that no unallowable costs are included inthe submission for reimbursement of actual in-direct costs. FAR 42.709 requires penalties tobe assessed if a contractor claims a cost in anindirect-cost proposal that is unallowable. Thepenalty provision applies only to “expressly un-allowable costs” — a term that includes onlythose costs specifically unallowable under a law,contract, or FAR/DFARS cost principle. Pen-alties are severe and can be as much as twicethe amount of the unallowable cost.

UNUSUAL INDIRECT-COSTREQUIREMENTS

Three major types of indirect costs are histori-cally controversial and are accounted for in a veryunique way in the government contracting envi-ronment. These are the costs for independentresearch and development (IR&D), bid and pro-posal (B&P) expenses, and cost of money forfacilities capital. IR&D and B&P costs are

unique because of their required method of ac-counting. First, accounting is performed on adirect, project-oriented basis as if the costs weredirect costs; next, accounting is performed as ifthe costs were indirect costs. In the past few years,Congress has directed significant changes in theallowability of IR&D and B&P costs. The costof money for facilities capital is an unusual indi-rect cost that does not exist in the commercialmarketplace. It represents an “imputed” cost thatis an amount paid to the contractor for a costthat he does not actually incur.

Independent Research and Development/Bid and Proposal Expenses

All companies producing high-technologyproducts must make large investments of cor-porate funds in research and development workin order to remain competitive. Large invest-ments must also be made in proposing newproducts or services to customers. This is true

CERTIFICATE OF FINAL INDIRECT COSTS

This is to certify that I have reviewed this proposal to establish final indirect cost rates and to thebest of my knowledge and belief:

1. All costs included in this proposal (identify proposal and date) to establish final indirect costrates for (identify period covered by rate) are allowable in accordance with the cost principlesof the Federal Acquisition Regulation (FAR) and its supplements applicable to the contractsto which the final indirect cost rates will apply; and

2. This proposal does not include any costs which are expressly unallowable under applicablecost principles of the FAR or its supplements.

Firm:

Signature:

Name of Corporate Official:

Title:

Date of Execution:

Exhibit 13. Certificate of Final Indirect Costs

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of companies vying for the commercial marketas well as of defense contractors. The nature ofthis work varies from conducting basic researchon new materials to developing improvementsin stealth technology. It also varies from atten-dance at presolicitation conferences to the de-velopment of test data to prepare cost estimatesfor a proposal. These efforts represent IR&Dand B&P, terms unique to government contract-ing. They are defined as follows:

• IR&D consists of contractor research and de-velopment efforts not performed under con-tract or grant and not required for the prepa-ration of a specific bid or proposal, either gov-ernment or commercial. IR&D is funded andmanaged at the contractor’s discretion fromcontractor-controlled resources. There arefour kinds of IR&D: basic research, appliedresearch, development, and systems concept-formulation studies.

• B&P is comprised of contractor efforts toprepare, submit, and support bids and pro-posals, either government or commercial,whether or not the bid is successful. Bothadministrative and technical efforts are in-cluded in B&P. The nature of the work inIR&D and B&P is sometimes the same.The difference is the intent to use B&P ef-forts to obtain a specific contract.

DoD policy recognizes IR&D/B&P as a costthat increases the technology base and the num-ber of contractors able to compete for DoD con-tracts. Although DoD provides financial sup-port for IR&D/B&P efforts, DoD has historicallyestablished limitations on the amount of cost thatcan be recovered by defense contractors. How-ever, within the past few years, many defensecontractors have scaled back their IR&D/B&Pdiscretionary spending plans. This action hasbeen driven by reduced sales in a declining mar-ket. Due to concerns that IR&D projects wouldbe further reduced as defense reductions con-tinue, Congress directed several significant

changes to IR&D/B&P policy. The changeshave been very favorable to defense industry. Inthe past few years, several legislative revisionshave encouraged defense contractors to increasetheir IR&D/B&P efforts.

Initially, Congress broadened the acceptablecriteria for allowable IR&D projects to includeany work of “potential interest” to DoD as op-posed to the then existing, more restrictive “po-tential military relevancy” criteria. Later, Con-gress directed the removal of all requirementsfor negotiated ceilings on allowable IR&D andB&P expenses. These very significant changesin allowability of IR&D/B&P expenses weremade effective for contractor fiscal years be-ginning after October 1992.

Prior provisions must be understood before thecurrent allowability provisions can be fullycomprehended because there was a 3-yearphase-in period for transition to the new provi-sions. In addition, the prior regulatory provi-sions will remain operative for several yearsbecause final indirect rates are often not nego-tiated until several years after costs are incurred.The negotiation of final indirect rates will beaddressed in more detail in Chapter 8.

Historically, two types of cost limitations wereestablished in the FAR based upon the amountof IR&D/B&P payments made to contractorsby DoD. A company that received more than$7 million from DoD for both IR&D and B&Pin the previous fiscal year was required to ne-gotiate an advance agreement establishing aceiling for allowability of IR&D/B&P for thesubsequent fiscal year.

Companies falling below the threshold werelimited in the following fiscal year to a ceilingset with a detailed formula specified in the FAR,which was based on historical expenditures forthat company. Companies requiring negotiatedadvance agreements were required to submit

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comprehensive annual proposals supported byboth technical and financial data. A governmentreview team, led by the predominant militaryservice doing business with the contractor, con-ducted onsite technical evaluations of thecontractor’s proposed projects. The purpose ofthe review was to evaluate the projects for tech-nical merit and to determine if the projects wereof potential interest to DoD.

The criteria for projects that meet the “poten-tial interest” test include those that:

(1) strengthen the U.S. defense industrial andtechnology base;

(2) enhance industrial competitiveness;(3) promote the development of various criti-

cal technologies, including those useful toprivate, commercial, and public sectors; and

(4) develop technologies achieving environ-mental benefits.

The technical evaluation was provided to a tri-service negotiator responsible for IR&D/B&Pnegotiation with that contractor. The tri-servicenegotiator used the results of the technical evalu-ation along with financial data to develop a DoDnegotiation position. The financial data typicallyreviewed included: 3 to 4 years of IR&D/B&Pexpenses, the contract mix, and the relationshipof DoD to commercial sales. Contractors withhigh technical quality and proposed projects hav-ing potential military interest were given higherceilings. Also, contractors who had actually spentin excess of previously negotiated ceilings tendedto be given higher ceilings.

From an industry perspective, large defense con-tractors have complained for several years thatthe process for establishing the ceilings was ex-cessively burdensome and expensive. As a re-sult of significant congressionally-directedchanges, no new ceilings were negotiated forcontractor fiscal years beginning after October1992. Also, the formula approach set forth in

the FAR for establishing ceilings for those otherthan the major companies was eliminated. Amaximum reimbursement amount for IR&D andB&P expenses for “major contractors” wasphased in over 3 years.

Major contractors are defined as those whosebusiness segments allocated more than $10 mil-lion in IR&D/B&P expenses to covered contractsin the preceding fiscal year. Covered contractsare defined as negotiated prime or subcontractsfor more than $100,000, except for fixed-pricecontracts or subcontracts without cost incentives.For major contractors, during the 3-year transi-tion period, the maximum reimbursementamount progressively increased each year fromthe negotiated 1992 advance agreement.

Each year, the maximum reimbursable amountwas the amount of allowable IR&D/B&P costsfrom the previous fiscal year, plus 5 percent ofthat amount, plus that amount multiplied by thelesser of:

(1) the percentage increase in total IR&D/B&Pfrom the prior year or

(2) the percentage rate of inflation as measuredby the research, development, test, andevaluation (RDT&E) price escalation index.

After the 3 transition years, all IR&D/B&P ex-penses are to be allowable as an indirect ex-pense to the extent that they are allocable andreasonable. Being allocable and reasonable arethe more general requirements for allowabilityfor any cost. While there will still be technicalcontent reviews of contractors’ proposed IR&D/B&P programs by the Defense Contract Man-agement Agency personnel, the more penetrat-ing tri-service reviews and ceiling negotiationshave been eliminated.

The accounting requirements for IR&D/B&Pexpenses for government contracts are veryunusual relative to commercial accounting prac-

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tices. In the commercial contracting environment,IR&D/B&P expenses are usually written off asperiod expenses each year. No efforts are madeto allocate these costs to specific products or con-tracts. In the defense contracting environment,IR&D/B&P expenses relate to distinct workprojects and include not only all direct costs re-lated to each project, such as materials, labor,and travel, but also to all allocable indirect costs,such as material, engineering, and manufactur-ing overhead. But it is important to note that G&Aexpenses are not considered to be allocable toIR&D/B&P projects.

With the exception of the absence of an appro-priate allocation of G&A expenses, IR&D/B&Pexpenses are determined on the same basis asif each project was under contract. Usually,IR&D/B&P expenses are accumulated in theG&A expense pool. But some contractorschoose not to include the expenses in G&A andprefer to have a separate IR&D/B&P indirectrate. In either case, CAS 420, “Accounting forIR&D/B&P Costs,” provides that IR&D/B&Pexpenses at the business-segment level shouldbe allocated on the same base that the contrac-tor uses for allocating G&A expenses.

Some flexibility is provided as an exception un-der CAS 420. Specifically, in instances when al-location of the cost through the G&A base doesnot provide for equitable cost allocation, such aswhen an IR&D/B&P project may benefit otherbusiness segments, the contracting officer mayapprove the special allocation.

Cost of Money

The cost of money for facilities capital em-ployed is a very unusual cost frequently misin-terpreted by acquisition personnel. It is not aninterest expense. Under the Federal AcquisitionRegulations, interest is an unallowable expenseand cannot be charged directly or indirectly to

government contracts. Also, the cost of moneyis not an actual expense incurred by the contrac-tor for which there is a cash payment. Yet, undergovernment acquisition regulations, the cost ofmoney for facilities capital is an allowable indi-rect cost that is relevant for pricing governmentcontracts. This cost is also called out as a sepa-rate line item on monthly Government Cost Per-formance Reports (CPRs), which are preparedby contractors and submitted to program offices.

To understand why there is a cost of money forfacilities capital, an appreciation must be de-veloped for the contractor’s perspective on in-vesting in capital equipment in the defense busi-ness. DoD policy has long encouraged itscontractors to invest in cost-reducing facilitiesand equipment, thus enabling the procurementof weapons systems at the lowest possible price.However, given that interest is an unallowablecost, no strong incentive exists for contractorsto invest in capital equipment. Such investmentstypically require large outlays of cash by con-tractors.

A contractor who borrows money to purchase fa-cilities, is required to pay unallowable interest onthe borrowed funds. But if the contractor’s moneyis used to purchase capital facilities and equip-ment, there is also an opportunity cost. It couldhave been used for other purposes, such as invest-ing it in a relatively risk-free government bond.The cost of money for facilities employed repre-sents a creative way devised by the governmentto reward contractors for investing in more effi-cient ways of producing defense products.

The cost of money for facilities capital is bestdescribed as an “imputed cost” determined byapplying a cost-of-money rate to the facilitiescapital employed in contract performance. Animputed cost is a cost attributed to somethingelse, in this case to a contractor’s investment infacilities and equipment.

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The investment base is the average net bookvalue of capital assets for a cost accountingperiod, usually the contractor’s fiscal year. Thebase includes items subject to depreciation oramortization and, also, to such items as landthat is not subject to depreciation. In addition,it includes capitalized leases and an allocationof corporate home office facilities to the busi-ness segment. However, the base does not in-clude investments in operating or workingcapital, such as inventories, accounts receiv-able, and other current assets. It is importantto note that the investment is determined with-out regard to whether its source of financingis borrowed or equity capital. This financingdecision is entirely made at the discretion ofthe contractor.

The asset values in the investment base are al-located to indirect-cost pools, such as engineer-ing overhead, manufacturing overhead, and theG&A expense pool. The allocation is made onany reasonable basis that approximates the ab-sorption of depreciation or amortization ex-pense related to the assets. The cost of moneyis then computed on the facilities capital in eachindirect-cost pool by multiplying the net bookvalue of the assets assigned to each pool by theTreasury rate.

The Treasury rate is a commonly used interestrate determined by the Secretary of the Trea-sury and published semiannually in the Fed-eral Register. It takes into consideration currentcommercial rates of interest for new loans ma-turing in approximately 5 years.

As an example of a cost-of-money computa-tion, if the current Treasury rate is 7 percentand the average net book value of the assetsassigned to a contractor’s manufacturing-over-head pool is $100 million, the cost of moneyattributed to manufacturing facilities would be$7 million for a 1-year period. Cost of moneyfactors are computed for the assets attributable

to each of the overhead pools by dividing theamount of the cost of money by the same unitof measurement used as the overhead alloca-tion base, such as direct labor dollars, machinehours, etc.

Continuing with the example, a manufacturing-overhead pool with a computed cost of moneyof $7 million allocated by direct-labor dollarsof $51 million would have a cost of money fac-tor of .13725 (i.e., $7 million/$51 million). Costof money computations are required to be takento 5 decimal places. The overhead allocationbase (direct labor dollars in this case) used todistribute an indirect expense pool refers to allwork done in the business unit, including com-mercial work. Annual cost-of-money factors areproposed and negotiated with the governmentfor forward-pricing purposes in the samemethod as overhead and G&A rates. Forward-pricing rates will be discussed in more detail inChapter 8.

Cost of money is subject to the same alloca-tion procedures as any other indirect expense.To distribute the manufacturing-pool cost ofmoney to a specific contract, the manufactur-ing labor cost identified with the contract ismultiplied by the applicable cost of moneyfactor. For example, if the manufacturing di-rect-labor cost proposed on a given contract is$5 million and the manufacturing cost ofmoney factor is .13725, the cost of money ap-plicable to the contract for the manufacturingeffort is $686,250. This procedure is repeatedfor each indirect cost pool. Consequently,some people refer to the cost of money for fa-cilities capital as a “mini-overhead pool.”Stated differently, the cost of money is con-sidered to be an allowable indirect expense thatis associated with an individual cost pool butseparately identified as cost of money. On agiven proposal, the cost of money amounts foreach indirect-cost pool are then totaled to ar-rive at the total contract facilities’ capital cost

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of money, and this must be specifically identi-fied as such in the proposal.

Some contractors, to improve their competitiveposition, may not claim the cost of money.Therefore, government regulations require that,if a contractor does not include cost of moneyin the proposal, it cannot be subsequentlyclaimed as an allowable cost if the contract isawarded to that contractor.

CURRENT ISSUES

Congressional involvement in defense procure-ment matters is the result, to a significant ex-tent, of large employee layoffs resulting fromdefense industry consolidation activities. Thisinvolvement seems to have a continuous majorimpact upon indirect costs. Recent examples ofcongressional actions that are somewhat con-troversial are the limitations relating to theallowability of restructuring costs, allowabilityof executive compensation, and the phaseoutof “M accounts.”

Restructuring Costs

The merger and acquisition whirlwind that hasoccurred within the past few years in the de-fense industry has generated many new and con-troversial issues affecting the allowability of in-direct costs. Historically, the government hasalways taken a strong, unfavorable position re-lating to mergers and acquisitions by disallow-ing the costs of activities related to the organi-zation or reorganization of business units.Essentially, the government’s past position hasbeen that organizational or reorganizationalcosts are disallowed because the governmentexpects to do business with firms that are al-ready efficiently organized; therefore, thereshould be no requirement for the payment ofthese costs.

FAR 31.205-27, “Organization Costs,” identi-fies certain categories of organizational costs thatare unallowable and defines them as those ex-penditures used to:

(1) plan or execute the organization or reorgani-zation of the corporate structure of a busi-ness, including mergers and acquisitions;

(2) resist or plan to resist the reorganization ofthe corporate structure of a business or tochange the controlling interest in the own-ership of a business; or

(3) raise capital.

Typically, these expenditures include, but are notlimited to, significant costs for investment coun-selors, management consultants, attorneys, ac-countants, and brokers. These specialists are re-quired because business organization andreorganization activities are usually complex andhighly dissimilar in nature. Many of the activitiesare performed by in-house business planning per-sonnel, corporate legal staff, and accounting per-sonnel as well as by outside professionals. In-house personnel usually work in an indirect capacityand generally do not keep project time records. Con-sequently, from the government’s perspective, theidentification and allowability of organization costshave always been areas of concern.

The adequacy of the regulatory provisions re-lating to organization costs have been severelytested in the current defense environment. Theterm “restructuring costs” was uncommon inthe defense industry a few years ago; it is ubiq-uitous today. In the current environment of in-creased competition due to the declining de-fense budget, many contractors are aggressivelyrestructuring and consolidating their operationsto become more efficient and competitive. Thistrend may mean closing plants, eliminatingjobs, relocating employees, moving machineryand equipment, and disposing of facilities. Insome cases, consolidation activities may coin-cide with mergers and acquisitions.

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But many defense contractors have to consoli-date and downsize, regardless of whether theyare involved in mergers and acquisitions. Theseactivities often result in significant expenses forseverance pay and early retirement incentives,pension plan changes, health benefit changes,and employee training. Such costs are usuallyindirect and, thus, have a major financial im-pact on indirect rates used for government con-tracting purposes. Since restructuring costs pro-vide a future economic benefit, they may beamortized over more than 1 year.

Consequently, indirect cost rates can be af-fected for several years. In the long run, re-structuring and consolidation activities suchas the consolidation of engineering, manufac-turing, and materiel operations should providesubstantial savings to DoD. The savings toDoD will be reflected in lower indirect rates,which will be applied to DoD contracts andtranslated into lower contract prices. Of course,the DoD share of restructuring savings willvary based on the total dollar value of futureDoD contracts in relation to the total dollarvalue of all other contracts, including commer-cial contracts.

We have stated that the government tends toquestion the allowability of costs related in anyway to business reorganization. However, ac-cording to guidance published by the UnderSecretary of Defense (Acquisition and Technol-ogy), it is now in DoD’s best interest to encour-age contractors to consolidate and restructureto reduce operating costs. To disallow the costsfor restructuring and consolidating efforts would,in effect, create a disincentive for reducing costs.Therefore, a differentiation has now been madebetween the type of costs identified in FAR31.205-27 as organization costs relating to merg-ers and acquisitions and restructuring costs thatresult from mergers and acquisitions. Althoughmerger and acquisition costs are unallowable, re-structuring costs may be allowed.

Note that restructuring costs do not include thecosts incurred to make an acquisition or merger.Restructuring efforts, which are nonrecurringin nature, represent managerial improvementprojects undertaken due to internal changes,such as downsizing or external changes, suchas mergers, acquisitions, or divestitures. Suchrestructuring efforts are expected to result in acurrent or future economic benefit for both thecontractor and the government and are not con-sidered to be organization costs within themeaning of FAR 31.205-27.

Unfortunately for defense contractors, therehas been a continuing debate within the gov-ernment as to how DoD should reimburserestructuring costs. The decision-making pro-cess for determining the allowability of re-structuring costs has become increasinglycomplicated due to congressional involve-ment in establishing allowability require-ments. At one point many thought that Con-gress would totally preclude contractors fromrecovering any of their restructuring costs.Many people in the political arena viewed thereimbursement of restructuring costs as “pay-offs for layoffs” and “subsidies for defensecontractors” (terms referred to in the media).

Through provisions in annual authorization orappropriation provisions over the past few years,Congress has continually introduced certainconditions that make it more and more difficultfor defense contractors to recover costs thatcould be associated with mergers and acqui-sitions in any way. Initially, Congress allowedDoD to reimburse contractors for restructur-ing costs associated with business combina-tions when such costs resulted in a net sav-ings to DoD. However, the Under Secretaryof Defense (Acquisition & Technology) or adesignee was required to certify that projec-tions of future savings were based on auditedcost data and were projected to result in over-all savings for DoD.

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Most recently, Congress has specified that cer-tain funds cannot be used to reimburse defensecontractors for external restructuring costs as-sociated with a business combination unlessthe merger results in:

• auditable DoD savings that exceed the costsallowed by at least a two-to-one ratio; or

• savings that exceed the costs allowed and,also, preserve a critical capability thatmight be lost to DoD, as certified to by theSecretary of Defense.

As a result of the restrictions, DoD providedguidance to personnel working in the fieldregarding the allowability of restructuringcost by further breaking the costs down be-tween external and internal restructuringcosts.

Specifically, DFARS 231.205-70 defines re-structuring costs as the costs (which may beboth direct and indirect) of restructuring ac-tivities. Restructuring activities are definedas nonroutine, nonrecurring, or extraordi-nary activities performed to combine facili-ties, operations, or the workforce, to elimi-nate redundant capabilities, improve futureoperations, and reduce overall costs. Exter-nal restructuring activities are further de-fined as activities occurring after a businesscombination that affects the operations ofcompanies not previously under commoncontrol.

External restructuring activities are a directoutgrowth of a business combination; andthey are normally initiated within 3 years ofthe combination. A combination is a transac-tion where assets of two or more companies,which were not previously under common con-trol, are combined by merger, acquisition, orsale and purchase. The congressional restric-tions apply only to external restructuring ac-tivities.

Restructuring costs that may be allowed include,but are not limited to, the following areas:

• severance pay• early retirement incentive payments• retraining costs• relocation expenses• outplacement expenses• continued medical, dental, and life insurance

coverage for terminated employees• relocation of plant and equipment

Restructuring savings should exceed restruc-turing costs on a present-value basis in orderto meet the congressionally mandated certifi-cation for reimbursement of external restruc-turing costs. This is important from a financialperspective because contractors incur signifi-cant up-front restructuring costs for transfer ofproduction capabilities, employee severance,etc. But most savings do not materialize untilseveral years later when passed on to the gov-ernment through lower prices on future con-tracts.

The congressional sensitivity to reimbursementof restructuring costs seems to be of a fault-finding nature. It is very clear that Congress isstrongly opposed to the payment of bonusesrelated to mergers and acquisitions in the de-fense industry. Specifically, DoD is prohibitedfrom reimbursing a contractor for the costs ofbonuses or other payments to an employee inexcess of the employee’s normal salary whensuch payments are part of restructuring costsassociated with a business combination.

A recent General Accounting Office (GAO) in-dependent review of seven business combi-nations indicated that DoD expected to saveabout $3.3 billion from contractor restructuringactivities. GAO was unable to determine the pre-cise impact of the restructuring on specific con-tract prices because it could not isolate the im-pact of restructuring activities from other

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nonrestructuring activities, such as changes inbusiness volume, quantities purchased, and ac-counting practice changes. However, their as-sessment showed that costs to DoD had beenlowered by hundreds of millions of dollars. DoDbenefited because the costs of defense contractswere lower than they would have been if therestructuring activities had not occurred.

From an industry perspective, to deal with thecontroversial issues relating to the allowabilityof restructuring costs, defense contractors mustestablish strong management controls fordocumenting these costs. Contractors shouldaccumulate these costs in separate categoriesof internal and external restructuring activi-ties. An advance agreement should be negoti-ated between the government and the contrac-tor to identify the restructuring costs and themethods needed to demonstrate savings toDoD. Due care should be exercised in prepar-ing a detailed restructuring cost and savingsproposal, which provides a basis for negotiat-ing the advance agreement on restructuringcosts.

The advance agreement should cover any costceilings and amortization periods for restruc-turing projects. It should be noted that, in ac-cordance with CASB Interpretation 95-01, re-structuring costs may be amortized over notmore than 5 years. Restructuring proposals arenot contract-pricing proposals and, therefore,need not be certified in accordance with theTruth in Negotiation Act. However, the effectof restructuring on forward-pricing rates andprojected contract costs should be disclosedimmediately. In the current environment, it isessential that DCMA, Defense Contract AuditAgency (DCAA), program offices, and con-tractors make special efforts to ensure up-frontcommunication and coordination for all mat-ters relating to the allowability of restructuringcosts.

Executive Compensation

The merger, consolidation, restructuring, anddownsizing activities discussed have in somecases resulted in significant layoffs or salaryfreezes for defense contractor employees. Atthe same time, some executives in the defenseindustry have received large incentive pay-ments as a result of the consolidation activi-ties. Many in the political arena consider thisto be very unfair. As a result, Congress hasbecome very involved in legislating the maxi-mum deductible amounts for tax purposes forAmerican industry, in general, as well as themaximum allowable amounts paid for execu-tive compensation for defense industry execu-tives.

For the past several fiscal years, the DefenseAuthorization and Appropriation Bills have pro-vided that allowable costs, charged to govern-ment contracts for taxable wages paid to theemployee for the year, plus elective deferredcompensation earned by the employee in theyear, could not exceed certain dollar amounts.

In 1995 the maximum allowable amount forexecutive compensation for defense contractorswas $250,000, and in 1996 it was reduced to$200,000. The amount was increased back tothe original $250,000 in 1997 and was alsomade applicable to civilian agency contracts aswell as defense contracts. Later, to arrive at amore permanent standard, Congress directed theOffice of Federal Procurement Policy (OFPP)to study commercially available surveys on ex-ecutive compensation to determine a “bench-mark” amount.

The OFPP subsequently conducted a study ofexecutive compensation paid to senior execu-tives in all publicly owned corporations withannual sales in excess of $50 million. The re-sulting “benchmark” amount, as determined byOFPP, was $342,986 per year — the median

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amount paid by these corporations for execu-tive compensation. Consequently, effective Janu-ary 1, 1998, the maximum allowable amount forexecutive compensation under all contracts is the“benchmark” amount. The amount is used untilrevised by OFPP and will not be escalated orindexed each year. Needless to say, the recentcongressional actions have been very controver-sial with industry.

Several definitions are important for arrivingat the amount of unallowable executive com-pensation. The definition of compensation isvery broad; it includes the total amounts forsalary, bonuses, deferred compensation, andemployer contributions to defined contributionpension plans. However, it does not includefringe benefits, such as health care benefits andemployer contributions to defined benefitplans. Also, the cap on allowability for execu-tive compensation only applies to those des-ignated as “senior” executives — the five mosthighly compensated employees in manage-ment positions at each home office and eachsegment of the contractor, whether or not thehome office or segment reports directly to cor-porate headquarters.

It should be noted that the allowability cap doesnot prohibit contractors from paying their ex-ecutives more than $342,986 per year, but it lim-its the amount that can be allocated to govern-ment contracts. The unallowable amounts overthe limitations are classified as indirect costs be-cause employees at the executive management levelwork in an indirect rather than a direct capacity.

A key issue from an indirect-cost-allocation per-spective is that the limitation is the dollaramount that can be placed into an indirect-costpool for allocation to all contracts, includingany commercial contracts. It is not the totalamount that the contractor can recover fromthe government for the fair share of indirectcosts allocable to negotiated contracts. Further,

the implementing FARs and DFARS providethat costs for individual compensation in ex-cess of the allowability cap are expressly un-allowable. This means that any costs in ex-cess of the allowability cap that are claimedby a contractor will also be subject to the in-direct-cost penalty provisions as discussedearlier in this chapter.

Expiration of Funds

Recent changes in government financial man-agement rules could potentially require pro-gram managers to scale back current require-ments to pay past bills for indirect costs.Recent congressionally mandated actions re-quire the phaseout of the “M accounts” overa period of several years. These accountscover obligated but unexpended funds. Bothobligated and unobligated balances are nowcanceled 5 years after the budget authorityexpires, regardless of whether the contractedgoods or services have been provided. There-after, any obligations and related upward ad-justments that would have been chargeable tothe canceled “M account” may only be paid outof current appropriations.

All DoD procurement funds not expendedwithin 5 years after being appropriated nowmust be returned to the Treasury. This legisla-tion has tremendous impact upon the manage-ment of indirect costs. Use of appropriatedfunds to make final payments on completedcontracts cannot take place until indirect-costaudits are completed by the DCAA and finalindirect-cost rates are negotiated by the DefenseContract Management Agency (DCMA).

Unfortunately, for many years this area has hada very low priority, and there is a large backlogof unsettled indirect-cost rates. It is not at allunusual for a contractor to have 5 years or moreof unsettled final indirect-cost rates. Reducingthe number of contractor fiscal year final-rate ne-

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gotiations is a top management priority for bothDCMA and DCAA, and considerableprogress is being made. From the program

manager’s perspective, delays settling finalindirect rates in a timely manner could re-sult in loss of obligated, but unexpended,funds.

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77COST ACCOUNTING STANDARDS

REQUIREMENTS

INTRODUCTION

In American industry, little authoritative crite-ria have been issued for establishing require-ments for cost accounting, particularly relatingto the basis for allocating indirect cost to spe-cific products or contracts. The methodologiesused to allocate indirect costs are essentiallymatters of managerial preference. This absenceof authoritative criteria is not the case with gov-ernment contracts. To understand indirect-costmanagement in the defense contracting envi-ronment, it is necessary to be familiar with thework of the Cost Accounting Standards Board(CASB). Their work has resulted in detailedguidance on accounting for indirect costs, par-ticularly on defining acceptable methods for al-locating these costs.

Although the defense industry has always beenrepresented on the CASB, many defense con-tractors have legally challenged many of thestandards’ provisions. This complicated litiga-tion history adds to the challenges that facepersonnel who do not have extensive cost ac-counting backgrounds. Many acquisition per-sonnel consider the Cost Accounting Standards(CAS) to be among the most complicated ofgovernment regulations.

The necessity for cost accounting standardsoriginated with congressional testimony byAdmiral Hyman Rickover, military officer andnuclear engineer. He maintained that due to thelack of guidance on cost accounting practicesin American industry, the government was un-

able to determine what actual costs and profitswere on defense contracts even though costbreakdowns were extensively negotiated priorto contract award.

Subsequent studies of defense contracts spurredby Admiral Rickover’s testimony indicated thatcomparing actual costs of contract performancewith earlier contract cost estimates was practi-cally impossible. It was alleged that not onlywere contract performance reports not struc-tured in the same fashion as original cost pro-posals, but contractors were changing their costaccounting methods during the performance ofcontracts. This allegation was of particular im-portance from a program management stand-point. The ability to identify possible contractcost overrun problems, particularly regardingoverhead costs, was very troublesome for ac-quisition managers under these circumstances.

As a result of problems identified subsequentto Admiral Rickover’s testimony, the CASB wasestablished in 1970 as an independent body thatreported to Congress. It was created to help as-sure that the government gets a fair price in itsprocurement. It was also tasked to issue rules,regulations, and standards aimed at achievinguniformity and consistency in the cost account-ing practices that were followed by defense con-tractors and subcontractors.

The CASB then became an executive author-ity for issuing pronouncements related to themeasurement, assignment, and allocation ofcosts. The purpose of regulations promulgated

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by the CASB is to provide for the disclosure ofcontractor’s actual cost accounting practices andto develop standards to be used in connectionwith negotiated contracts. Cost accounting stan-dards were originally applicable only to defensecontracts; but now they apply to negotiated con-tracts and subcontracts valued at $500,000 andabove throughout the government. This changeextends CAS coverage to many governmentcontractors for the first time. Today, the Boardis organized under the Office of Federal Pro-curement Policy (OFPP) and consists of fivemembers representing government, industry,and the accounting profession.

“Exhibit 14. Cost Accounting Standards,” iden-tifies the comprehensive standards issued by theCASB and provides a brief summary of eachstandard’s requirements. The promulgations ofthe CASB have the full force and effect of lawon those contractors subject to the standards.The CASs provide guidelines related to the al-locability of costs to government contracts butdo not provide guidance on the allowability ofthose costs — a totally different concept.Allowability is a procurement concept whileallocability is an accounting concept. Guidanceon allowability is provided in the FAR andDFARS.

Cost accounting standards do not apply to con-tracts awarded based upon market prices ofcommercial items. The regulations also providethat small business concerns are exempt fromthe CAS requirements.

APPLICABILITY

Cost Accounting Standards apply to contractsand not government agencies or contractors.Contracts subject to CASs are negotiated con-tracts in excess of $500,000 and are referred toas “covered contracts.” Subcontracts are sub-

ject to the cost accounting standards only if theprime contract, or a higher tier subcontract, is acovered contract. A CAS-covered contract maybe subject to either full or modified CAS cov-erage. Full CAS coverage requires the contrac-tor to comply with all of the cost accountingstandards in effect on the date of the award ofthe contract; and it applies to a business unitthat received either:

(1) a single CAS-covered contract of $50 mil-lion or more or

(2) a net total of $50 million in CAS-coveredawards, of which at least one exceeded $7.5million during the previous cost account-ing period (referred to as the “trigger con-tract).”

The trigger contract provision provides that acontractor or subcontractor that does not havea single government contract with a value ofmore than $7.5M is CAS-exempt.

A CAS-covered contract is eligible for modi-fied CAS coverage if neither of the above crite-ria are met. A modified CAS contract is subjectonly to CAS 401, “Consistency in Estimating,Accumulating, and Reporting Costs”; CAS 402,“Consistency in Allocating Cost Incurred for theSame Purpose”; CAS 405, “Accounting forUnallowable Costs”; and CAS 406, “Cost Ac-counting Period.”

The Defense Authorization Act for FY 2000contains a provision for streamlining theapplicability of cost accounting standards. Itprovides that the head of an executive agencycan waive the applicability of CAS for acontract or subcontract with a value of lessthan $15M if the official determines that thecontractor segment is primarily engaged in thesale of commercial items. The official hasfurther discretion to waive CAS applicabilityunder exceptional circumstances when neces-sary to meet the agency’s needs.

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DISCLOSURE STATEMENT

The CAS Disclosure Statement, which appliesto contractors and not to contracts, provides acomprehensive description of the contractor’scost accounting practices to be used on con-tracts subject to the CASB rules. Contractorsand subcontractors meeting the below criteriaare required, as a condition of contracting, toprovide written disclosure of their actual or pro-posed cost accounting practices.

Those required to submit a disclosure state-ment include:

(1) any business unit that is selected to receivea CAS-covered contract or subcontract of$50 million or more; and

(2) any company that, together with its segments,received net awards of negotiated prime con-tracts and subcontracts subject to CASs to-taling more than $50 million in its most re-cent cost accounting period.

When a disclosure statement is required, a sepa-rate disclosure statement must be submitted foreach segment that had costs included in the to-tal price of any CAS-covered contract or sub-contract exceeding $500,000 (unless thesegment’s CAS-covered awards are less than30 percent of the total segment sales for theperiod and less than $10 million).

Among other things, the disclosure statementprovides essential information on thecontractor’s indirect-cost pool structure, includ-ing a functional breakdown of indirect expensesand the various bases used for allocating indi-rect costs. In addition, the contractor must dis-close its method of distinguishing direct fromindirect costs. The disclosure statement providesacquisition personnel with a valuable tool tohelp them understand the company-specific costaccounting practices the contractor follows.

Government acquisition personnel must treatcontractor’s disclosure statements as highly con-fidential information. The statements cannot bereleased to the public, as a competitive disadvan-tage could result from any such disclosure.

Contractors are required to certify on eachcontract-pricing proposal cover sheet whether ornot a disclosure statement has been submitted. Thelack of a disclosure statement can prevent a con-tractor from receiving a contract award. Separatedisclosure statements are required for each busi-ness unit within the contractor organization thatuses different cost accounting practices.

COST ACCOUNTING STANDARDSRELATING TO INDIRECT COSTS

Eight of the Cost Accounting Standards are es-pecially important for the understanding of indi-rect costs. Each of these is described in moredetail as follows:

CAS 401: Consistency in Estimating, Accu-mulating, and Reporting Costs. This standardrequires a contractor to be consistent when es-timating costs to price a proposal and, subse-quently, when accumulating and reporting thosecosts. Consistency is especially important whendealing with the following areas:

(1) classification of elements or functions ofcosts as direct or indirect

(2) the indirect-cost pools to which each ele-ment or function of cost is charged

(3) the methods of allocating indirect costs tothe contract

Cost estimates for proposal purposes are pre-sented in such detail that any significant costcan be compared with the actual cost accumu-lated and reported. The standard provides spe-cific examples to illustrate applications of costaccounting standards that are considered con-sistent and inconsistent.

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Noncompliance with CAS 401 can occur whena contractor fails to estimate costs in accordancewith established or disclosed cost accountingpractices; and also occurs when a contractor es-timates in accordance with disclosed or estab-lished cost accounting practices but accumu-lates on a different basis. As an example, a con-tractor estimates costs for a cost-type contractbased on allocating manufacturing overheadusing direct-labor dollars; and, after award ofthe contract, the manufacturing overhead allo-cation base is changed to machine hours with-out notifying the government of the change andwithout submitting a disclosure statement re-vision. Further, assume that this change resultedin a significant cost overrun on the cost-typecontract as costs were shifted from fixed-pricecontracts to cost contracts. This inconsistencywould represent a noncompliance with CAS401 because the contractor did not accumulatecosts on the same basis as the estimates. In thiscase, a noncompliance with the CASs occurredbecause the contractor did not notify the gov-ernment of the change and submit the requireddisclosure statement revision. Contractors areallowed to change accounting practices if re-quired notifications and submissions are made.

Compliance with CAS 401 requirements im-proves the managerial visibility over costs dur-ing contract performance and facilitates theevaluation of a contractor’s estimating capabili-ties. Note that CAS 401 does allow a contrac-tor to use greater detail in accumulating andreporting costs than in estimating costs. Forexample, a contractor may record engineeringindirect labor based on actual costs for eachindividual but estimate on the basis of an aver-age indirect-labor rate for such labor.

CAS 402: Consistency in Allocating Cost In-curred for the Same Purpose. CAS 402 is in-tended to prevent so-called “double counting”of costs. Double counting occurs when costitems are charged directly to a contract without

eliminating like-cost items from indirect-costpools that are also allocated in some part to thatcontract. Thus a contract might be charged di-rectly with a specific direct cost but get an addi-tional share of the same kind of cost incurred forother purposes through an indirect-cost alloca-tion. Consequently, the standard requires that allcosts incurred for the same purpose in like cir-cumstances be treated only as direct costs or onlyas indirect costs when making allocations to con-tracts.

As an example, suppose a contractor normallyallocates all travel costs as indirect cost andpreviously disclosed this practice in a disclo-sure statement. For purposes of a new proposal,the contractor intends to charge the travel costsof personnel (whose time is charged as directlabor) directly to the contract. Since travel costsof personnel (whose time is accounted for asdirect labor) working on other contracts arecosts that are incurred for the same purpose,these costs may no longer be included withinindirect-cost pools for the purpose of alloca-tion to any covered government contract.

The government is quite concerned with thestrong motivation on the part of contractors tocharge the maximum amount of costs directlyto cost-type contracts. This could occur when aparticular cost is charged as direct cost to gov-ernment cost-type contracts and charged as in-direct cost when related to government fixed-price or commercial contracts. As an example,assume that the costs of program managementfor a government cost-type contract are chargeddirectly to the contract. Furthermore, assumethese same costs for fixed-price and commer-cial contracts are included in overhead costs andallocated to all final cost objectives, includingthe government cost-type contract. As a result,the government cost-type contract is allocatedall program management costs associated withthat contract and a share of the program man-agement costs of all other contracts. Such incon-

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sistencies result in double counting, with exces-sive charges to the government.

On the other side of the coin and from thecontractor’s perspective, government personnelshould not request preferential treatment byasking the contractor to absorb certain costs asindirect that should be charged as direct in ac-cordance with the contractor’s accounting prac-tices. For example, assume that a governmentcost-type contract requires special security per-sonnel due to the classified nature of the work.Government personnel should not ask the con-tractor to include these people in the normalplant security force in order to charge the costas indirect. In this case, fixed-price and com-mercial contracts would receive an allocationof the contract security costs but would receiveno benefit from the incurrence of the costs. Theimportant test is to determine if the costs wereincurred for the same purpose, i.e., “like-costs,”and “in like-circumstances.” In this case, secu-rity personnel required for a specific contractare not like-costs in like-circumstances withgeneral-purpose plant security costs.

Government personnel should also be very cau-tious about requesting “preferential” programoverhead rates that could destroy the total per-spective of fair and equitable distribution of in-direct costs. Compliance with such a requestcould place the contractor in potential violationof CAS 402.

An important point is that bid and proposal costsincurred pursuant to the specific requirementof an existing contract are considered as hav-ing been incurred in different circumstanceswith other bid and proposal costs and may becharged as direct costs to the specific contract.The circumstance is quite different because thecosts of preparing proposals that are specificallyrequired by the provisions of an existing con-tract relate only to that contract, while other pro-

posals relate to all contractor work. Therefore,such costs are not “like-costs” incurred in “like-circumstances” and do not constitute doublecounting. To ensure compliance with this stan-dard, the contractor’s disclosure statement shouldclearly describe the criteria used to distinguishbetween direct and indirect costs.

CAS 403: Allocation of Home Office Ex-penses to Segments. This standard establishescriteria for allocating home office expenses tobusiness segments based on the “causal or ben-eficial” relationship between home office ex-penses and certain business segments. The im-pact of the standard has caused companies tosignificantly increase the cost that is separatelyidentified and directly allocated from home of-fices to business segments. This standardstresses the importance of minimizing theamount of “residual expenses” or those ex-penses remaining at the home office to be allo-cated as overall management expense. A three-step sequential process is defined for allocat-ing home office expenses:

1. Direct Allocation. Expenses are identifiedfor direct allocation to specific business seg-ments to the maximum extent possible. Directallocation is mandatory, not an option, when apractical identification can be made. For ex-ample, government procurement policy costsmight be directly identified with the businesssegments doing business with the government,while manufacturing policy costs might be iden-tified with the business segments engaging inmanufacturing.

2. Indirect Allocation. Expenses that are notdirectly allocated should be pooled into logicaland homogeneous groups and then allocatedusing appropriate bases that show the relation-ship of the expenses to the segments concerned.Examples of such indirect expenses and appro-priate allocation bases follow:

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• personnel administration — the number ofemployees, labor hours, payroll, and the num-ber of hires

• data processing services — machine time andthe number of reports prepared

• centralized purchasing — the number of pur-chase orders, value of purchases, and thenumber of line items

• centralized warehousing — square footage,value of materials, and volume

• central telephone service — usage costs andthe number of instruments

3. Residual Expenses. Home office expensesthat remain after all direct and indirect alloca-tions have been made should be allocated basedon a total activity base. These expenses gener-ally have no special benefit to any particularsegment, but they are necessary to the overallbusiness operations. Examples of such expensesare costs for the chief executive officer, chief fi-nancial officer, board of directors, and any staffwho cannot be identified with specific activi-ties of a business segment. When residual ex-penses exceed a certain amount, the standardrequires the use of a three-factor formula forallocation to business segments. This formulais the simple average of the business segment’spayroll, operating revenue, and net book valueof capital assets and inventories as a propor-tion of the company’s total for these three fac-tors.

It should be noted that CAS 403 does have aprovision allowing management flexibility. Itspecifically permits a special allocation whenthe government and contractor can agree thatan inequitable allocation of residual expenseswould result from strict compliance with thestandard. For example, situations involvinggovernment-owned and contractor-operatedplants, foreign subsidiaries, or sales subsidiar-ies could require special allocations rather thanstrict use of the three-factor formula. In suchsituations, certain segments may have operations

that are relatively self-sufficient and require onlyminimal management and administrative supportfrom the corporate or home office. Conversely, asegment may require a special allocation in greateramounts if it is highly dependent upon the homeoffice or corporate staff for management and ad-ministrative support.

CAS 404: Capitalization of Tangible Assets.Contractors must have a written capitalizationpolicy that is reasonable and consistently ap-plied. This policy must distinguish betweencapital assets and expenses. The standard re-quires capitalization for those assets that havea service life of at least 2 years and an acquisi-tion cost of $5,000 or more. Shorter service livesand smaller amounts may be substituted by thecontractor. Costs necessary to bring an asset online, such as installation and initial testing andinspection (if they are material), must also becapitalized. Tangible capital assets constructedby contractors for their own use must be capital-ized at amounts that include all indirect costsproperly allocable to such assets, including anallocation of general and administrative (G&A)expenses and the cost of money. Leased assetsthat are considered to be purchases are also sub-ject to the standard. The requirements of CAS404 differ substantially from generally acceptedaccounting principles (GAAP) regarding thevaluation of capital assets subsequent to a busi-ness combination. For example, if the assetsgenerate depreciation expense in the most re-cent accounting period prior to the businesscombination, allowable costs for depreciationare calculated based on the seller’s net bookvalue. This process is referred to as the “no step-up, no step-down” rule.

CAS 406: Cost Accounting Period. This stan-dard provides that the cost accounting periodused by contractors must be either their fiscalyear or a fixed annual period other than theirfiscal year (if agreed to by the government). Theidea of a monthly cost accounting period is not

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appropriate for contract cost accounting pur-poses. Direct and indirect costs are not incurredevenly during the fiscal year. In practice, it iscommon to have large variances in amounts eachmonth, particularly with the direct allocationbases, such as direct labor or machine hours.Capital-asset decisions regarding the acquisitionof fixed assets, such as plant and equipment, aremade on a long-term rather than a short-termbasis.

Consequently, monthly indirect expenses fordepreciation of fixed assets are not meaning-ful. It is possible that a given contract could befully performed within only a few months of acontractor’s fiscal year. In such cases, this stan-dard would prevent either party to the contractfrom insisting upon monthly overhead rates inorder to maximize or minimize their share ofindirect cost. The period to determine the totalcosts allocable to a contract is the entire costaccounting period, which is the contractor’s fis-cal year. All indirect rates used for estimating,accumulating, and reporting costs must be basedon the contractor’s fiscal year.

CAS 410: Allocation of Business Unit Gen-eral and Administrative Expense to FinalCost Objectives. The standard defines the typesof expenses that are considered to be G&A ex-penses and provides acceptable criteria for al-locating such expenses to the final cost objec-tives of the business segment. The accountingfor G&A expenses represents one of the verysignificant differences between commercialaccounting practices and government contractaccounting practices. For commercial account-ing purposes, such costs are normally treatedas expenses related to the total operation of thebusiness and not related to the production of aspecific item. The expenses are considered tobe “period expenses” and not “product costs.”Commercial companies typically do not makeany efforts to allocate such period expenses tofinal cost objectives, such as specific products

or contracts. Therefore, in the commercial world,G&A expenses are simply deducted as expenseson the business segment income statement toarrive at net profit or loss for the accounting pe-riod. From the contractor’s perspective, this prac-tice is totally unacceptable for government con-tracting purposes. The contractor must allocateall costs to contracts to ensure that costs are atleast recovered (much less making a profit) onnegotiated contracts. Therefore, for governmentcontracting purposes, G&A expenses must betreated as part of contract costs. Cost account-ing practices that are unique to governmentcontracting have been developed to allocate suchcosts to contracts. Business-unit G&A expensesare required to be included in a separate indi-rect-cost pool and are to be allocated only to fi-nal cost objects or contracts. G&A is definedfor government contracting purposes as an ex-pense incurred for managing and administeringthe business unit as a whole. It does not includethose management expenses whose causal orbeneficial relationship can be more directly al-located. Therefore, any management expensesthat can be more directly allocated should beremoved from the G&A expense pool. Examplesof such expenses could be purchasing, subcon-tract administration, and program management.Purchasing, for example, could be more appro-priately allocated based on the number of pur-chase orders or on the value of materials pur-chased instead of being a part of the G&A costpool.

From an industry perspective, the most contro-versial issue regarding CAS 410 has been thedesignation of specific allocation bases. Thestandard requires the use of a cost-input basethat best represents the total activity of the busi-ness unit. The bases used are total-cost input,value-added input, or a single-cost-element in-put, such as direct-labor hours or dollars. Theintent of the standard is to include, in the alloca-tion base, all activities that represent the produc-tive activity of the business segment.

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For example, the costs of intercompany trans-fers should be included in the allocation baseand such transfers should bear G&A. The stan-dard prevents the use of allocation bases otherthan the cost input. The allocation bases that can-not be used include the cost of sales, employeehead count, or a broad-formula approach suchas the three-factor formula used for allocatingresidual home office expenses. The total-costinput base is the most common method used bydefense contractors to distribute or allocate G&Aexpenses. Total-cost input is the total cost placedinto work-in-process during the contractor’s fis-cal year. Although it is commonly said that to-tal-cost input is the preferred method for allocat-ing G&A, the standard does not provide anypreference for this method. In fact, a value-addedbase may be the most appropriate base in somecircumstances. Indeed, the CAS even goes sofar as to mandate the use of the value-added basein certain circumstances. A landmark case, FordAerospace (ASBCA 23833) found the contrac-tor had no choice but to use a value-added baseunder the CAS. As a result it is now clearly es-tablished that there is no preference for a total-cost input base. A value-added cost-input baseis total-cost input less material and subcontractcosts. This base should be used where the inclu-sion of materials and subcontract cost would sig-nificantly distort the allocation of G&A, such aswhen there is significant use of government-fur-nished components for which there are no ma-terials cost to the contractor.

CAS 410 does have some flexibility. A specialallocation of G&A expense is permitted if thegovernment and the contractor agree in advancethat a particular contract would receive signifi-cantly more or less benefits from G&A ex-penses than it would receive from a cost-input-based allocation.

CAS 418: Allocation of Direct and IndirectCosts. Of all the cost accounting standards is-sued, CAS 418 is probably the most valuable

from the standpoint of providing authoritativecriteria for the management of indirect costs. Thisstandard, which was highly controversial withdefense contractors when first issued, requiresthe consistent classification of direct and indi-rect costs; establishes criteria for the accumula-tion of indirect costs into “homogeneous” costpools, such as operational overhead pools andservice centers; and provides guidance relatingto the selection of allocation methods based onthe “beneficial or causal” relationship betweenan indirect-cost pool and cost objectives.

To comply with CAS 418, the contractor musthave a written statement of accounting policiesand practices for classifying costs as direct orindirect. The contractor’s indirect costs must begrouped into logical and homogeneous indirect-cost pools. This requirement means that the costof functions or activities that are to be pooledmust have the same or similar beneficial orcausal relationship to cost objectives. This con-cept of homogeneity is achieved if the finaloutput of goods and services or the activities orfunctions in the pool are the same or similar. Ifthe activities or functions are unlike but the re-lationship to benefiting cost objectives are thesame or similar, homogeneity is also achieved.

An example of a homogeneous indirect-costpool would be when a contractor accumulatesall costs that relate to the activities of buildingownership, maintenance, and utilities into oneindirect-cost pool, designated as “occupancycost,” for subsequent allocation to all cost ob-jectives. Although the costs of these activitiesrepresent unlike costs, each of the activities hasthe same or a similar relationship to all cost ob-jectives that occupy space in the contractor’s fa-cility.

On the other hand, assume that a contractor in-cludes the indirect costs of machining and as-sembling activities into a single manufacturingoverhead pool. The machining activity may not

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have the same or similar beneficial or casual re-lationship to contracts or cost objectives as doesthe assembling activity. In this case, thecontractor’s single manufacturing-overhead poolwould not be homogeneous in accordance withthe provisions of CAS 418; and separate poolswould be required to comply with the standard.

The lack of homogeneity of indirect-cost poolsmay often occur when a contractor’s activitiesare decentralized. The use of separate indirect-cost rates for each geographical location willnormally produce more equitable allocations ofindirect costs than the use of composite or company-wide rates. When off-site work (away from acontractor’s plant) is performed at governmentfacilities, separate off-site rates are usually re-quired. Off-site overhead rates should be basedon eliminating, from the overhead pool, thoseindirect costs that do not benefit off-site activi-ties. For example, occupancy costs may beeliminated from off-site pools because thecontractor uses government facilities rather thancompany-owned facilities.

From the government’s perspective, it is gener-ally maintained that the subdividing of indirect-cost pools provides more accurate cost infor-mation for government contracts. But thenumber and type of cost pools should be gov-erned by practical considerations. Some defensecontractors have been very concerned aboutgovernment personnel advocating a large in-crease in the number of indirect-cost pools.

While additional cost pools may provide, to somedegree, better matching of costs incurred to ben-efits received, contractors are concerned that itcould create pricing problems due to the sensitiv-ity of smaller pools to changes in volume. Forexample, under the assumption that a contractorhas a single plant-wide manufacturing-overheadrate, if business volume should shift betweenseveral products, the changes in volume wouldcancel out and the overhead rate would not sig-

nificantly change. But if each product has its ownindirect-cost pool, then the several indirect ratescould vacillate significantly if business volumechanges. Also, from the contractor’s perspective,it is more costly from an administrative stand-point to manage a large number of cost pools.

CAS 418 provides considerable guidance forselecting allocation bases for various indirect-cost pools. To understand the allocation of op-erational indirect-cost pools, a comparison withthe allocation of the business segment G&Acost pool is beneficial. As discussed, G&A costsrelate to the operation of the business as awhole; and the costs are allocated under CAS410 on a base representing total activity. On theother hand, operational indirect-cost pools arerelated to the production of goods and servicesand not to the operation of the business seg-ment as a whole.

Indirect costs related to the production of goodsand services are allocated over the appropriatemeasure of productive activity. Basically, thereare two kinds of operational indirect-cost pools.They are set apart in CAS 418 as either costpools that do or do not contain a materialamount of the costs of management or supervi-sion of activities that involve direct labor or di-rect material costs. Indirect cost pools with amaterial amount of the costs of management orsupervision are commonly referred to as over-head or burden pools. Those that do not con-tain these costs are commonly referred to asservice or support centers. The preferred allo-cation bases set out in CAS 418 are contingentupon whether the cost pools contain materialamounts of management or supervisory costs.

For cost pools containing significant manage-ment or supervisory cost, the preferred alloca-tion base is direct-labor hours or dollars, ma-chine hours, units of production, or theappropriate measure that is representative of theactivity being supervised. The most common

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base used for allocating overhead is direct labordollars. This base is usually representative of theactivity being supervised, and the information isreadily available from the contractor’s payrolland labor-distribution records.

CAS 418 provides preferred hierarchical guid-ance for the allocation of indirect-cost pools thatdo not include material amounts of the cost ofmanagement or supervision of activities involv-ing direct-labor or direct-material costs. Theseindirect-cost pools are referred to as servicecenters or support centers. Such centers arefound throughout a business segment and con-stitute certain activities that usually feed pro-ductive functions or support management. Ex-amples of such activities are computer services,company aircraft, transportation services, andprint shops. The preferred allocation base is onethat measures resource consumption, such aslabor hours or machine hours expended in ren-dering the services. The second order of pref-erence is measure of output, such as the num-ber of units produced or reports processed. Ifneither of the first two measures is usable, asurrogate measure of output or activity, whichvaries in proportion to the services received,may be used, such as the number of employeesserviced.

It should be realized that any given allocationbase may be an acceptable base in a particularcase and unacceptable in another. For example,a weakness of the most common overhead al-location base, direct-labor dollars, is that thetotal direct-labor cost represents the sum of thehigh- and low-wage workers. When labor cat-egories within an overhead pool vary signifi-cantly, such as when there are high-priced re-search mechanics working with low-paid pro-duction workers, overhead cost allocations willbe significantly different than they would be iflabor hours were used. In this case, if labor costis used as a base, more overhead will be allo-cated to work performed by the higher-paid

workers. This allocation process could causean overstatement of the overhead allocated tothe work performed by higher-paid employees.

Total direct material dollars may not be an ap-propriate base for allocating material handlingcosts if it includes significant costs for itemsthat are not received at the contractor’s plantbut are shipped directly to end users. In addi-tion, in some cases, the materials that are higherin costs, such as subcontracted items, may befar more expensive to purchase and handle. Aseparate overhead pool may be appropriate forthe higher valued, more complex items requiredto be procured through major subcontracts.Also, in cases where there are two or three prod-ucts produced, and one is fabricated with veryexpensive material and the others composed ofsomething less expensive, the product with thehigh material costs would absorb a dispropor-tionate share of the overhead expense. Thisproblem could be very major from a financialstandpoint when government-furnished equip-ment is provided by the government at no costto the contractor and the allocation base used isdirect material dollars.

The use of machine hours as an allocation basefor manufacturing overhead is appropriate wheninvestments in plant and equipment are substan-tial and manual labor is of lesser importance.With the recent increases in automated manu-facturing operations, the use of machine-oriented bases will become more relevant in dis-tributing indirect costs. The primary objectionto the use of machine hours as an allocationbase in the past has been the absence of ad-equate records on machine utilization for manypieces of equipment.

Management is generally opposed to the estab-lishment of new machine utilization records andthe collecting of special cost data not otherwiserequired for management control purposes.With the recent emphasis on improving the ac-

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curacy of indirect-cost allocation, in the futuresubstantial emphasis will likely be placed onanalyzing the various activities of a business,such as the volume of shop orders, engineer-ing changes, and purchase requisitions.

Government acquisition personnel often getinvolved in examining indirect-cost poolstructure and various allocation bases usedby contractors. Their objective is to ensurethat indirect-cost allocations on negotiatedcontracts are fair and equitable and consis-tent with CAS 418. When CAS 418 was origi-nally issued, the CASB intended that the cre-ation of additional indirect-cost pools wouldbe required only if the changes would resultin material differences in allocations of indi-rect cost. In addition, from an industry per-spective, the general rule is that a smallernumber of indirect-cost pools is better unlessa material difference in the allocation of in-direct costs would occur.

If government acquisition personnel for somereason believe that the contractor’s overheadpool structure is not fair and equitable, theyshould be able to show, prior to recommendingchanges to the existing indirect-cost pool struc-ture, that a material misallocation of costs togovernment contracts will result.

The CASB realized that unique problems in costallocation could occur and provided flexibilityto the contracting parties. When a particularcontract, in relation to other contracts, receivessignificantly more or fewer benefits from anindirect-cost pool than it would from the alloca-tion of such costs using a base determined pur-suant to CAS 418, the government and contrac-tor may agree to a special allocation from thatindirect-cost pool to the particular contract.

CAS 420: Accounting for Independent Re-search and Development and Bid and Pro-posal Costs. This standard is concerned with

defining Independent Research and Develop-ment (IR&D) and Bid and Proposal (B&P) cost,providing the criteria for accumulating these twosignificant costs, providing criteria for allocat-ing these costs to cost objectives, and ensuringconsistency among contractors in the account-ing for IR&D/B&P costs.

IR&D is defined as the cost of an effort that isnot sponsored by a grant or otherwise requiredin performance of a contract, which falls withinthe areas of basic and applied research, devel-opment, and systems and other concept formu-lation studies. B&P cost is defined as the costof preparing, submitting, or supporting any bidor proposal that is not supported by a grant orotherwise required for the performance of a con-tract.

The standard requires that the basic unit for theidentification and accumulation of IR&D andB&P costs will be the individual IR&D or B&Pproject. The individual project cost consists ofall costs, both direct and indirect, allocated tothat effort except business unit G&A costs. Forexample, if an engineer is working on an IR&Dproject in the engineering organization, the costof the project will include both engineering di-rect labor and engineering overhead. Of course,if materials were used on the project, directmaterial and material overhead would also beadded to the total project costs. G&A costs areexcluded because IR&D and B&P costs are ofthe same nature as G&A costs.

The standard requires that all IR&D and B&Pcosts accumulated at the segment level must beallocated to all final cost objectives at the busi-ness unit by means of the same base used by thebusiness unit to allocate its G&A costs. The stan-dard further provides that any IR&D and B&Pcosts that are accumulated at the home office andcan be identified with a specific segment shouldbe allocated to that segment.

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In accordance with CAS 403, all other IR&Dand B&P costs accumulated at the home officeshould be allocated among all segments bymeans of the same base used to allocate residualexpenses. If a company has several segmentsperforming IR&D projects that are technicallyapplicable to only a portion of these segments,CAS 420 provides that the cost of those projectsbe allocated to the benefiting segments. Thestandard also permits a special allocation in un-usual circumstances; however, an advanceagreement is required between the two parties.

CONTRACT PRICE ADJUSTMENTS

It is quite obvious that the requirements of thecost accounting standards are written primarilywith the government’s interest in mind. In fact,the government exercises tremendous powerthrough the administration of the CASs becauseit can adjust a contract price after negotiationsare completed. If a contractor fails to followthe disclosed cost accounting practices or com-ply with a cost accounting standard; and, as aresult, government costs are increased on a CAS-covered contract, the government is entitled to adownward price adjustment with interest. Anydisagreements between the government and con-tractors regarding compliance are handled asdisputes under the contract.

The government’s right to a price adjustmenton all CAS-covered contracts does not meanthat contractors cannot change their account-ing system. Contractors often change their ac-counting systems subsequent to negotiationswith the government. However, they must pro-vide written notification of any proposedchanges 60 days before the planned implemen-tation. The notification is to include a descrip-tion of the accounting change and an estimate ofthe general dollar magnitude that the change willhave on all CAS-covered contracts.

Subsequent to the notification of the change andwhen a more comprehensive analysis of thechange has been completed, the contractor isrequired to submit a detailed proposal of the costimpact of the changes. If the proposed changedecreases costs to the government, a downwardadjustment will be negotiated. The governmentwill allow a cost increase only if the contractingofficer determines that the change is desirableand not detrimental to the government.

Both the government and the contractor canrequest a change in accounting practices. Overtime, cost accounting practices, which wereonce equitable, may become inequitable due tochanged circumstances. Consequently, to remainin compliance with the standards, contractorsmay need to change their cost accounting prac-tices. For example, changes in manufacturingprocesses and practices, changes in product mix,conversion from direct-labor to machine-hourallocation bases, or adoption of standard costsmay necessitate the revision of existing indirect-cost-rate structures.

At the present time, the large-scale restructur-ing activities occurring in defense industry cor-porations will probably initiate many account-ing system changes. The current managerialemphasis on total quality management pro-grams, such as efforts to reduce overhead costsor adoption of best practices, can also cause re-visions in cost accounting practices.

Government acquisition personnel should beaware that accounting changes should be viewedfrom a long-term, total company perspective asopposed to a short-term, program perspective.A program’s indirect-cost allocation could beincreased on a short-term basis; however, on alonger-term basis, the net effect could be lowercosts for the government as a whole becauseother programs receive fewer cost allocations inthe future. As an example, it would appear that,in the long run, restructuring changes should

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Exhibit 14. Cost Accounting Standards

COST ACCOUNTING STANDARDS

CAS 401: Consistency in Estimating, Ac-cumulating, and Reporting Costs. The costaccounting practices used in accumulating andreporting of actual cost must be consistent withthe practices used in estimating costs in pric-ing proposals. Cost estimates must be preparedin such detail so that any significant cost canbe subsequently compared with actual cost ac-cumulations. The purpose of this standard isto enhance the likelihood that comparabletransactions are treated alike and to obtain im-proved reliability of estimates and comparisonswith performance.

CAS 402: Consistency in Allocating CostIncurred for the Same Purpose. The sametype of cost must be consistently classifiedas direct or indirect with respect to all workperformed. The purpose of this standard is torequire that each type of cost is allocated onlyonce and on only one basis to any contract orother cost objective in order to prevent over-charging of some contracts and to eliminatedouble counting.

CAS 403: Allocation of Home Office Ex-penses to Segments. Establishes the criteriafor allocation of home office expenses to seg-ments and minimizes the amount of such ex-penses classified as residual. Home office ex-penses are to be directly allocated to the ex-tent practical on the basis of the beneficial orcasual relationship between the home office

and segments. Home office expenses that aredeemed residual expenses (which are thoseexpenses that are not identifiable with specificactivities of segments, such as the expenses ofthe Chief Executive Officer) must be allocatedin accordance with a three-factor formula whenthey exceed certain amounts. The three fac-tors are: operating revenue, payroll, and capi-tal assets plus inventories. When the three-fac-tor formula is not required, residual expensesmust be allocated over a base that is represen-tative of the total activity of the segments.

CAS 404: Capitalization of Tangible Assets.This standard facilitates the consistent mea-surement of costs based on a capitalizationpolicy that adheres to the criteria of the stan-dard. Contractors must possess and consis-tently follow a written policy on capitalizationpractices. Currently, the acquisition cost of tan-gible assets must be capitalized when the ac-quisition cost is greater than $5,000 and theestimated service life exceeds two years.

CAS 405: Accounting for UnallowableCosts. The purpose of this standard is to fa-cilitate the negotiation, audit, and settlementof unallowable costs. Unallowable costs mustbe segregated and identified as such in all pric-ing and billing to the government. The main-tenance of records in sufficient detail to pro-vide visibility of unallowable costs and theaccounting treatment of such costs is required.

result in efficiencies and lower costs for the gov-ernment. This is one of the primary reasons thatthe administration of the CASs is done by the

administrative contracting officer (ACO). TheACO must view the contractor from a total com-pany perspective and not from a program-spe-cific perspective.

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COST ACCOUNTING STANDARDS (continued)

CAS 406: Cost Accounting Period. This ruleprovides criteria for the periods to be used ascost accounting periods for contract estimat-ing, accumulating, and reporting of cost. A con-tractor must use his fiscal year as his cost ac-counting period for developing overhead ratesfor pricing and charging any government workperformed during the fiscal year, unless thereis a mutually agreed-to period that is the es-tablished practice of the contractor.

CAS 407: Use of Standard Costs for Di-rect Material and Direct Labor. Providesthe criteria for using standard costs for esti-mating, accumulating, and reporting costs ofdirect material and direct labor. The standardalso provides criteria relating to the establish-ment of standards, accumulation of standardcosts, and disposition of variances from stan-dard costs. The stated criteria must be metbefore standard costs may be used for gov-ernment contracts.

CAS 408: Accounting for Costs of Compen-sated Personal Absence. Compensated per-sonal absence costs are to be assigned to thecost accounting period in which the entitlementis earned. Entitlement is recognized on an ac-crual basis at the time the employer becomesliable to pay in the event of a layoff or otherdisciplinary termination. The purpose of thisstandard is to assign costs to the cost account-ing period in which the related labor is per-formed and in which labor costs are recog-nized.

CAS 409: Depreciation of Tangible Capi-tal Assets. Provides criteria for assigningcosts of tangible assets to cost accounting pe-riods and for consistent allocation of those costs

to cost objectives. The contractor may selectany appropriate method of depreciation thatreflects the pattern of consumption over thelife of the asset. Estimated service lives are notto be less than the life spans that are supportedby the contractor’s records of past experience.Estimated residual values must be determinedfor all capital assets or groups of assets. Theestimated residual value must be deducted fromthe capitalized value in computing the depre-ciation cost base except in certain limited cir-cumstances. Depreciation of assets used byservice centers should be charged to the ser-vice center. Depreciation costs are generallyallocated as indirect expenses to contracts.They may be charged directly only if thecharges are based on usage and the costs oflike assets used for similar purposes are alsocharged direct.

CAS 410: Allocation of Business Unit Gen-eral and Administrative Expense to CostObjectives. This standard provides criteria forthe allocation of the cost of general and ad-ministrative expenses based on their benefi-cial or causal relationships. Business segmentG&A must be grouped in a separate indirect-cost pool and allocated on a base measuredby cost input. Three types of cost input allo-cation bases are provided; total cost input,value added input, and single element costinput. General and administrative expenses,whose beneficial or causal relationship to costobjectives are more directly measured byother than cost input, are to be excluded fromG&A and must be separately allocated.

CAS 411: Accounting for Acquisition Costsof Material. This requires the contractor tohave written statements of accounting policies

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COST ACCOUNTING STANDARDS (continued)

and practices for accumulating the costs of ma-terial and for allocating costs of material to costobjectives. Material inventory records must bekept for each category ofmaterial with some exceptions. The standardprovides that material specifically acquired foridentified contracts may be charged directlyto the contract. The cost of material used solelyin performing indirect functions (or if it is nota significant element of production cost) maybe allocated to an indirect-cost pool. The ac-ceptable methods of costing when issuingmaterial from inventory are; FIFO (first-in,first-out), moving or weighted average, stan-dard cost, or LIFO (last-in, first-out).

CAS 412: Cost Accounting Standards forComposition and Measurement of PensionCosts. Prior to this standard, there was no au-thoritative guidance regarding components ofpension costs that could be properly includedas contract costs, or any criteria for measur-ing and assigning pension costs to cost ac-counting periods. This standard establishes thecomponents of pension costs and the bases formeasuring such costs. The standard also pro-vides criteria for determining the amount ofpension cost to be assigned to cost accountingperiods.

CAS 413: Adjustment and Allocation ofPension Costs. This standard provides for ad-justment of pension cost for actuarial gainsand losses, their assignment to cost account-ing periods, and bases for allocation of pen-sion costs to business segments. Actuarialgains and losses are to be calculated annuallyand are to be assigned to the cost accountingperiod for which the actuarial valuation is madeand to subsequent accounting periods. Pensioncosts are to be measured by the valuation of

pension fund assets using a method that rec-ognizes fair market values with considerationfor short-term market fluctuations. Pension plancosts are to be separately allocated to segmentsbased on active participation of employees.

CAS 414: Cost of Money as an Element ofthe Cost of Facilities Capital. This providesfor the explicit recognition of the cost ofmoney for facilities capital as an element ofcontract costs. A contractor’s net book valueof facilities is measured and allocated in ac-cordance with set criteria. The allocatedamount is used as a base to which a cost ofmoney rate is applied. The rate is based oninterest rates determined by the Secretary ofthe Treasury. Facilities capital items includerecorded facilities, land, leased property, andcorporate or group facilities. A facilities capi-tal cost of money factor is developed for eachindirect-cost pool for which a significantamount of facilities capital has been allocated.The cost of capital committed to facilities isseparately computed for each contract.

CAS 415: Accounting for the Cost of De-ferred Compensation. This rule providescriteria for the measurement and assignmentof deferred compensation costs to cost ac-counting periods. The cost of deferred com-pensation is to be assigned to the cost account-ing period in which the contractor incurs anobligation to compensate the employee. Themeasurement of the amount of the deferredcompensation is the present value of the fu-ture benefits to be paid by the contractor.

CAS 416: Accounting for Insurance Costs.This standard provides criteria for the measure-ment of insurance costs, the assignment ofsuch costs to cost accounting periods, and their

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COST ACCOUNTING STANDARDS (continued)

allocation to cost objectives. The amount ofinsurance cost to be assigned to a cost account-ing period is the projected average loss for thatperiod plus insurance administrative expensesin that period. Insurance costs are to be allo-cated to cost objectives on the basis of the ben-eficial or causal relationship between the in-surance costs and the benefiting or causing costobjectives.

CAS 417: Cost of Money as an Element ofthe Cost of Capital Assets Under Construc-tion. Establishes criteria for the measurementof the cost of money attributable to capital as-sets under construction, fabrication, or devel-opment as an element of the cost of those as-sets. This standard improves cost measurementby providing for recognition of cost of con-tractor investment in assets under construction;and provides greater uniformity in accountingfor asset acquisition costs.

CAS 418: Allocation of Direct and IndirectCosts. This provides for consistent determi-nation of direct and indirect costs, providescriteria for the accumulation of indirect costs,including service center and overhead costsin indirect-cost pools, and provides guidancerelating to the selection of allocation measuresbased on the beneficial or causal relationshipbetween an indirect-cost pool and cost objec-tives. For those indirect-cost pools contain-ing a material amount of the costs of manage-ment or supervision of activities involving

direct labor or materials, the selected alloca-tion base is to be representative of the activitybeing managed or supervised (e.g., direct la-bor, machine hours, direct materials). For in-direct-cost pools that do not contain a materialamount of management or supervision costs,the allocation base shall be, in order of prefer-ence: an appropriate measure of resource con-sumption, measure of output of the activities,or a surrogate measure that varies in propor-tion to the services received.

CAS 419. This standard was consolidatedwith CAS 418 after comment.

CAS 420: Accounting for Independent Re-search and Development Costs and Bid andProposal Costs. This rule provides criteriafor the accumulation of independent researchand development (IR&D) costs and bid andproposal (B&P) costs. It also provides crite-ria for the allocation of such costs to cost ob-jectives based on the beneficial or causal re-lationship between such costs and costobjectives. The standard provides that the ba-sic unit for the identification and accumula-tion of IR&D/B&P is the individual project.This includes all allocable costs, includingmaterials and overhead — except G&A ex-penses. IR&D and B&P expenses not allo-cated by a special allocation (based on a ben-eficial or causal relationship) must beallocated to final cost objectives on the samebase used to allocate general and adminis-trative expenses.

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88HOW THE GOVERNMENT MONITORS

INDIRECT COSTS

INTRODUCTION

The DoD Federal Acquisition Supplement(DFARS) sets forth a very clear policy. It re-lates DoD’s approach for ensuring that mana-gerial attention, of both the contractor and gov-ernment, is focused on contractor indirect costs.It strongly emphasizes that defense contractorsare responsible for managing and controllingtheir own indirect costs. DoD’s objectives areto systemically monitor how the contractorplans and controls these costs and to conductsufficient tests of the contractor’s control sys-tem to ensure that the costs are effectively man-aged.

Individual indirect expenses at contractor fa-cilities simply cannot be monitored by govern-ment personnel due to the sheer volume of thebusiness transactions involved. Thus, the focusof DoD monitoring activities is on the policies,procedures, and practices used by individualcontractors in controlling their indirect costs.The bottom-line objective of DoD personnel,in the final analysis, is to ensure that DoD paysonly its fair share of indirect costs that are allo-cated to the government’s flexibly priced con-tracts.

Within the government, monitoring indirect costis a major activity of the contract administra-tion function (defined in FAR Part 42). The or-ganization primarily responsible for contractadministration within DoD is the Defense Con-tract Management Agency (DCMA). This or-ganization is, in effect, an extension of program

offices at contractor plants. The DCMA has con-centrated top management attention toward ad-dressing the monitoring of indirect costs and hasaggressively pursued a major command initia-tive of “Overhead Management.” DCMA, aswell as many major program managers, has be-come very concerned with the increasing levelof indirect costs throughout the defense indus-try. “Program affordability” has become themanagerial keyword for the continuation ofmajor defense programs as the defense budgetdeclines. In addition to the overall industry is-sue of a declining business base that drives in-creases in indirect rates, many contractors havebeen experiencing extraordinary changes intheir corporate structures due to merger, acqui-sition, restructuring, and consolidation activi-ties. In the short run, these significant organi-zational changes tend to increase indirect costs.

In addition to the structural changes, determin-ing which party is responsible for paying ex-pensive environmental cleanup costs is a majorindirect-cost issue at senior levels within theacquisition community. So a very complex areaof contract management has become even morecomplicated. Since the DCMA is the primaryDoD organization responsible for determiningwhether indirect costs are reasonable, allowable,and allocable, it must resolve these issues inthe process of negotiating indirect rates withnumerous defense contractors.

It is important to note that monitoring indirectcosts by the government in the shipbuildingindustry is not the responsibility of the DCMA.

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As is often heard in the defense acquisition com-munity, “shipbuilding is different.” Because ofthe specialized nature of this industry, the NavySupervisors of Shipbuilding Conversion & Re-pairs (SUPSHIPS) provide all contract admin-istration (including negotiating indirect costs)and onsite technical expertise for the Navy’s newship construction and repair efforts. TheSUPSHIPS are primarily technical and engineer-ing activities in the field, and contract adminis-tration is only one aspect of their broad mission.These organizations are uniquely placed to man-age the integration of various contractor person-nel with the ship’s force, numerous other ship-yard workers, and Navy personnel performingthe numerous activities required in the construc-tion and repair of ships. In addition, expertise isneeded for dealing with the ship’s crew, who re-main aboard during maintenance periods andcontinue to work and train on the ship as it un-dergoes repairs.

Within the SUPSHIP onsite organization, allactivities relating to the monitoring of indirectcosts are the responsibility of the ContractsDepartment. An unusual aspect of shipbuild-ing is that the contracts function includes bothProcurement Contracting Officer (PCO) andAdministrative Contracting Officer (ACO)functions. The Navy’s objective is to provide“one face” to the shipbuilding and ship repairindustry and to retain full management controlof contract administration functions with no del-egations to the DCMA. The Naval Sea SystemsCommand is the headquarters for SUPSHIPSand provides overall guidance relating toindirect-cost matters. With the significant de-creases in shipbuilding budgets and the result-ing reductions in the business bases for ship-building contractors, the control of overhead ispresently considered to be one of the “high vis-ibly” topics at the shipyards.

Government and industry are very different interms of how they assign the responsibility for

the monitoring of indirect costs. In industry, asexplained in detail earlier, monitoring indirectcost is essentially a financial management func-tion. But in the government the function pri-marily falls under the heading of contract man-agement.

DCMA OVERHEAD CENTER

To come to grips with the increasingly compli-cated area of monitoring indirect cost and toaddress the concerns of program managers, whohave experienced significant increases in indi-rect rates, the DCMA established an OverheadCenter to assist ACOs in the indirect-cost arena.

DCMA management realized that the issues in-volving the allowability and allocability of indi-rect costs had become so complicated that de-fense contractors, when negotiating with thegovernment, would typically bring in profes-sional outside consultants to address some ofthe issues related to mergers, acquisitions, re-organizations, pensions, environmental pollu-tion, and other major issues. Unfortunately,there is no place within DCMA for contractmanagement personnel to obtain such profes-sional advice and guidance related to many ofthese emerging issues.

In addition, DCMA is very concerned with en-suring that defense contractors receive consis-tent treatment from the government in negoti-ating the very large and complex issues involvingindirect cost. Consequently, DCMA establishedan Overhead Center to provide contract-man-agement personnel with a central place to ob-tain policy advice and guidance related to indi-rect-cost matters.

The center is responsible for:

• bringing a national focus to indirect-cost issues,• performing research and analysis to support

field negotiation,

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• anticipating emerging issues and acting to in-fluence DoD policy,

• providing timely information to program offices,• reviewing precedent-setting issues (espe-

cially those involving the cost accountingstandards and cost principles),

• researching and analyzing Armed ServicesBoard of Contract Appeals (ASBCA) andCourt of Claims legal decisions for support-ing negotiations,

• analyzing negotiation results to derive “les-sons learned” for future negotiations, and

• maintaining a core capability for performingoverhead “should-cost” reviews. (“Should-cost” reviews will be discussed in more de-tail when government monitoring techniquesare examined.)

The Overhead Center is staffed with a smallgroup of specialists who work in areas such asbusiness reorganizations, pensions, cost ac-counting standards, cost principles, independentresearch and development, bid and proposals,electronic data processing, and actuarial science.

The Overhead Center also includes the Legal Prac-tice Group, which is staffed with a small numberof attorneys who provide legal and negotiationsupport for resolving complex indirect-cost issues.Essential industrial engineering and technical sup-port is provided to the Overhead Center on a ma-trix basis at DCMA Headquarters.

Now certain review teams, specializing in suchareas as insurance and pension, operate in thefield and report directly to the center. Later thefunctions performed by these specialized reviewteams will be discussed.

RELATIONSHIP TOPROGRAM OFFICES

Monitoring indirect-costs requires great relianceon program offices to help establish a realisticforecast of the business base. Program offices

are in an excellent position to provide currentinformation, such as quantity forecasts, deliv-ery schedules, requirement changes, productionoptions, and time-phased estimates. This infor-mation is invaluable for negotiating indirect-cost allocation bases with defense contractors.Program managers should make special effortsto assist the government monitoring team in anyway possible and should work toward strength-ening the monitoring process by improvingmanagement visibility related to their programs.As an absolute minimum, information requestedby DCMA from program managers should pro-vide valuable information for an independent“sanity check” on estimates received from con-tractors.

Program offices should be actively involved inthe government’s monitoring process to ensurethat their contractors adequately control indi-rect costs. It is essential that they are very fa-miliar with their contractor’s indirect-cost struc-ture in order to understand programmaticfunctions related to cost estimating, pricing,negotiating, and cost reporting. It should be rec-ognized that one of the most difficult tasks forarriving at the cost of any weapon system is thedetermination of the proper amount of indirectcosts to assign to each system.

GOVERNMENT TEAM

Procurement Contracting Officer (PCO)

The PCO is the government’s legal representa-tive and is the individual with the authority toaward, administer, and terminate governmentcontracts. However, certain responsibilities ofthe PCO can be delegated to authorized repre-sentatives. It is customary, after award of ma-jor defense contracts, for the PCO to delegateresponsibility for administration of the contractto an ACO. In so doing, the PCO still retainsoverall control of contracts. The ACO supportsthe PCO by obtaining timely and accurate in-

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formation about numerous contractor opera-tions. This support is especially valuable inthe indirect-cost area because indirect ratesare of major interest to the PCO for contractnegotiation purposes. It is essential that con-tinuing liaison be maintained between thePCO and the ACO during the entire life ofcontracts.

Administrative Contracting Officer (ACO)

The contract administration responsibility del-egated to the ACO includes many generalbusiness-oriented functions. Overall, the FARidentifies some 60 contract administrative func-tions that may be delegated to various person-nel working in the field.

Some functions relevant to the area of indirectcosts include:

• negotiating indirect rates to be used for gov-ernment contracting purposes,

• negotiating advance agreements,• reviewing rates as indirect costs are incurred,• analyzing historical indirect-costs trends,• analyzing variances between incurred costs

and actual costs,• determining reasonableness of indirect costs,

and• determining the adequacy of contractor’s ac-

counting systems.

In practice, monitoring indirect cost involvesevery ongoing activity at a defense contractor’splant. All activities are in some way includedin forecasted operations as either direct or indi-rect cost. Out of necessity, monitoring indirectcost must be a team effort. The team leader forthe government monitoring efforts is the ACO,who usually is located onsite at the contractor’splant. The ACO is responsible for coordinatingthe efforts of many government specialists inresidence at the contractor’s plant, as membersof the government team.

Corporate Administration ContractingOfficer/Defense Corporate Executive(CACO/DCE)

Contractors with more than one business seg-ment frequently have various corporate-widepolicies, procedures, and plans that necessitategovernment review and negotiation of certainindirect costs at the corporate headquarterslevel.

For example, the corporate level can manage:

• pension plans,• health care plans,• insurance programs,• independent research and development pro-

grams,• bid and proposal programs,• executive compensation plans,• union agreements,• foreign operations, and• taxes.

In addition, some corporations operate with cen-tralized management control and may have con-siderable decision-making authority at the cor-porate level. The related indirect costs at thecorporate level must be allocated to the busi-ness segments on a reasonable basis. Suchindirect-cost allocations often involve large,complex costs collected at intermediate groupoffices as well as at corporate offices.

Today, in the declining defense environment,many large indirect costs, such as restructuringactivities, discontinued operations, and environ-mental cleanup operations, are increasingly man-aged at the corporate level. Such cost allocationssignificantly affect the work of many ACOs whomonitor indirect cost at the business-segmentlevel. In this situation, the government may des-ignate a CACO, who is responsible for contractadministrative functions at the corporate level,including the monitoring of indirect costs.

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The CACO ensures consistency in the variousbusiness segments performing governmentwork and may negotiate advance agreementsfor certain major indirect costs. The CACOworks closely with, and provides significant in-puts to, the ACOs located at the business-segment level. In effect, the CACO negotiatescorporate indirect-cost allocations on behalf ofall ACOs. DCMA has recently designated de-fense corporate executives (DCEs) at the fivelargest defense contractors. DCEs have corpo-rate-wide responsibility and act as the DoD li-aison representative with corporate manage-ment.

Defense Contract Audit Agency (DCAA)

The DCAA is the principal advisor withinDoD on all financial accounting, cost account-ing, and contract audit matters relating to thedefense industry. Therefore, the cognizantDCAA auditor, usually located at major con-tractor locations, plays an important role in allmatters relating to indirect costs. DCAA con-ducts several types of contractor managementsystems audits as well as pre-award audits,proposal audits, and audits at the completionof contracts — all of which are instrumentalin establishing indirect rates. DCAA operatesin an advisory role in relationship to the con-tract management community. While the es-tablishment of all indirect rates with majorcontractors is a joint effort on the part of theACO and the DCAA, the ACO is the individualwho is the final decision maker and the indi-vidual who has the authority to negotiate rateswith the contractor. An exception is that manysmall contractors have what are referred to as“audit-determined” rates, and the DCAA is theinitial decision maker for the government. Inthe case of audit-determined rates, if an agree-ment cannot be reached between the DCAAand a contractor, the issue is elevated to theACO for resolution.

Other Team Members

Many individuals located at contractor’splants are members of the government moni-toring team. The engineer is one of the keymembers who provides the important techni-cal capability for reviewing and evaluatingdirect material, direct labor, and other direct-cost estimates contained in the contractor’sindirect-rate forecasts. Normally, the engineeris very familiar with the contractor’s engi-neering processes, manufacturing processes,work-measurement systems, and plant layoutand is extremely valuable when evaluating thecontractor’s forecasted engineering workload,manufacturing rates, workforce size, skill mixof employees, realization and efficiency rates,and amortization methods for special toolingand test equipment. Other government per-sonnel play important roles in the indirect-cost monitoring process as specialists in theareas of quality, packaging, transportation, se-curity, and government property.

Again, the scope of indirect costs necessitatesthat monitoring efforts by the government mustbe a team effort. All of the team members mustdo their part so the DoD can meet its objectiveof paying for only its fair share of thecontractor’s indirect costs.

MONITORING TECHNIQUES

The government’s indirect-cost monitoring ef-forts consists of several managerial techniques,including establishing three separate types ofindirect rates to be used solely for governmentcontracting purposes, tracking of actual ratesas they are incurred, performing several typesof penetrating reviews of contractor manage-ment-control systems, and doing in-depth ex-aminations of specific types of indirect costs.

The primary technique used by the governmentto ensure that it pays only its fair share of the

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Exhibit 15. Life Cycle of Indirect-cost Rates

contractor’s indirect costs is to establish totallyseparate rates with contractors to be used for gov-ernment-contracting purposes. These rates areknown as forward-pricing, billing, and final rates.

Since defense contractors usually have someunallowable costs in every indirect-cost pool,all three of these rates will normally be lessthan the contractor’s true indirect rates. Firstof all, forward-pricing rates are developed forpricing and negotiating new procurementsand changes to existing procurements. Theserates represent estimates of anticipated futureindirect costs. The second rate developed forgovernment contracting purposes is the bill-ing rate, which is used by the contractor toobtain payment for indirect costs incurredduring the performance of contracts. Finally,actual rates are negotiated at the conclusionof the contractor’s fiscal year to arrive at thefinal allowable cost on all cost-type contracts.All three of these rates are developed for each

contractor fiscal year. “Exhibit 15. Life Cycleof Indirect-cost Rates” summarizes the threerates used for government contracting pur-poses. The following narrative provides anexplanation of the process used by the con-tractor and the government in developing eachof the indirect rates and the relative impor-tance of the rates to program managementpersonnel.

Forward-pricing Rates

Forward-pricing rates, or bidding rates, as theyare sometimes called, are projected for eachindirect pool in the contractor’s cost account-ing system and are used by contractors in de-veloping cost proposals to be submitted to thegovernment. These rates are derived from thecompany planning process, where the contrac-tor projects detailed direct and indirect coststhat will be incurred in the accomplishment ofprojected sales.

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For direct cost, the contractor’s cost estimatingsystem will provide time-phased cost estimatesfor each element of direct labor, direct material,and other direct charges. These costs then willbe used to determine an appropriate amount ofindirect cost and allocation bases after adjust-ments are made to comply with government con-tracting requirements that dictate the allowabilityof costs. Thus, the forward-pricing rate repre-sents a projected “allowable” rate based on thetotal estimated business volume.

For large contractors, the ACO and the con-tractor attempt to negotiate a written agreementfor forward-pricing rates to be used by the con-tractor on all proposals to the government. Theresulting Forward-Pricing Rate Agreement(FPRA) is beneficial to program managers be-cause, without the agreement, all indirect rateswill require separate negotiations with contrac-tors as a part of the negotiation of each con-tractual action. An FPRA is also beneficial tothe contractors. They can use the same rateswith all government customers, and they do nothave to separately negotiate the indirect rateswith each and every customer. Since the FPRAbenefits both parties, it may be requested bythe procurement contracting officer, adminis-trative contracting officer, or the contractor.

It is important to recognize that, in the nego-tiation of forward-pricing rates, contractorshave far more information available to themfor estimating purposes than the governmentdoes. Therefore, the government requires thecontractor to submit a detailed proposal forthese business-wide costs. The government’sjob is then to evaluate what the contractor hasproposed to them as opposed to making totallyindependent estimates.

A contractor’s forward-pricing proposal shouldcontain the following types of data:

• projections and management assumptions re-lating to the business-segment sales forecast

• delineation of potential customers, specificweapons system programs, foreign militarysales, and commercial sales

• identification of any planned corporate struc-ture changes, mergers, acquisitions, discon-tinuation of operations, etc.

• estimated capital investments for plant, equip-ment, and tooling

• planned disposition of idle facilities• engineering workload projections, planned

material requirements, manufacturing sched-ules, and product delivery schedules

• time-phased breakdown of forecasted direct-cost employees anticipated to be working oncontracts, independent research and develop-ment projects, bid and proposal projects, andcompany capital investment projects

• data supporting various direct-cost estimatingfactors unique to the contractor’s operations

• estimated direct-cost bases used to allocateindirect costs

• time-phased breakdown by function of fore-casted indirect-cost employees for eachindirect-cost pool

The contractor is not required to certify cost orpricing data related to a forward-pricing rateproposal. Under the Truth in Negotiations Act(TINA), the certificate that is signed in conjunc-tion with each particular contract proposal alsocovers the forward-pricing rates related to thatproposal. So the contractor must make effortsto ensure that the rates are kept current. Typi-cally, a rate analysis is made (at a minimum)on a quarterly basis to ensure that a determina-tion is made as to whether a revised forward-pricing proposal must be submitted.

The ACO usually immediately forwards thecontractor’s forward-pricing rate proposal to theDCAA auditor and other indirect-cost teammembers for review and analysis. Upon comple-tion of the analysis, team members and procur-

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ing activities having significant interest will berequested to participate in developing thegovernment’s negotiation objectives and to as-sist in rate negotiations. During the negotiationprocess, the ACO may also refer complex prob-lem areas to their regional office and to theDCMA Overhead Center for assistance. Uponcompletion of negotiations and the conclusionof an agreement with the contractor, the ACOforwards a copy of the FPRA to all procuringactivities having a substantial amount of busi-ness with the contractor.

The FPRA will be used in the negotiation ofcontractual actions expected to be performedduring the period covered by the agreement. Inaddition to indirect rates, the FPRA usuallycontains many factors to be used in estimatingvarious direct-cost elements. For example,based on the company’s projected salary meritprogram and union contract terms, monthly la-bor rates by labor category may be agreed towith the government in advance. Other factorscommonly negotiated in advance as part of theFPRA include: materials escalation; excess us-age; obsolescence; scrappage; labor realizationand efficiency; and certain factors of produc-tion, such as manufacturing planning, qualityassurance, and testing.

An FPRA is very valuable to program officesbecause it enables them to focus their effortson estimates of direct-cost drivers unique to aprogram. Indirect rates applicable to all DoDbusiness can then be applied to direct cost anddo not require separate negotiation. Typically,an FPRA will cover the current year and at least2 future years. However, the agreement providesfor cancellation at the option of either party andwill require the contractor to submit to the gov-ernment any significant change in forecastedrates.

Of paramount importance in establishing anFPRA is the establishment of realistic projec-

tions of the volume of business that the contrac-tor will accomplish in future years. Actually, pro-gram offices are in the best position to provideACOs with such estimates.

Some valuable information that major programmanagers can provide includes:

• overall program schedule• major milestones• program time phasing• delivery schedules• follow-on buys• major modifications• foreign military sales potential• future research and development require-

ments• spare parts buys• future logistical requirements

Often, the program office will have informa-tion that is more current than that available tothe contractor. For example, the program officecould be in the process of investigating programoptions due to a schedule slip necessitated byfunding reallocations. The program office couldprovide current inputs to the ACO by validat-ing the program strategies and assumptionsmade by the contractor in preparing FPRA in-puts relative to their respective programs.

This input from program offices is so impor-tant that ACOs may often invite representativesfrom major program offices to participate inactual FPRA negotiations. Unfortunately, dis-cussion with operating personnel in the fieldindicates that requests for assistance from ACOsto program offices are sometimes ignored. Froma program management perspective, not onlyshould program managers assist ACOs in nego-tiating FPRAs; but they should strongly encour-age their contractors to enter into an FPRA toreduce the work requirements of procuring ac-tivities related to each proposed contractual ac-tion. An FPRA is a powerful tool for reducing

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costs of weapon systems because it addressesmany of the very high-cost elements in mostdefense contracts.

In some cases, it may not be possible to negoti-ate an FPRA. Contractors may be unwilling tonegotiate because the business base is chang-ing rapidly, significant issues may be in litiga-tion, certain corporate or group issues are un-resolved with the government, cost accountingchanges are in process, or corporate merger andacquisition activities are under way.

In addition, the government and the contractormay reach a negotiation impasse for many rea-sons. In such cases, the ACO will normallyunilaterally establish forward-pricing “recom-mended rates” (FPRRs) for use by procuringactivities in negotiating future DoD require-ments.

In some instances, the government and the con-tractor may negotiate some of the rates but notall. In this case there could be a partial FPRA. Itis important to note that, in addition to using theforward-pricing rates for cost proposal purposes,the rates are also used for numerous cost-estimat-ing purposes and for preparing estimates atcompletion for contract performance reporting.

Billing Rates

Since indirect costs can only be settled withcertainty at the end of the contractor’s fiscalyear, a different rate is needed to make cashpayments to contractors for the estimated al-lowable indirect costs as they are being incurred.To determine the amount of “reimbursable”indirect cost, the contractor uses a billing or pro-visional rate. The billing rate provides a methodfor interim reimbursement of indirect costs atestimated rates, subject to final adjustment. Thisrate influences how rapidly a contractor is reim-

bursed for indirect expenses incurred and affectscash flow but not the price that the contractorwill ultimately be paid.

Billing rates are used by the contractor in sub-mitting invoices for progress payments on fixed-price contracts as well as for cost incurred oncost-reimbursement-type contracts. If the con-tractor and the government cannot agree in ad-vance on billing rates, the ACO may unilaterallydetermine the billing rates to be used for payingthe contractor. The objective in setting the bill-ing rate is to approximate the rate for the year asaccurately as possible using actuals-to-date andestimates for the remainder of the year.

If a significant difference between the billingrate and the actual rate-to-date develops, it is inthe best interest of the government and the con-tractor to adjust the billing rate to its most likelyyear-end value. When determining the billingrate, the ACO considers that some indirect costswill potentially be disallowed by the govern-ment and provides for a slight margin of errorin anticipating year-end actuals. The objectivefor the government is to develop billing ratesthat are set low enough to avoid overpaymentto the contractor for indirect costs incurred.

It is important to keep in mind that billing ratesare temporary in nature. The contractor is paidfor incurred indirect cost on a temporary basis,but actual indirect rates that are negotiated muchlater are permanent. It is necessary to have bill-ing rates even if there are already forward-pricing rates because both the government andthe contractor become smarter as time passes.They accumulate actual experience for indirectcosts incurred in each overhead pool and ac-tual experience for each direct-cost allocationbase. As the year progresses, the billing rate be-comes a far more accurate basis for paying thecontractor for indirect costs incurred than aforward-pricing rate would be.

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Final Rates

The third and last type of indirect rate used solelyfor government contracting purposes is the finalrate, which cannot be negotiated until some timeafter the end of the company’s fiscal year. In prac-tice, this rate is often referred to as “year-endactuals.” Within 6 months after the end of its fis-cal year, the contractor is required to submit afinal indirect-rate proposal. In conjunction withthe submission, DoD contractors are required tocertify that all costs included in the proposal areallowable in accordance with contract require-ments and DoD cost principles.

FAR 42.709 provides penalties that may be as-sessed if a contractor claims a cost in anindirect-cost proposal that is expressly unallow-able or is established as being unallowablethrough mutual agreement. These unallowablecosts are costs specifically identified as unal-lowable by law, regulation, or contractual pro-vision. The ACO is responsible for determin-ing whether or not a penalty will be assessed.Penalties, which were initiated by Congress, canbe very severe. They may be as much as twotimes the amount of the unallowable cost inaddition to the amount of unallowable cost plusinterest. For example, if a contractor included$1 million of expressly unallowable cost in itsproposal, it could conceivably cost the company$3 million plus interest.

The contractor’s final indirect-rate proposal isreviewed and analyzed by the DCAA forallowability of actual costs, and recommenda-tions are made to the ACO for negotiating finalrates. These reviews are often referred to asincurred-cost reviews. The ACO will evaluateall recommendations made by the DCAA, andit is the ACO who has the responsibility for ne-gotiating “fair and reasonable” final rates. How-ever, as mentioned before, the CACO will ne-gotiate final amounts relating to corporate-levelindirect costs, which are allocated to the busi-

ness segments. Upon completion of negotiations,a written final indirect-cost rate agreement issigned by the contractor and the government.The agreement is automatically incorporated intocontracts in accordance with the “allowable costand payment” clause.

Final indirect rates may be established by themethod of audit determination at some smallercontractor operations that were not specifiedfor ACO determination. If an agreement can-not be reached between the contractor and thegovernment, such disagreements will be con-sidered to be a dispute within the meaning ofthe disputes clause in the contract. It shouldbe noted that time delays are often encoun-tered before final rates are agreed to; there-fore, billing rates should be retroactively re-vised to prevent significant overpayments orunderpayments during the delay. In this case,the billing rate revision will reflect a decre-ment factor as determined by the governmentfor historically disallowed amounts from prior-year audits.

The final rate is determined by dividing thenegotiated allowable indirect cost by the ne-gotiated allowable direct-allocation base foreach indirect-cost pool. Unless certain costsrequire a legal decision, final rates are not sub-ject to change. Final indirect rates are used toadjust billing rates on cost-reimbursement con-tracts to arrive at the actual amounts of indi-rect costs that the contractor will be reimbursedfor the applicable year. Final rates also pro-vide the essential information for closing outcost-reimbursable contracts. Such contractscannot be closed, with full payment of fee, un-til government-approved final rates are estab-lished. Final rates are also used in negotiatingthe final price of fixed-price incentive, fixed-price redeterminable contracts, and in anyother situations that require indirect costs tobe settled before contract prices are estab-lished.

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In previous years, it was not unusual for the ne-gotiation of final rates to take 5 years or longer.In the past, the settlement of final indirect rateswas a low priority, with primary emphasis placedon current contractual actions. The result was avery large backlog of contracts awaiting finalcloseout. Delays in negotiating final actual over-head rates have recently created exceptionallydifficult problems due to the impact of defensemergers and acquisitions.

For example, Lockheed merged with Martin-Marietta, which had acquired General Electric,which had acquired RCA. Yet, according to theAegis program office, the final rates had notbeen settled for work performed by RCA whilethe current work was being performed byLockheed-Martin. Needless to say, it was ex-tremely difficult for current contractor employ-ees to locate records and to provide explana-tions relating to the allowability of indirect costsdealing with acquired contractors. Recall thatthe contractor is responsible for proving thatcosts are reasonable.

Within the past few years, DoD managementhas taken significant steps to deal with this prob-lem. Management became focused on the settle-ment of final rates when changes were made tothe “M accounts” and, as a result, program fundscould potentially be cancelled. (Refer to Chap-ter 6 for a discussion of the “M account” legis-lative issue.)

The settlement of final indirect rates and theclosing of old contracts is now a high priorityissue throughout DoD. Both DCMA andDCAA are tracking this issue closely; it is oneof their top priorities. DoD has established a veryaggressive goal of reducing the backlog of un-settled final overhead rates to 1 year.

The strategy for attaining this goal is often re-ferred to as the “6-12-6” rule for major con-tractors and the “6-24-6” rule for non-major

contractors. The rule relates to the criteria forreducing the monthly cycle times for complet-ing the settlement of final overhead rates withcontractors. A major contractor is one that has$70 million or more in cost-reimbursement-typecontracts while a non-major contractor has lessthan this amount. This rule means that majorcontractors, have 6 months after the end of theirfiscal year to submit their overhead claim to thegovernment. Of course, contractors are encour-aged to get their overhead claims in earlier ifpossible. The DCAA then has 12 months (24months for non-major contractors) to completethe audit of the contractor’s overhead claim andto submit their audit report of questioned coststo the ACO. The ACO then has 6 months tonegotiate and settle the final allowable overheadrates with the contractor. To accomplish thisgoal and reduce the current backlog, the DCAAis often working on multiyear reviews (e.g.,examining 2 to 3 years of indirect costs at onceinstead of just 1 year at a time).

In addition, contractors and the government areworking on establishing a “real time” audit phi-losophy to the extent practicable. This meansthat indirect costs are evaluated and reviewed,to the maximum extent, as they are incurred bythe contractor rather than waiting until the con-tractor submits an overhead claim 6 monthsafter the fiscal year is over. Questions relatingto the allowability of costs are much easier forthe contractor to answer when the costs are in-curred as opposed to waiting many months fol-lowing the end of the contractor’s fiscal year.There is no question that the government isgetting much better at “keeping current” in set-tling final indirect-cost rates.

In a small number of cases, in order to facilitatethe timely settlement of overhead years and toclose out contracts, an ACO may decide to “rollforward” certain overhead costs to a later fiscalyear. This may occur when a cost allowabilitydetermination is dependent upon a future event.

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For example, the allowability of legal costs fordefending against a fraud charge brought by thegovernment might be rolled forward to the yearin which the legal issue is resolved, i.e., the caseis finally decided.

Any decision to roll forward costs must not re-sult in increased cost to the government becausethere is a significant change in the contractor’spercentage of flexibly priced contracts when thefinal overhead adjustment is made. The con-tractor must agree that the actual overhead costswill be determined by applying the approximategovernment participation rate on flexibly pricedcontracts for the year in which the contractorrecorded the costs. From a government perspec-tive, all ACO decisions to roll forward indirectcosts to future overhead years must be coordi-nated with legal counsel and the DCMA Over-head Center. Indirect cost should not be rolledforward simply because the issue of allowabilityis difficult to resolve.

FAR 42.708 provides for quick closeout proce-dures which, under certain circumstances, allowcontracting officers to negotiate a settlement ofindirect costs for a specific contract in advanceof the determination of final indirect-cost rates.

Quick closeout procedures may be used when:

(1) the contract is physically complete,(2) the amount of unsettled indirect cost to be

allocated to the contract is relatively insig-nificant, and

(3) agreement can be reached on a reasonableestimate of allocable dollars.

Indirect-cost amounts are considered to be rela-tively insignificant when:

(a) the total unsettled indirect-cost allocated toany one contract does not exceed $1 mil-lion and

(b) the cumulative unsettled indirect costs to be al-located to one or more contracts in a single fis-cal year do not exceed 15 percent of the esti-mated total unsettled indirect costs allocable tocost-type contracts for that fiscal year.

Further, the contracting officer may waive the15 percent restriction on the amount of cumu-lative unsettled indirect-costs based upon a riskassessment that considers the contractor’s ac-counting, purchasing, and estimating systemsplus any other concerns of responsible govern-ment personnel.

The quick closeout procedure should be usedwhenever possible as it enables the timelydeobligation of program funds for possible useelsewhere. It should be noted that indirect-costrates used in the quick closeout of a contractare not considered to be a binding precedentfor establishing final indirect-cost rates for othercontracts. If the criteria contained in FAR42.708 are met, the provision for quick close-out can be applied not only to the final fiscalyear of a contract, when performance may beonly for a brief period, but also to all other openfiscal years with unsettled indirect-cost rates.

In some situations, the government may placeindirect-cost ceilings in contracts. This mayoccur under a cost-sharing arrangement whena contractor participates in the costs of a con-tract and is willing to accept indirect rates thatare lower than their anticipated actual rates.Other situations where indirect-rate ceilingsmay be placed in contracts by the governmentare new or recently reorganized companies withrapidly increasing indirect rates (without reduc-tions in indirect costs) and companies quotingunreasonable rates in order to improve theircompetitive positions. In these cases, the gov-ernment is not obligated to pay any additionalamount if the final indirect rates exceed thenegotiated ceiling rates. Of course, contractors

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must be willing to accept these contract termsbecause both parties must sign the contract.

When questioning which of the three indirectrates gives the government the most control overindirect costs, the answer, very definitely, isforward-pricing rates. The establishment offorward-pricing rates represents the only oppor-tunity that the government has to affect indirectcosts before the costs are incurred. From thegovernment’s perspective, it is often very diffi-cult to argue that a cost is unreasonable whenthe contractor has already paid it. Also, whilethe negotiation of final rates is important for de-termining the final costs to be charged to cost-type contracts, it is not that significant for firm-fixed-price contracts unless there is some incentiveor redeterminable provision.

The only value added with final rates for firm-fixed-price contracts is the managerial visibil-ity that it provides for the negotiation of subse-quent forward-pricing rates. It is in the bestinterest of the government to stress indirect-costavoidance by rigorously pursuing the negotia-tion of forward-pricing rates.

Tracking Indirect Costs

Once the contractor’s fiscal year begins, theACO sets up a system for tracking thecontractor’s actual indirect costs as they are in-curred. In this regard, the leading thrust of theDCMA major initiative on overhead manage-ment is the intensified tracking of indirect costsby DCMA personnel. The primary objective ofthe intensified tracking is to alert the govern-ment team of any significant cost overrun prob-lems and to gauge the reasonableness offorward-pricing and billing rates. A compari-son of actual versus target is made for both theindirect-cost elements and the direct-cost allo-cation bases for each indirect-cost pool. Thecomparison is made each month for both themonthly incremental and year-to-date amounts.

To avoid duplication of effort with thecontractor’s management control system, thegovernment team should make special effortsto identify existing reports used by the contrac-tor for controlling indirect costs. Typically, onewould expect contractors to prepare monthlyreports that summarize the actual allowableoverhead rates on a monthly and year-to-datebasis.

The contractor is responsible for advising thegovernment of any significant rate changes inorder to comply with Truth in Negotiations Actrequirements. The actual rates should be com-pared to forward-pricing and billing rates, andthe major differences should be analyzed to de-termine if the differences are temporary or per-manent. Contractor analysis results should bedisclosed to the ACO.

If the contractor’s budgetary and variance analy-sis procedures are considered to be adequate,the outputs from the contractor’s system maybe acceptable for use by the government teamin monitoring the contractor’s indirect costs.This method is the most economical and effi-cient way to monitor contractor indirect costs,since it precludes the preparation of specialgovernment reports.

Generally, in performing a variance analysis,the government team will request a writtenexplanation from the contractor for variancesincluding:

(1) indirect-cost elements that are plus or minus3 percent of the target and greater than$10,000 and

(2) direct-cost allocation bases that are plusor minus $100,000 of the target.

Significant variances could lead to further analy-ses by the government team and could also leadto a review of some operational aspect of thecontractor’s business. The government team will

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determine whether any unfavorable trends arelikely to continue for the remainder of the year.If the trend is likely to continue, the contractorwill be notified that the current rates are no longervalid for forward-pricing and billing purposes.Dependent upon the significance of the prob-lem, a written corrective-action plan may be re-quested from the contractor.

Some large contractors have recently started apractice of inviting DCMA personnel to theirinternal monthly overhead meetings. The pur-pose of these meetings is to address overheadproblems quickly before large cost overruns areexperienced. This practice significantly reducesthe administrative requirements, as written re-ports and explanations may no longer be nec-essary in many instances. The practice alsoseems to build an open and trusting workingrelationship between the parties.

To avoid any management surprises for programoffices, the government team should ensure thatsignificant indirect-cost problems, along withproposed contractor solutions, are immediatelybrought to the attention of the program office.Indirect-cost problems could have a very sig-nificant financial impact upon program costestimates.

Contractor Systems Reviews (CSRs)

Indirect-cost monitoring encompasses certainlarge-scale, systems-oriented reviews that arerequired under certain conditions by the FAR,DFARS, or DoD instructions. The pertinentregulations or instructions designate the respon-sible lead organization, such as the DCMA orDCAA, and specifically spell out the criteriafor the reviews. The performance of requiredsystems reviews often employ government spe-cialists who are not onsite at the contractor’splant. Consequently, government specialistsfrom external organizations may be assigned

on a temporary basis and for a limited period oftime, usually a matter of weeks.

A by-product of performing the required sys-tem reviews is that it provides a great opportu-nity for government personnel to evaluate thereasonableness of contractor’s indirect costs.Essentially, contractor functions being evalu-ated during systems reviews are functions thatare performed by indirect-cost-type employees.Therefore, in the performance of the reviews,information is obtained on the various tasksbeing performed by indirect-cost personnel; andan essential part of each review should be toevaluate whether the functions are being per-formed in an efficient and effective manner. Anysignificant indirect-cost problems, such as over-staffing or uneconomical practices, should bediscussed during the systems reviews.

The following required reviews and surveillanceactivities are important for monitoring indirectcost and should be scheduled to occur beforeforward-pricing rate negotiations are completed.

Contractor Purchasing System Reviews (CPSRs)

FAR 44.3 requires the ACO to determine theneed for conducting a contractor purchasingsystem review (CPSR) for each contractorwhose sales to the government, using other thansealed-bid procedures, are expected to exceed$25 million during the next fiscal year. If thereare indications of significant purchasing prob-lems, the reviews may also be considered atsmaller contractor locations. The determinationas to whether a CPSR continues to be neededis made by the cognizant contract administra-tion organization at least every 3 years. A CPSRrequires a comprehensive evaluation of acontractor’s purchasing organization and prac-tices. Upon completion of the review, the cog-nizant ACO is responsible for granting, with-holding, or withdrawing approval of thecontractor’s purchasing system.

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Normally, a purchasing system analyst serves asthe team leader and actually conducts the reviewson behalf of the ACO. For contractors with ma-jor defense systems, the review team includesspecialists in engineering, production, qualityassurance, and acquisition management func-tions. Recognizing that the material and subcon-tract content for a large defense production con-tract can often be substantial, DoD is veryinterested in the efficiency and effectiveness ofthe contractor’s purchasing system. Purchasingfunctions have a significant impact on indirectcosts, as large numbers of contractor indirect-cost employees are typically performing the func-tions of preparing requests for proposals, per-forming cost/price analysis, making sourceselection decisions, buying parts from vendors,administering subcontracts, arranging leases, andpreparing and maintaining purchasing policiesand procedures.

Estimating System Reviews (ESRs)

DFAR 215.811 requires contractors to haveadequate written procedures to document theutilization of reliable and efficient estimatingtechniques. A large defense contractor is sub-ject to estimating-system disclosure, mainte-nance, and review requirements if, in the pre-ceding fiscal year, the contractor received DoDprime contacts or subcontracts totaling $50million or more for which certified cost or pric-ing data was required. In addition, if a contrac-tor received $10 million or more in such con-tracts and the contracting officer, withconcurrence or at the request of the ACO, de-termines that it is in the best interest of the gov-ernment (if for example significant estimatingproblems are believed to exist), the contractormay be subject to an estimating system review(ESR). The reviews are conducted every 3 yearsbut may be lengthened or shortened based onan assessment of the contractor’s past experi-ence and current vulnerability.

The cognizant DCAA auditor, on behalf of theACO, serves as team leader in conducting esti-mating system reviews. Estimating system re-views can be complex, and normally the ACOwill designate quality control, production en-gineering, packaging, transportation, and otherspecialists to assist DCAA as members of thegovernment review team. The ACO has the au-thority to approve or disapprove all or selectedportions of the contractor’s estimating system.

A contractor’s estimating system includes poli-cies, procedures, organization, estimating meth-ods, and work-measurement techniques. Esti-mating functions are performed predominatelyby indirect-cost-type employees, and the func-tions typically will have a significant impactupon indirect costs. In conjunction with per-forming estimating system reviews, governmenttechnical specialists will normally examine pro-duction processes, shop practices, machineloadings, time-and-motion factors, and otherareas. The continuing performance of estimat-ing system reviews on a cyclical basis providesthe government with significant insight into thecontractor’s ability to manage indirect costs.The scope of the estimating system review alsoincludes an analysis of the methods used to es-tablish reliability in the sales forecast and theextent to which the forecast data are reflectedin indirect-cost projections. It also includes ananalysis of the contractor’s plans relating to theacquisition of new and improved capital equip-ment, which will generate large depreciation-or amortization-related indirect costs.

Compensation System Reviews (CSRs)

FAR 42.302 requires the ACO to review thecontractor’s compensation system. However,DCAA is designated as the responsible organi-zation within DoD for actually performing com-pensation system reviews (CSRs) as separateassignments. DCAA makes recommendationsto the ACO, who is responsible for negotiating

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indirect rates. It is DCAA policy that an employeecompensation system review be performed atthose defense contractor locations where, in thecontractor’s preceding fiscal year, the contractorreceived at least $50 million in government salesunder negotiated prime contracts and subcon-tracts for which such sales represented at least10 percent of the total sales volume. Compensa-tion system reviews are scheduled every 3 yearsand, to the extent possible, are scheduled to oc-cur prior to major proposal actions. A CSR rep-resents a complete evaluation of the contractor’semployee-compensation system including poli-cies, procedures, practices, and costs. The re-view is made to determine whether the compen-sation structure conforms to sound businesspractices and whether employee compensationcosts are reasonable in accordance with FAR31.205-6. The scope of the CSR includes ex-ecutive compensation, bonuses, salary merit in-creases, incentive awards, employee stock op-tions, off-site pay, severance pay, cost-of-livingallowances, health and life insurance, pensions,retirement, annuities, and other fringe benefits.Of course, the scope of the review includes bothindirect- and direct-cost employees. Due to thehighly technical nature of defense work, laborcosts are usually significant cost drivers for bothdirect and indirect costs.

Contractor Insurance/Pension Reviews (CIPRs)

DFARS 242.73 requires a contractor insurance/pension review system for each contractorwhose qualifying contracts to the governmentexceeded $40 million during the contractorspreceding fiscal year. Qualifying sales are con-tracts for which cost or pricing data were re-quired or the contracts were priced on other thana firm-fixed price or fixed price with an eco-nomic price-adjustment basis. A CIPR is per-formed based upon an ACO’s request for con-tractors who meet these requirements. The ACO,with advice from the Defense Logistics Agency

Insurance/Pension Specialist and DCAA audi-tor, determines the need for a CIPR based on arisk assessment of the contractor’s past experi-ence and current vulnerability. A special CIPR,which is limited in scope, may be appropriateunder certain circumstances, such as prior to amajor contract award or subsequent to a mergeror divestiture. DCMA is the designated organi-zation responsible for performing the reviews,which are conducted jointly with the DCAA. Ifmajor issues are encountered, an actuary fromthe DCMA Overhead Center may join the team.At the completion of the reviews, recommenda-tions are made to the ACO, who is responsiblefor determining the allowability of thecontractor’s insurance and pension costs.

A CIPR represents a comprehensive and in-depth review of a contractor’s insurance pro-grams, pension plans, and other deferred com-pensation plans. The objective is to determinewhether the contractor’s plans are in compli-ance with the FAR and contract clauses, whichmay require a certain type of insurance withspecific coverage. An analysis is made of thecontractor’s insurance expenses for employ-ers liability, product liability, property and ca-sualty, employee group, and workmen’s com-pensation. The analysis of pension expensesincludes employee savings and thrift plans aswell as normal pension plans. Insurance andpension expenses are usually very large con-tributors to indirect expenses. At the presenttime, this is an area of very strong emphasison the part of DCMA due to the increasing levelof contract terminations, mergers, acquisitions,and consolidations ongoing as companiesdownsize. Of particular note are the issues in-volving pension expenses; they are not routinelyencountered, can become very complex, andinvolve very large amounts of indirect costs.

Material Management and AccountingSystem (MMAS) Reviews

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DFARS 242.72 requires that a contractor is sub-ject to material management and accounting sys-tem disclosure, demonstration, and maintainabil-ity if the contractor received certain “qualifiyingsales” of $40 million or more in the precedingfiscal year. Qualifying sales are those for whichcost and pricing data were required or that werepriced on other than a firm-fixed price or fixed-price with economic price adjustment basis. Thecognizant contract administration and audit ac-tivity jointly manage programs for evaluatingmaterial management and accounting systems.The ACO appoints a review team leader and en-sures that the team includes appropriate func-tional specialists, such as engineers, industrialspecialists, property administrators, and auditors.It is important to note that the reviews are notconducted on a regular recurring basis as theACO determines the need for a MMAS reviewbased on a risk assessment of the contractor’spast experience and current vulnerability.

A contractor’s MMAS sets forth the manage-ment controls for identifying requirements, ini-tiating procurements, and maintaining materi-als necessary to support production operations.It also provides accounting information neces-sary for product costing and inventory pricingpurposes. The personnel who are performingfunctions relating to materials management areoften classified as indirect-cost employees, andthese expenses are often major cost drivers ofindirect costs. For example, contractor employ-ees are engaged in expediting parts, controllinginventory, analyzing material problems, andwarehousing. In addition, these reviews focuson many management issues that affect indi-rect costs, such as excesses or shortages of in-ventory, rework, scrap, and returned material.Further, the accuracy of contract materialcharges (whether they are direct or indirect) arecovered in these reviews.

Earned-Value Management Systems (EVMSs)

DoD Regulation 5000.2-R, Appendix VI, pro-vides criteria for evaluating contractors earned-value management systems (formerly referred toas cost schedule control system criteria) on cer-tain large, risky, cost-based weapon system con-tracts. Industry standards based on “best prac-tices” have recently been developed forearned-value management systems. As an ini-tiative under acquisition reform, these standardshave been accepted by the government as a re-placement for the DoD cost/schedule controlsystems criteria (C/SCSC). Earned-value man-agement is a tool that allows both contractor andgovernment program managers to look into tech-nical, cost, and schedule progress on complexprojects. Essentially, it is a technique used to planand determine project status, and it provides forthe earning of a budget value as each unit ofwork is completed under a contract. It is a pri-mary function of program management thatplaces strong emphasis on the planning and in-tegration of technical, cost, and schedule aspectsof a program to support decision making by pro-gram managers. Indirect-cost management is animportant part of this.

DoD applies the industry EVMS criteria througha contractual clause on contracts that have anestimated research, development, test, and evalu-ation cost of $73 million or more or estimatedprocurement cost of $315 million or more. Be-low the mandatory thresholds, program mangersmay use less formal techniques consistent withanticipated risk. It should be noted that DoD setsminimum earned-value management systemsrequirements for firm-fixed-price contracts, timeand material contracts, or contracts that consistmostly of level-of-effort-type work only on anexception basis. The primary output of thecontractor’s earned-value management system isa monthly cost performance report (CPR), whichidentifies contract schedule and cost variancesalong with contractor comments on significantproblem areas, reasons for variances, andplanned corrective actions. Typically, the

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monthly CPR for major weapons systems pro-vides for the reporting of indirect expenses, witha requirement that the contractor analyze signifi-cant variances between budgeted and actual in-direct rates. Most important, program managerswant to identify, as early as possible, any nega-tive cost or schedule changes that will affect theperformance of their programs.

Today, most major defense contractors’ earned-value management systems have met govern-ment requirements. Over the past several years,contractors have completed a process of review,demonstration, and validation of their systems.For those contractors who do not have approvedsystems, the government will perform a Com-pliance Evaluation to assess the contractor’sproposed system against the industry standards.

After approval, the government maintains sur-veillance to ensure continued satisfactory sys-tem operation. The Contract AdministrationOffice (Defense Contract Management Agencyor Supervisor of Shipbuilding) carries out sur-veillance using a multifunctional team approachthat combines production and manufacturing,engineering, quality assurance, and programsupport groups. Program management officesand the DCAA provide support to the CAO asrequired. After the initial acceptance of thecontractor’s system, no further formal systemevaluation reviews are conducted unless thereis a serious need “for cause” determined by thegovernment. If required, a post-acceptance re-view (PAR) would be performed; but it maybe tailored and limited in scope to address onlyspecific issues, such as untimely cost data, inac-curate schedule data, or failure to address techni-cal problems.

DoD 5000.2-R also requires an Integrated Base-line Review (IBR) within 6 months of the awardof cost-type and fixed-price incentive contractsexceeding $6 million. This review is not a con-tractor systems-oriented review but a formal re-

view conducted jointly by the government pro-gram manager, technical staff, and their contrac-tor counterparts. This review will verify the tech-nical content, logical sequencing of the work,and adequacy of resources in the PerformanceMeasurement Baseline (PMB). An IBR is alsoperformed when work on a production optionof a development contract begins. Also, and IBRis conducted at the discretion of the programmanager, when a major modification to an ex-isting contract significantly changes the existingperformance management baseline.

The industry standard contains 32 specific cri-teria for an acceptable earned-value manage-ment system. The standards have been brokenout by nine business “process groups.” One ofthe business processes is the “indirect manage-ment” process. This process group provides thefollowing major requirements for contractorearned-value systems that specifically relate tohow the contractor manages indirect costs:

• The managerial positions responsible for es-tablishing and controlling indirect budgetsshould be clearly identified in the contractor’sorganizational structure.

• The PMB should contain budgets for indi-rect costs at the level appropriate for projector company management.

• The projected indirect costs, contract workbreakdown structure, and organizational lev-els should be established by a rational, trace-able budgeting process.

• The contractor’s disclosure statement shoulddefine the contractor’s indirect managementprocess. It should include a definition of in-direct expenses, description of overheadpools, and items of cost assigned to each over-head pool.

• Projected indirect rates should be adjusted in atimely manner to reflect: (a) changes in the cur-rent or projected base, (b) the level of over-head expenditures, and (c) the overhead struc-ture. The EVMS should use the most current

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overhead rates to establish the PMB.• The contractor’s accounting system should

provide for the summarization of indirectcosts from the point of allocation through theContract Work Breakdown Structure(CWBS), the Organizational BreakdownStructure (OBS), and the total contract level.

• Overhead rates should be updated frequentlyenough to ensure a realistic monthly alloca-tion of indirect costs without significant ad-justments to performance measurement in-formation.

• The evaluation of variances between indirectbudgets and costs should initiate managementaction to correct the causes of the variances.

• Indirect variances should be identified by el-ement of expense.

• To ensure that the most accurate rates are usedfor estimate at completion (EAC) purposes,the contractor’s system should base theserates on historical experience, contemplatedmanagement improvements, projected eco-nomic escalation, and anticipated businessvolume.

Government personnel working in the earned-value management area obtain considerableknowledge about the efficiency with whichthe contractor performs many functions thatare required to be integrated throughout theplant by program management. Many of thesefunctions are classified as indirect-costs bycontractors and may be significant cost driv-ers of indirect costs. Therefore, a resultingadditional benefit to government personnelevaluating earned-value management is thatan awareness is created of the necessity forthe performance of certain indirect functions,and valuable insight is gained as to the effi-ciency with which the indirect functions arebeing performed.

DCAA Operational Audits

The DCAA, a separate agency under the direc-tion and control of the DoD Comptroller, per-forms numerous functions relating to the moni-toring of indirect costs. This placement of DCAAunder the organizational control of the DoDComptroller provides an internal control mea-sure for DoD management because of the sepa-ration of an independent audit advisory functionfrom the acquisition management function.DCAA conducts all contract audits for DoD andprovides accounting and financial advisory ser-vices for the negotiation and administration ofcontracts and subcontracts. Based on discussionswith DCAA personnel, DCAA management hasrecently given executive emphasis to their op-erational auditing work. The purpose of opera-tional audits is to evaluate the economy and ef-ficiency of specific contractor functions oroperations. The audits may result in the identifi-cation of opportunities for cost reduction andmay provide benefits for future forward-pricingnegotiations.

The DCAA’s primary focus, when selectingwhere to conduct operational audits, is to moni-tor overhead-cost control, particularly at thelargest contractors. To ensure that significantcost savings potential is present, risk assess-ments are performed prior to commencing theaudits. The DCAA has recently reported suc-cessful operational audits, which resulted in sig-nificant reductions in indirect costs. These au-dits had considerable involvement of industrialengineers, and they include the following items:

• elimination of idle facilities and reduction infloor space through cancellation of leases

• reduction in the number of computer servicecenters

• make-versus-buy analyses• cost containment measures regarding em-

ployee health care and workmen’s compen-sation costs

• improvement in supplier rating systems

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• sharing of “best practices” with subcontrac-tors and suppliers

• direct and indirect labor utilization

DCAA personnel report that they are gettingincreased cooperation from contractors byperforming the operational audits in a con-structive, noncritical, team-oriented manner.As an example, a recent joint DCAA/DCMAoperational audit in the information systemsarea indicated that considerable savings of ap-proximately $6 million could be achieved ifcertain work was performed by software ven-dors rather than by in-house personnel. Aftercompletion of the joint DCAA/DCMA opera-tions audit, the contractor performed a largerscale review and found that $12.5 million ratherthan $6 million could, in fact, be saved with fur-ther elimination, reduction, consolidation, andoutsourcing of certain work.

DCAA Systems Reviews

In addition to the increased focus on overheadin performing operational audits, the DCAAperforms (as a normal part of its contract audit-ing function) a number of pertinent contractorsystems-oriented reviews. Although the specificobjectives of the reviews are not to analyze theamount of indirect costs, the systems reviewsare very relevant to the monitoring of indirectcosts. For example, the reviews are orientedtoward evaluating the effectiveness of large sys-tems, such as electronic data processing, ac-counting, billing, etc., that are used for effi-ciently managing all work at contractor plants.These systems are usually uniquely designedby the contractor and are based on the nature ofits business and the products it makes. In theprocess of performing these reviews, the DCAAmust perform an evaluation of the effectivenessand efficiency of the performance of numerousfunctions. Any functions that are unnecessary,duplicative, or inefficient should surface. Sincecontractor management systems, by their nature,

relate to the total business, the people workingin this area are primarily indirect-cost or over-head personnel. Consequently, from the govern-ments perspective, the performance of these re-views makes a very strong contribution towardthe monitoring of indirect costs. For example, ifthe electronic processing or accounting functionsare overstaffed, it should become apparent whenthe large-scale reviews are conducted.

It is DCAA’s policy that each relevant account-ing or management system that has a signifi-cant impact on government contract costs bereviewed on a cyclical basis. The frequency ofthe reviews is based on a risk assessment; how-ever, generally they are conducted every 2 to 4years. While the nature and extent of the auditeffort depends upon the contractor’s size, theamount of government business, and the riskassessment, the coverage normally includes thefollowing contractor systems reviews:

Accounting System Reviews

Contractors receive various cost-reimbursementand incentive contracts, which provide for pay-ments based on costs or on a percentage or stageof completion. Therefore, they must establishand maintain an accounting system that pro-vides assurance that cost accounting informa-tion is reliable and that the risk of misallocationsand mischarges are minimized. Contractors’cost accounting systems should be written andshould provide a complete description of all costaccounting practices affecting government con-tracts. The requirement for a disclosure state-ment, as explained in Chapter 7, should satisfythis requirement for those contractors coveredby Cost Accounting Standards. Contractorsshould also have policies and procedures forensuring that any changes made in cost account-ing practices are properly disclosed to the gov-ernment along with the related cost impact ongovernment contracts.

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In the performance of accounting system re-views, DCAA conducts numerous tests that tiein specifically with the monitoring of indirectcosts. These tests cover an evaluation of thecontractor’s methods of:

• assigning costs as direct or indirect to costobjectives;

• ensuring that indirect costs are accumulatedin logical, homogeneous cost pools;

• determining that allocation bases used by thecontractor for the allocation of indirect costsare equitable;

• ensuring that items of the same nature asthose charged as direct costs are not includedin the indirect-cost pools;

• evaluating the adequacy of functional or de-partmental breakdown of indirect expenses;

• ensuring that costs are properly classified asallowable or unallowable;

• ensuring that there is clear identification ofpersonnel responsible for preparing and ap-proving business transactions; and

• evaluating the currency of the system from atechnological modernization perspective.

Electronic Data Processing System Reviews

The extensive use of computers and other elec-tronic data processing (EDP) equipment by de-fense contractors requires that DCAA review,from an internal control perspective, the EDPorganization, functions, and control proceduresused throughout contractor’s operations. EDPsystem reviews are becoming more and moresignificant due to the increased use of comput-ers, the increased need for software, and the con-stantly changing technology. EDP systems aremajor cost drivers because of the large costs as-sociated with equipment, software, and person-nel. In performing EDP system reviews, theDCAA becomes very familiar with the manyfunctions performed and with how effectively theyare performed. For example, an EDP system re-view would include an evaluation of hardware

acquisition, software development work, systemstests, computer operations, database administra-tion, security, system maintenance, and the use-fulness of output information. The EDP systemsreview is of tremendous benefit in evaluating thereasonableness of contractor indirect costs as thesemajor costs are primarily indirect in nature. In fact,this has been an area of considerable importancein recent contractor actions to reduce overheadcosts through the combining of computer-centeroperations and the standardization of systemsthrough adoption of best practices. In addition, avery fertile area for possible reduction in indirectcosts is the analysis of the purchase of computerservices from outside vendors versus in-house per-formance by contractor computer-center person-nel.

Contractor Budget and Planning SystemReviews

DCAA’s primary objective in conducting bud-get and planning system reviews is to establishthat a sound budgetary system is operating forcompany planning and control purposes. Thereviews are performed at least every 3 years forthose contractors that receive DoD prime con-tracts or subcontracts of at least $50 million andthat require the submission of cost or pricingdata. These reviews may also be considered atsmaller contractor locations where there are in-dications of significant budgeting-system prob-lems. Contractors are expected to prepare bud-gets for all major activities within their plantthat will have an impact on government con-tracts. A major consideration in performingthese reviews is whether the reports to the gov-ernment on major contracts for weapon systemsare consistent with the contractor’s latest bud-getary data used for internal management pur-poses. In addition to ensuring that managerialobjectives are met, the contractor’s budgetarysystem provides valuable data for use in devel-oping estimates, particularly indirect-cost projec-tions and cost-allocation-base estimates.

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Labor System Reviews

DoD weapons systems require a high degree ofengineering; and, consequently, labor is usu-ally a very significant cost that is charged todefense contracts. In addition, direct labor isoften used as the base for allocating indirectcosts, particularly in engineering areas. There-fore, DCAA places considerable audit empha-sis on the management controls exercised bycontractors for ensuring that labor costs chargedto DoD contracts are in compliance with costaccounting standards, generally accepted ac-counting principles, and contract terms. Usu-ally, a defense contractor could expect to havethe DCAA perform “floor checks” on a regularbasis as a component of their internal controlreviews. In addition to evaluating the adequacyof the contractor’s labor-recording system andassessing control risk relating to allocability andallowability of labor costs, the DCAA consid-ers these reviews to be very important from anindirect-cost monitoring standpoint. In the pro-cess of performing the reviews, the governmentpersonnel are on the production floor and con-tinuously observing numerous contractor activi-ties. The onsite observations can provide leadson questionable levels of indirect costs, suchas idle personnel, equipment, or facilities. Theseareas would then be subject to examination inmore detail with an operational audit.

Billing System Reviews

DCAA performs reviews of contractor billingsystems in order to ensure that vouchers sub-mitted by the contractor for payment under DoDcontracts are prepared in accordance with ap-plicable regulations, advanced agreements, andspecific contract terms. Since it is not practicalto audit billings other than on a test basis, thecontractor should have controls in place forapplying the proper indirect expense rates inthe billings. If significant deviations occur be-tween billing rates and rates that are actually

being incurred during the year, adjustmentsshould be promptly made to the billing rates.Systems should be in place to ensure that, atyear’s end, the amount of indirect costs reim-bursed to the contractor is as close as possibleto the actual allowable billing rates.

DoD “Should-Cost” Reviews

The concern for increased indirect costs due tothe decline in defense business has resulted inDoD management actively pursuing the use of“should-cost” reviews as a means to help drivedown contractor indirect costs. Should-cost re-views can be oriented toward achieving costavoidances for both direct and indirect costs.Many government procurement personnel ex-press the opinion that should-cost reviews havebeen found to be particularly beneficial whenthey are performed in conjunction with the evalu-ation and negotiation of major sole-source pro-posals or major forward-pricing rate proposals.

A should-cost review is a specialized form ofcost analysis that is used to challenge acontractor’s management and operating sys-tems. Should-cost reviews do not assume theuse of the contractor’s existing workforce, meth-ods, facilities, or management and operatingsystems. It represents a large-scale, penetrat-ing, and in-depth analysis, which requires anumber of highly experienced government per-sonnel. Historically, should-cost reviews havebeen primarily of two types — program or over-head should-cost reviews. The program should-cost review must be performed in certain cir-cumstances before the award of a major systemscontract. These circumstances are when:

• a contract that is expected to exceed $100 mil-lion is to be awarded on a sole-source basis,

• there are future-year production requirementsfor substantial quantities of like items,

• some initial production has already takenplace,

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• major changes in the system are unlikely, or• the items being acquired have a history of in-

creasing costs.

On the other hand, overhead should-cost re-views are large-scale reviews that focus on in-direct costs relating to the contractor’s entireoperations rather than to a specific program.It includes an analysis of significant indirect-cost drivers as well as the appropriateness ofthe various direct-allocation bases for the in-direct expenses. At the present time, DCMAconsiders the primary drivers of overhead tobe indirect labor, fringe benefits, computer-associated costs, and facilities-related ex-penses. Considerable effort in overheadshould-cost reviews is directed to an evalua-tion of the estimate of the contractor’s totalbusiness base, including defense and commer-cial programs. The overhead should-costanalysis is intended to challenge thecontractor’s existing manpower, methods, fa-cilities, and management control systems thatare classified as indirect expenses. Conse-quently, it is essential that overhead should-cost reviews employ integrated teams of gov-ernment engineering, contracting, contractadministration, pricing, and auditing person-nel from both local and regional DCMA andDCAA offices as well as personnel from DoDprogram offices. Overhead should-cost teamsare usually organized into four sub-teams — asales forecast/business-base team, indirect la-bor team, non-labor expense team, and an in-tegrating team. Because of the comprehen-sive nature of overhead should-cost reviews,staffing requirements have, in some cases, ex-ceeded 50 team members.

Recent changes to the DFARS provide that thegovernment should consider performing anoverhead should-cost review of a contractor’sbusiness segment when:

• projected annual sales to DoD exceed $1 bil-lion;

• projected DoD business exceeds 30 percentof the contractor’s total business;

• the level of sole-source DoD contracts is high;• a significant volume of proposal activity is

expected;• production or development of a major weap-

ons system or program is anticipated; and• contractor cost-reduction initiatives appear

inadequate.

Generally, overhead should-cost reviews are notperformed more frequently than every 3 years.

Overhead should-cost reviews are extremelyunpopular with industry primarily because theyspecifically relate to indirect costs, which areoften considered by management to be discre-tionary. In addition, the government often re-quests access to the contractor’s total businessoperations, which includes commercial businessas well as specific government programs or con-tracts. Overhead should-cost reviews are alsovery resource consuming for both the contrac-tor and the government. The large amount ofcontractor data that is required to be providedto the government for overhead should-cost re-views is considered to be highly sensitive, pro-prietary information and must be closely pro-tected from disclosure to unauthorized personnel.

One current primary objective of the DCMA isto strengthen its capabilities for monitoring in-direct costs. Of particular importance is thestrengthening of its ability to manage overheadshould-cost reviews. The selection of contrac-tors as candidates for overhead should-cost re-views is based on recommendations receivedfrom several sources. DCMA practices providefor the prioritization of the overhead should-cost reviews at contractor locations based on arisk assessment conducted with input frommajor buying activities as well as from localcontract administration and audit personnel. A

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risk assessment is conducted for those contrac-tors who have flexibly priced contracts with thegovernment that, in total, are greater than $100million. Many factors are considered in the riskassessment. In addition to the amount of busi-ness that is done with DoD on a flexibly pricedbasis, DCMA is also concerned with sales trendsin order to target those contractors offering thegreatest opportunity for significant cost reduc-tions. DCMA also considers the volume ofplanned proposals, particularly those for devel-opment or production work. DCMA criteria in-cludes a consideration for the current status ofthe adequacy of contractors’ management con-trol systems. For example, certain systems suchas the contractor’s estimating system, purchas-ing system, earned-value system, and account-ing system may require government review andvalidation. Consideration is also given to theadequacy of the contractor’s overhead-cost re-duction efforts and to what extent such contrac-tor efforts are shared with the government. Dueto the large amount of merger and acquisitionactivity in the defense industry, a significant factorconsidered by DCMA is whether or not the con-tractor has been involved in a recent major re-structuring. If so, an overhead should-cost re-view could result in a duplication of effort as thegovernment could be in the process of evaluat-ing the contractor’s cost-savings plans resultingfrom restructuring activities.

Recent trends seem to be toward the concept oftailoring all should-cost reviews (to the maxi-mum extent) to the specific concerns of theDCMA customer, the program offices, and buy-ing commands. For example, the scope of ashould-cost review could be only a specificproduct or specific indirect-cost driver as op-posed to a more encompassing program or to-tal overhead-cost review. The trend also seemsto be toward the use of smaller governmentteams whose participants are more experienced

and have strong backgrounds in analyzing indi-rect costs.Correction of Problems

The ACO is responsible for ensuring that con-tractors are responsive to recommendationsmade by government personnel during their in-direct-cost monitoring efforts, which are iden-tified in the tracking of actual rates, operationsaudits, and overhead should-cost reviews. If thecontractor disagrees with recommendationsmade by government personnel, they will re-spond with their rationale for disagreement inwriting to the ACO. Otherwise, the contractorwill submit a corrective action plan detailingthe actions to be taken to correct any deficien-cies or plans to reduce indirect costs. The ACOhas tremendous clout in monitoring indirectcosts; and, in very serious situations, the ACOcould suspend progress payments or reimburse-ment of costs based on the estimated cost riskto the government. In addition, on a continu-ous basis, the ACO considers the status of allgovernment monitoring efforts during the nego-tiation of indirect rates for forward-pricing andbilling rate purposes.

Program Office and DCMA Relationship

Program managers and their staffs cannot effec-tively manage the acquisition of a weapons sys-tem unless they understand their contractor’s coststructure and stay abreast of the status of theircontractor’s total business. Program office person-nel should, to the maximum extent, use the ex-pertise available from the government cost-monitoring staff who are very familiar with thecontractor’s operations. The ACO, who is a mem-ber of the DCMA, is designated as the single pointof contact for the government at the contractor’splant. The ACO has the responsibility of keepingthe procurement contracting officer and programmanager informed of the current status of indirectcosts and any potential major problem areas thatcould affect cost performance.

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The ACO should periodically brief program of-fices on the:

• contractor’s indirect-cost control systemmethods used by the government to monitorindirect costs

• current status of actual indirect rates com-pared to forecasted rates

• current status of forward-pricing rate nego-tiations

• current status of the settlement of the prioryear’s actual rates

• the status of any of the contractor’s specialprojects to reduce indirect costs

• organizational changes• business process changes• operations audits• the current status of any major indirect-cost

issues (i.e., environmental costs, restructur-ing costs, health care benefits, etc.)

In addition, the ACO should request inputfrom the program offices as to any concernsthat they may have about the contractor’s in-direct costs. These concerns should then be

strongly considered in performing risk assess-ments and in making decisions on the areasthat should be examined in more detail inconjunction with selecting operational audits.The briefings should also serve to emphasizeto program managers the need for program-matic input regarding the contractor’s fore-casted business base. Program office person-nel need to be sensitive to overhead issuesand recognize when they should convey tothe ACO certain information that could havea significant impact on indirect-cost rates. Thecomplexity of controlling indirect-costs ne-cessitates the sharing of information on acontinuing basis between the program offices,DCMA, DCAA, as well as with contractors.The fact that the program manager is a majorcustomer of the contractor and has tremen-dous clout in dealing with the contractorshould never be forgotten. The program man-ager should encourage their contractors to bevery aggressive in managing indirect costs.In this regard, some program managers haverecently placed contractual incentives on thecontractor’s ability to control indirect costs.

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Sum-1

SUMMARY

Indirect costs are applicable to the entire contractor business base and are, to a greatextent, discretionary in nature. Issues that affect indirect or overhead costs presentproblems that reoccur each fiscal year. The contractors have the responsibility tomanage these very significant costs. How contractors classify their costs — direct orindirect — is entirely up to them. But contractors are required to have a managementcontrol system in place to effectively manage these costs. Defense contractors havebeen very concerned about high overhead costs due to the declining business baseand have undertaken special projects to address the problem. For competitive rea-sons, they have made large-scale efforts to reduce indirect and overhead costs.

The role of the government is to monitor rather than to manage indirect cost. Clearly,the government has the necessary capability in place to adequately monitor contrac-tors’ indirect costs. If the system works as designed and all team members, includingthe program offices, perform their functions, the government program manager shouldnot be surprised by any large financial impacts due to the application of indirect ratesto direct costs for their program. The developmental nature and tremendous risksinvolved in DoD work often dictate a need to perform the work on a contractual basisthat is flexibly priced. Experiences with major programs (such as the A-12 aircraftprogram) have shown significant problems often arise when attempts are made toperform work on a fixed-price basis. When it is necessary to perform work on anegotiated basis, the government assumes greater risk and must work closely withcontractors to ensure that indirect costs are aggressively controlled.

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