Comparative and Trend Analyses in Risk Assessments

Happy New Year everyone and welcome to our first blog post of 2019. As we begin this new year, the Government is in the midst of a partial shutdown. However, Defense, Energy, Education, VA, Labor, and Health and Human Services remain fully funded, open and are conducting business as usual. Agencies affected by the shutdown include Justice, Agriculture, Treasury, State, Interior, Transportation, Commerce, and HUD. Companies with contracts with those agencies might be feeling an impact, or soon will. No one is yet predicting how long the partial shutdown will last. If this one is like previous shutdowns however, all those furloughed Government employees will receive their full pay - they just get, what amounts to extra paid vacation.

But since contract auditors are, for the most part, open for business, this is not a time to sit back and let your policies, procedures, practices, and internal controls take a furlough. Those things are important - past, present, and future. They are important for supporting incurred costs, for supporting estimates of future costs, and used by auditors for trend analyses and comparative analyses. How do contract auditors employ trend/comparative analyses in their work and what are the results of those analyses used for? To answer those questions, we'll take a look at a standard audit program for evaluating labor costs using employee interviews. How do auditors decide who from hundreds or thousands of employees to interview? Their's is not a haphazard selection. Auditor's expend a lot of effort into a risk assessment, the results of which lead the auditor to select specific persons (or groups of persons) they need to check on. One of the steps in performing the risk assessment is the trend analysis/comparative analyses steps.

Auditors are free to and expected to exercise their professional judgment as to what kinds of comparative and trend analyses need to be performed. But there are two specific analyses called for in the standard audit program: ratio of direct to indirect labor and trend lines of sensitive accounts.

1. Ratio of direct to indirect. Auditors will perform trend analyses to disclose any significant increases in the ratio of direct to indirect labor accounts. If disclosed, contractors will be requested to explain those fluctuations. If there is no apparent (or satisfactory) explanation, auditors are instructed to further evaluate those fluctuations.

There was a not-so-famous case years ago - back when there were caps on IR&D/B&P expenditures - where such an analysis showed that indirect costs increased significantly in the last couple of months of the fiscal year. Further investigation disclosed that this increase coincided with the contractor reaching its maximum IR&D expenditures. A criminal investigation and subsequent settlement disclosed that employees were instructed to mischarge their time once the IR&D budget was exhausted. The contractor ended up sending a lot of money back to the Government.

2. Comparative analysis of sensitive labor accounts. Auditors are instructed to perform comparative analyses of sensitive labor accounts. What are sensitive labor accounts?  That's not stated but probably includes any labor accounts that are charged directly or indirectly to Government contracts - especially cost-type (or reimbursable) contracts. Again, contractors will need to be able to explain significant fluctuations. Auditors are looking for situations where labor is being excluded from an indirect allocation base or mischarged from the direct labor base to the indirect cost pool. By omitting a project or product line from the indirect allocation base, the resulting rate will be increased and the Government overcharged.

DoD Formally Rescinds IR&D Technical Discussion Regulation

The Defense Department amended it FAR Supplement (DFARS) back in November 2016 to require contractors to engage in and document a technical interchange as part of the criteria for determining the allowability of IR&D (Independent Research and Development) expenses. Before IR&D costs could be considered allowable under Government contracts beginning in 2017, contractors were required to engage in a technical interchange with a technical or operational DoD Government employee before the costs were incurred.

DCAA (Defense Contract Audit Agency) published guidance telling its auditors to question any IR&D expenses that were not supported by documentation that a technical interchange occurred prior to the costs being incurred.

The requirement was essentially unworkable since on one within DoD knew what technical exchanges were supposed to look like. Additionally, there wasn't enough technical people within the procurement community to engage in deep technical discussions with contractors, and tirdly, no one with DoD was volunteering to step up and have such discussions.

Less than a year later, in September 2016, the Defense Department issued a class deviation directing contracting officer to not require contractors to engage in technical exchanges as a condition of cost allowability. DCAA issued conforming guidance that instructed its audit staff to no longer question IR&D costs for lack of technical interchange documentation. This guidance applied to all current and future audits of any type.

Last week, the Defense Department formally and quietly rescinded the requirement.

DoD is amending the DFARS to remove the text at DFARS 231.205-18(c)(iii)(C)(4) which requires major contractors to engage in and document a technical interchange with the Government, prior to generating independent research and development (IR&D) costs for IR&D projects initiated in fiscaal year 2017 and later, in order for those costs to be determined allowable.

DoD further stated that

...the DFARS coverage was outmoded and recommended removal, since requiring a technical interchange between the Government and major contractors is unnecessary. The objective of the interchange can be met through other means.

This is perhaps the quickest that any regulation has become "outmoded" in the history of procurement regulations - 10 months from a necessary regulation to becoming outmoded.

Requirement to Engage in Technical Exchanges of IR&D Projects Lifted

DFARS (DoD FAR Supplement) 231.205-18 was amended back in November 2016 to require contractors to engage in or document a technical interchange as part of the criteria for determining allowable IR&D (Independent Research and Development) costs. In order for IR&D costs to be determined allowable for IR&D projects initiated in fiscal years 2017 and later, major contractors are required to engage in a technical interchange with a technical or operational DoD Government employee before IR&D costs were incurred. Additionally, the regulations required that contractors document the interchange in the Defense Technical Information Center (DTIC).

This requirement was essentially unworkable since no one within DoD knew what technical exchanges were supposed to look like. Additionally, there wasn't enough technical people withing the procurement community to engage in deep technical discussions with contractors and thirdly, no one within DoD was volunteering to step up and have such discussions. In short, the requirement was unworkable.

Realizing the ridiculousness of the requirement, DPAP (Defense Procurement Acquisition Policy) issued a Class Deviation  last September directing contracting officers to not require contractors to engage in the technical interchange. As a result of the Class Deviation, the requirements of DFARS 231.205-18/(c)(iii)(C)(4) are no longer part of the criteria a contracting officer must consider in determining a contractor's allowable IR&D costs.

DCAA (Defense Contract Audit Agency) has now issued conforming guidance to its auditors - not only for current IR&D expenditures but retroactive from when the requirement first became effective (i.e. Fiscal Year 2017). Specifically, the guidance instructs contract auditors "For all current and future audits of any type, no audit procedures should be performed to verify that the contractor engaged in technical interchanges prior to incurring independent research and development (IR&D) costs."

Good news for contractors.

Technical Interchanges of IR&D Projects No Longer Required as a Condition of Allowability

Good news for major defense contractors.

The Department of Defense issued a class deviation regarding the requirement for Independent Research and Development technical exchanges. (See Class Deviation 2017-O0010 dated September 14, 2017).

Under the existing DFARS (DoD FAR Supplement) Cost Principle (DFARS 231.205-18(c)(iii)(C)(4), major contractors are required to engage in or document a technical interchange as part of the criteria for determining a contractor's annual independent research and development costs to be allowable.

This requirement has been controversial since it was enacted back in 2016 primarily because DoD didn't develop the internal structure to host or coordinate these technical exchanges. DCMA (Defense Contract Management Agency) backed away from any involvement early on saying it didn't have anyone qualified to engage in such technical interchanges. (see Enhancing the Effectiveness of Independent Research and Development for more information on requirement).

As a result of this deviation the actions require by DFARS (engaging in technical interchanges with a technical or operational DoD Government employee prior to the generation of IR&D costs and documenting those interchanges) are no longer part of the criteria a contracting officer must consider in determining a major contractor's IR&D costs to be allowable.

This class deviation is effective until it is incorporated in DFARS or until it is rescinded. Look for it to be incorporated into DFARS. It was bad policy from the beginning.

DoD Relaxes IR&D Technical Interchange Rules for Fiscal Year 2017

Last month, a new regulation requiring DoD contractors who expend more than $11 million a year on IR&D activities to engage in technical interchanges with DoD employees before the costs were incurred as a condition of allowability, went into effect (see Contractors Must Now Engage in Technical Exchanges with DoD Prior to Incurring IR&D Costs).

Many contractors are already in their fiscal years 2017 and for calendar year contractors, 2017 is just a month away. It seemed impractical, if impossible, for contractors to engage in constructive technical interchanges with DoD personnel in such a short period of time so DoD last week, relaxed the rules to allow discussion to occur sometime during fiscal year 2017 instead of requiring discussions prior to the incurrence of costs in 2017 (see Class Deviation - Enhancing the Effectiveness of Independent Research and Development).

The old and new requirements read as follows. Differences are italicized.

OLD: For IR&D projects initiated in the contractor's fiscal year 2017 and later, as a prerequisite for the subsequent determination of allowability, the contractor shall engage in a technical interchange with a technical or operational DoD Government employee before IR&D costs are generated so that contractor plans and goals for IR&D projects benefit from the awareness of and feedback by a DoD Government employee who is informed of related ongoing and future potential interest opportunities. 

NEW: For IR&D projects initiated in the contractor's fiscal year 2017, as a prerequisite for the subsequent determination of allowability, the contractor shall engage in a technical interchange with a technical or operational DoD Government employee sometime during the contractor's fiscal year 2017 so that contractor plans and goals for IR&D projects benefit from the awareness of and feedback by a DoD Government employee who is informed of related ongoing and future potential interest opportunities.

The class deviation applies only to contractor fiscal years 2017 and alleviates the requirement that the technical interchanges occur before costs are generated for IR&D projects initiated in the contractor's fiscal year 2017 to afford contractors a phase-in period to develop processes and procedures.

DoD Wants to Add IR&D Costs to "Evaluated" Cost of Proposal

Last Friday, we discussed the new DFARS (DoD FAR Supplement) provision that requires contractors to engage in "technical discussions" with someone withing DoD concerning their IR&D (Independent Research and Development) projects as a precondition to having costs associated with those projects, reimbursed by the Government (see Contractors Must Now Engage in Technical Exchanges with DoD Prior to Incurring IR&D Costs).

The controversies over this provision lies in the perceived bureaucratic obstacles that will get in the way of contractor efficiency and effectiveness in deciding when to initiate new IR&D programs. The Government doesn't seem to think it will be a big deal but such preconditions often become impediments.

Now, DoD is proposing regulations that will take these same IR&D costs and add them to contractors' cost proposals if the two are related. That way, a contractor cannot use IR&D funds to gain a competitive cost advantage over another contractor that is spending its IR&D funds on programs unrelated to the proposed program.

DoD is proposing to amend the DFARS to require contracting officers to adjust the total evaluated price of ... proposals, for evaluation purposes only, to include the amount by which the offerors propose that future independent research and development investments reduce the price of the proposals

The objective of this rule is to ensure that substantial future independent research and development expenses, as a  means to reduce evaluated bid prices in competitive source selections, are evaluated in a uniform way during competitive source selections.

Fortunately, for most contractors, this new requirement will apply only to major defense acquisition programs (10 USC 2430) and major automated information systems acquisitions (10 USC 2445a). Most small entities should not be impacted as major defense acquisition programs and major automated information systems acquisition policies normally apply to large contractors, because the cost, magnitude, and production requirements of such programs are generally beyond the capability or capacity of small entities.

Remember, DoD will already have reams of information concerning the technical direct of contractor IR&D projects as a result of the new requirement for contractors to engage in technical discussions prior to incurring any costs under the programs. You can be certain that that information will be available and used to ensure that contractors comply with this new regulation when it becomes final.

Contractors Must Now Engage in Technical Exchanges with DoD Prior to Incurring IR&D Costs

Last February, DoD published a proposed regulation for its FAR Supplement (DFARS) that would require "major contractors" to engage in technical interchanges with DoD before IR&D costs (Independent Research and Development Costs) are generated. Major contractors in this context are defined as those that allocate more than $11 million in IR&D and B&P (Bid and Proposal) costs per year to DoD prime contracts (see Enhancing the Effectiveness of Independent Research and Development). The effective date of this new requirement is today, November 4, 2016.

The new regulation adds a provision to DoD's cost principle on IR&D costs at DFARS 231.205-18 that reads as follows:

For IR&D projects initiated in the contractor’s fiscal year 2017 and later, as a prerequisite for the subsequent determination of allowability, the contractor shall— 

1. Engage in a technical interchange with a technical or operational DoD Government employee before IR&D costs are generated so that contractor plans and goals for IR&D projects benefit from the awareness of and feedback by a DoD Government employee who is informed of related ongoing and future potential interest opportunities. If the contractor does not have a point of contact for the technical interchange, the contractor may contact the Office of the Assistant Secretary of Defense for Research and Engineering (OASD R&E). Contact information for OASD R&E can be found at http://www.acq.osd.mil/rd/contacts/; and 

1. Use the online input form for IR&D projects reported to DTIC to document the technical interchange, which includes the name of the DoD Government employee and the date the technical interchange occurred. 

This new provision is essentially unchanged from the proposed revision to which there were significant public concerns raised over the efficiency, efficacy, and practicalities of engaging in a technical dialog with a DoD employee prior to incurring any costs under the IR&D project.

DoD believes that this "dialog" will enhance the effectiveness of IR&D projects by ensuring that both IR&D performers (i.e. contractors) and their potential DoD customers have sufficient awareness of each other's efforts and provide industry with some feedback on the relevance of proposed and completed IR&D work.

DoD, in response to concerns of bureacratic bungling, downplayed such potential, promising that DoD would sufficiently have its act together so as not to pose an impediment to contractor plans. Time will certainly tell on that one. In the meantime, contractors should be aware that the contract auditors now have another tool to question costs - failure to engage in technical interchange.

New Guidebook on Cost Principles from DCAA

The Defense Contract Audit Agency (DCAA) has eliminated Chapter 7, Audit Guidance on Selected Areas of Costs, from its Contract Audit Manual and replaced it with a new and greatly expanded guidebook on FAR Part 31 Cost Principles. DCAA writes:

This Guidebook addresses FAR 31.2 and other areas of cost audited. In this first edition of the guidebook, we have expanded what used to be included in Chapter 7 by adding 23 additional chapters to address FAR 31.2 cost principals that had not previously been included in CAM. Initially, many sections of the guidebook are a replica of what was in Chapter 7; however, we have rewritten and updated 13 areas of cost. We will be continuing to rewrite the other chapters in this guidebook and will publish them as completed.

The 13 updated chapters include:

1. Bonus and incentive compensation (Chapter 7)
2. Depreciation (Chapter 19)
3. IR&D/B&P (Chapter 33)
4. Legal (Chapter 41)
5. Royalties (Chapter 64)
6. Pensions (Chapter 53)
7. Manufacturing and production engineering (Chapter 45)
8. Joint ventures and teaming arrangements (Chapter 37)
9. Insurance (Chapter 34)
10. Idle facilities and idle capacity (Chapter 32)
11. Patents (Chapter 52)
12. Consultants (Chapter 58)
13. Alcoholic beverages (Chapter 2)

This new guide is definitely a work in process as many of the chapters state "This chapter is currently under construction.

The cost covered by the guide are listed in alphabetical order rather than FAR Part 31 order which may be easier or more cumbersome to navigate depending upon your familiarity with FAR. It appears that each FAR cost principle is covered as well as many other types of costs not specifically covered in the FAR.

We should note that this is intended to be guidance for the contract auditor and not the final word on what is allowable or not allowable. Many disputes have risen over DCAA's interpretation of FAR and the Government does not always prevail.

You can access DCAA's new guidebook directly by clicking here. 

Enhancing the Effectiveness of Independent Research and Development

About four years ago, the Department of Defense (DoD) revised its FAR Supplement (DFARS) to make the allowability of Independent Research and Development Costs (IR&D) contingent upon reporting IR&D projects and costs into on on-line system (see Allowability of IR&D Costs Now Contingent Upon Reporting). Last Fall, DoD issued a "White Paper" recommending an added condition that would require contractors to notify the Government prior to incurring costs on IR&D projects. (see DoD Wants Contractors to Disclose Their IR&D Activities Before Incurring Any Costs, Disclosure of IR&D Projects Prior to Incurring Costs, and Failure to Report IR&D Expenditures May Render Such Costs Expressly Unallowable).

In a step toward making its wish come true, DoD published a revision to its  IR&D cost principle today (DFARS 231.205-18 that, if adopted, will add the pre-notification requirement as a condition of making IR&D expenditures allowable under Defense contracts.

Specifically, the proposal adds the following requirement to the existing cost principle:

For IR&D projects initiated in the contractor's fiscal year 2017 and later, as a prerequisite for the subsequent determination of allowability, major contractors must (i) engage in a technical interchange with a technical or operational DoD Government employee before IR&D costs are generated so that the contractor plans and goals for IR&D projects benefit from the awareness of and feedback by a DoD employee who is informed or related ongoing and future potential interest opportunities and (ii) use the online input form for IR&D projects reported to DTIC to document the technical interchange, which includes the name of the DoD Government employee and the date the technical interchange occurred.

"Major contractors" in the foregoing requirement are those that allocate more than $11 million in IR&D and B&P (Bid and Proposal) costs per  year to DoD prime contracts.

According to the proposal, the intent of such engagement is not to reduce the independence of IR&D investment selection, nor to establish a bureaucratic requirement for Government approval prior to initiating an IR&D project. Instead, the objective of this engagement is to ensure that both IR&D performers and their potential DoD customers have sufficient awareness of each other's efforts and to provide industry with some feedback on the relevance of proposed and completed IR&D work.

We can foresee some logistical issues when trying to engage a DoD technical person prior to incurring IR&D costs. Finding someone qualified or with the right clearances to discuss IR&D projects in a timely manner could be problematic. Who in DoD will be responsible for "designating" the responsible person?

If you care to weigh in on this proposal, comments are due by April 18, 2015. Fiscal year 2017 is not that far off. For many contractors, it begins on July 1st of this year.

IR&D Funds Used to Augment Development Contracts

In its "Implementation Directive for Better Buying Power 3.0 - Achieving Dominant Capabilities Through Technical Excellence and Innovation" the Defense Department noted a concern when "promised future IR&D (Independent Research and Development) expenditures are used to substantially reduce the bid price on competitive procurements. In some cases, the Government believes that price proposals for developmental work are reduced by using a separate source of Government funding - namely IR&D funds - to gain a price advantage in a specific competitive bid. IR&D costs are allowable under the Federal Acquisition Regulations (FAR) and the DoD FAR Supplement (DFARS) with a few exceptions and are spread across a contractor's total business (usually) through the application of the G&A (General and Administrative) rate. According to the Defense Department, using such activities to undercut the competition is not the intended purpose of making IR&D an allowable cost.

This concern is not new. Contractors have wide latitude on how to spend their IR&D funds and as long as their is some level of "relevance" to the Government, the projects and related costs are rarely questioned. For decades, the Government has known contractors use IR&D funds to augment their "funded" developmental contracts.

The Defense Department is now considering a proposed approach whereby solicitations would require offerors to describe in detail the nature and value of prospective IR&D projects on which the offeror would rely to perform the resultant contract. Then, as a standard approach, DoD would evaluate proposals in a manner that would take into account the reliance by adjusting the total evaluated price to the Government, for evaluation purposes only, to include the value of related future IR&D projects.

The Defense Department is seeking comments on such an approach in order to assist in the development of a proposed DFARS rule. Specifically, the department is

...interested in understanding whether the planned approach would achieve the objective of treating the proposed use of substantial future IR&D expenses as a means to reduce evaluated bid prices in competitive source selections in a uniform manner that is consistent with the objective of making IR&D an allowable cost.

We don't see how this will ever work. But, if you've got any ideas, you might want to attend DoD's meeting next month.

Behind the Scenes - Labor Floorchecks

Most Government contractors (with cost-type contracts) have experienced the labor floorcheck circus. The contract auditor drops by, often unannounced, and informs the contractors that he is there to interview some employees to make sure they are complying with timekeeping policies and procedures (e.g. daily timecard postings) and that there is consistency between the work they are actually performing and what is indicated on their timecards. A listing of employees is produced and everyone heads out to the plant to find and interview those employees.

Contractors might wonder how the particular employees were selected. Auditors tend to be circumspect and might respond that they were randomly selected. The next question a contractor should ask is, randomly selected from what universe? You see, before the auditor shows up, he has undoubtedly performed some kind of risk assessment based on analysis of historical data and trends. Selections are not made haphazardly. Selections of employees to interview are usually made because the auditor wants to focus on a particular contract, or department, or charging practice.

Here are a few things that go on behind the scenes before an auditor shows up to conduct a floorcheck.

• Trend analysis - the auditor will perform trend analyses to disclose an significant increases in the ration of direct to indirect labor accounts. According to DCAA, significant fluctuations in the ratio of direct to indirect costs should be explained. If there is no apparent explanation, this are should be further evaluated to ensure that the contractor is not misclassifying direct contract costs to selling and marketing costs or to IR&D/B&P costs).
• Comparative analysis - the auditor will perform a comparative analysis of sensitive labor accounts and request contractors to explain significant fluctuations. The auditors are instructed to be alert to situations where labor is being excluded from overhead allocation bases or transferred from the allocation base to the indirect cost pool. Both situations would increase indirect rates.
• Overrun contracts - the auditor will determine contracts that are currently in an overrun position or projected to be in an overrun position. According to DCAA, labor effort associated with contracts at or near an overrun position is more likely to be mischaged. 
• Funding - Like overrun contracts, the unavailability of funding may cause the contractor to divert costs that are over the contract funds or budget to other cost objectives.

These are just a few of the factors an auditor will consider in making his selection of employees to floorcheck. An appreciation of these factors should help contractors better understand the auditors' focus when conducting floorchecks.

Failure to Report IR&D Expenditures May Render Such Costs Expressly Unallowable

Last week we spent a couple of postings on a proposal by DoD to require contractors to coordinate their IR&D (Independent Research & Development) plans with the Government (see: DoD Wants Contractors to Disclose Their IR&D Activities Before Incurring Any Costs) and the current rules that require contractors allocating more than $11 million of IR&D expenditures to Government contracts to report their expenditures in an online database (see: Disclosure of IR&D Projects Prior to Incurring Costs). The current rules have just begun to come into play - the DoD gave contractors until the end of 2014 to submit their initial reports.

The data submitted in on-line reporting facility are estimates and there is no expectation that they reconcile to actual costs. However, there is an expectation that the projects be reported in the database and this database will be accessible to both DCAA (Defense Contract Audit Agency) and DCMA (Defense Contract Management Agency) for their review.

This reporting requirement should not be taken lightly. It is a condition for the allowability of those IR&D costs. DCAA, for one, will be testing contractor projects against the reporting database and will, at a minimum, question any costs not found in the database. DCAA's guidance on the matter reads as follows:

If the contractor fails to input the IR&D information into the DTIC database, the costs are expressly unallowable; audit teams should question the costs and recommend application of penalties. If the team identifies significant expressly unallowable costs, consider reporting a noncompliance with CAS 405, Accounting for unallowable costs. 

So, in addition to questioning unreported IR&D costs, DCAA will recommend that the Contracting Officer level penalties for claiming expressly unallowable costs and if the particular contractor is subject to full or modified CAS (Cost Accounting Standards), will cite them in non-compliance with CAS 405 (which will add interest to the amount disallowed).

Disclosure of IR&D Projects Prior to Incurring Costs

Earlier this week we discussed DoD's recent "white paper" describing its plans to require contractors, as a condition of IR&D (Independent Research and Development) cost allowability, to notify the Government prior to expending any funds on the project. If you missed that posting, click here. Similar provisions already exist for "major contractors". Major contractors are those allocating more than $11 million of IR&D/B&P costs per year to DoD contracts. Regulatory coverage is found in DFARS (DoD FAR Supplement) 231.205-18, Independent research and development and bid and proposal costs. Section (c)(3)(C) of that cost principle states:

For a contractor's annual IR&D costs to be allowable, the IR&D projects generating the costs must be reported to the Defense Technical Information Center (DTIC) ... The inputs must be updated annually and when the project is completed. Copies of the input and updates must be made available for review by the cognizant administrative contracting officer (ACO) and the cognizant Defense Contract Audit Agency auditor to support the allowability of the costs.

Additionally, the ACO must determine whether IR&D/B&P projects are of potential interest to DoD and provide the results of the determination to the contractor.

The existing regulation differs from the proposed regulation in two major areas. First, the new regulations will apply to all DoD contractors; not just those allocating more than $11 million of IR&D costs to DoD contracts (and subcontracts). Second, the existing provision does not include a requirement to notify the Government prior to the expenditure of funds. It only requires annual reporting of projects and costs incurred.

Although the annual reporting is currently a condition for allowability and copies of inputs must be made available to DCAA, the Agency has not revised its guidance for auditing IR&D/B&P costs to require auditors to request such information. Since the $11 million threshold is very high, the reporting requirements affect relatively few contractors and DCAA management can ensure adequate audit coverage with a few phone calls. However, if the threshold is taken away so that all contractors must report, corresponding audit guidance might be needed.

DoD Wants Contractors to Disclose Their IR&D Activities Before Incurring Any Costs

The Department of Defense (DoD) issued a white paper on August 26, 2015 entitled "Enhancing the Effectiveness of Independent Research and Development (IR&D)". The Department's idea of enhancing effectiveness in this case is requiring contractors to notify the Department prior to initiating an IR&D project. Failure to notify the Government will render the costs potentially unallowable.

"... the Department and the Industrial Base need to work together to ensure the department has visibility into the opportunity created by government-reimbursed IR&D efforts performed by defense contractors. "

Contractor investments are not directed by the Government. They are identified by contractors to advance a particular ability to develop and deliver superior and more competitive products. According to DoD however, contractor IR&D efforts can have the best payoff when the Government is well informed of the investments that contractors are making and when contractors are well informed about related investments being made elsewhere in the Government's R&D portfolios and about Government plans for potential future acquisitions where this IR&D may be relevant.

To ensure that a two-way dialogue occurs and to provide some minimum oversight of IR&D expenditures, DoD believes that proposed new IR&D efforts should be communicated to appropriate DoD personnel. The Department's intent is not to reduce the independence of IR&D investment selection, nor to establish a bureaucratic requirement for Government approval prior to initiating an IR&D project. Instead, the objective of this engagement is to ensure that both IR&D performers and their potential DoD customers have sufficient awareness of each other's efforts and to provide industry with some feedback on the relevance of proposed and completed IR&D work.

The intent of this new policy is that by fiscal year 2017, every new IR&D project will be preceded by an engagement with appropriate DoD technical or operational staff to ensure that the department is award of the goals and plans for the effort. To document this interchange, DoD will require contractors to record the name and Government party with whom, and date when, a technical interchange took place prior to the IR&D project initiation.

Allowability Determinations.  Under DoD's proposal, the Defense Contract Management Agency (DCMA) and the Defense Contract Audit Agency (DCAA) will use the coordination information to make allowability determinations. Projects that haven't been "coordinated" prior to initiating work, may very well be determined unallowable. Expect auditors to test whether any costs were incurred prior to the coordination date. If they find any pre-agreement costs, expect the auditors to question them.

Allowability of B&P Costs to Prepare Cost Overrun Proposal

Bid and Proposal (B&P) costs are addressed in the FAR cost principles under FAR 31.205-18, Independent Research and Development and Bid and Proposal Costs (IR&D/B&P). The definition of B&P is given in Section (a):

"Bid and proposal (B&P) costs” means the costs incurred in preparing, submitting, and supporting bids and proposals (whether or not solicited) on potential Government or non-Government contracts. The term does not include the costs of effort sponsored by a grant or cooperative agreement, or required in the performance of a contract.

The allowability of B&P costs is given in Section (c):

Except as provided in paragraphs (d) and (e) of this subsection, or as provided in agency regulations, costs for IR&D and B&P are allowable as indirect expenses on contracts to the extent that those costs are allocable and reasonable.

Given this background, we come to a situation where a contracting officer was faced with a contractor that was overrunning a contract baseline due to no fault of the Government and was wondering whether the cost for the contractor to prepare a cost overrun proposal was allowable.

Obviously, the contracting officer did not want to reimburse the contractor for costs that wouldn't have been incurred had the contractor not overrun the contract in the first place. It seemed to the contracting officer that the contractor was being rewarded when it should have been penalized.

The response from DoD to the contracting officer's plea was not very helpful (at least for the contracting officer). DoD essentially stated that if the contracting officer needed a basis for disallowing the costs, it should look to the FAR 31.201-2(a), Determining Allocability. Forget about FAR 31.205-18 because that is not going to help.

DoD concluded that there is no specific limitation in FAR subpart 31.2 that make bid and proposal costs expressly unallowable. But in order to determine if the bid and proposal costs you are concerned with are allowable, a thoughtful examination of the Allocability clause is in order. Then, DoD goes on to paraphrase the allocability cost principle.

DoD also instructed the contracting officer to compare the proposed accounting practice for the bid and proposal costs at issue with the established accounting practices of the contractor. If different, the contractor could be cited for noncompliance with FAR 31.202 which imposes the requirement that costs incurred for the same purpose and under the same circumstances be accounted for as either direct or indirect, but not both methods. That guidance could be problematical because there are situations where contractors are allowed to charge B&P costs direct and indirect both. For example, a contract with a line item that requires contractors submit a proposal for a follow-on production would be a situation where contractors can (and have) deviate from their regular charging practices.

Manufacturing and Production Engineering Costs (M&PE)

One of the least known FAR cost principles is FAR 31.205-25 covering Manufacturing and Production Engineering Costs (M&PE). In has remained unchanged since 1983 when it was expanded to expand upon the activities covered by the definition. The definition of allowable MP&E costs includes:

1. Developing and deploying new or improved materials, systems, processes, methods, equipment, tools and techniques that are or are expected to be used in producing products or services
2. Developing and deploying pilot production lines;
3. Improving current production functions, such as plan layout, production scheduling and control, methods and job analysis, equipment capabilities and capacities, inspection techniques, and tooling analysis (including tooling design and application improvements);
4. Material and manufacturing producibility analysis for production suitability and to optimize manufacturing processes, methods, and techniques.

The FAR definition of M&PE also includes a listing of the activities that are not included in the definition.

1. Basic and applied research effort related to new technology, materials, systems, processes, methods, equipment, tools and techniques. Such technical effort is governed by the IR&D (Independent Research and Development) FAR cost principle (see FAR 31.205-18)
2. Development effort for manufacturing or production materials, systems, processes, methods, equipment, tools and techniques that are intended for sale. Such effort is also governed by the IR&D FAR cost principle.

Sound confusing? Think of it this way. IR&D entails developing a potential new product. M&PE on the other hand entails developing a process or tool that is not intended for resale.

Prior to 1992, there were caps imposed on what the Government was willing to reimburse contractors for IR&D expenses. In some cases these caps were negotiated as advance agreements. In other cases, there were formula that escalated prior year expenditures. When the caps were lifted, the significance of this M&PE cost principle was diminished. The reason for that was because if a contractor came close to expending its IR&D budget, thereby not getting reimbursed for the expenditures, it would simply reclassify the activities into M&PE which was not subject to caps. There were several cases involving contractor attempts to reclassify IR&D costs into M&PE. In most cases, the contractor lost.

Now, since neither IR&D nor M&PE costs are capped, it makes seemingly little difference on how the costs are classified with one exception. Contractors can capitalize M&PE expenses and amortize those costs over a period of years. IR&D costs on the other hand, are considered period costs and must be expensed in the year incurred. This could make a difference for some contractors under certain circumstances.

Deferred IR&D Expense

Deferred IR&D (Independent Research and Development Costs) are those costs that were incurred in previous accounting period. Generally, deferred IR&D costs are unallowable. However there is one exception to this rule. If a contractor has developed a specific product at its own risk in anticipation of recovering the development costs in the sale price of the product, the costs may be allowable if certain conditions are met. Those conditions include:

• The total amount of IR&D costs applicable to the product can be identified.
• The pro-ration of such costs to sales of the product is reasonable.
• The contractor had no Government business during the time that the costs were incurred or did not allocate IR&D costs to Government contracts except to pro-rate the cost of developing a specific product to the sales of that product.
• No costs of current IR&D programs are allocated to Government work except to prorate the costs of developing a specific product to the sales of that product.

If the Government decides to recognize deferred IR&D, the contract must include a specific provision setting forth the amount of deferred IR&D costs that are allocable to the contract. Additionally, the Government must document in its negotiation memorandum the circumstances pertaining to the case and the reason for accepting the deferred costs.

Back in 2000 and 2001, a contractor capitalized some IR&D costs that it incurred to develop software that it asserted was a precursor to that required for an Air Force contract. It amortized the development costs in 2002 through 2005 of which some of those costs were allocated to the Air Force contract. The Air Force contract did not contain a provision allowing deferred IR&D costs be to charged.

The auditors questioned the amortization of the deferred IR&D costs. The contractor appealed to the ASBCA (Armed Services Board of Contract Appeals). The ASBCA, without deciding and commenting upon whether the costs could have been allocable to the contract, supported the auditor because there was no recognition of deferred IR&D costs in the contract. The Board stated:

"In this case, there is nothing in the contract specifically authorizing any deferred IR&D costs to be charged to this contract  as specified in FAR 31.205-18(d)(2)..."

That decision is pretty straight forward - no contract authorization, not allowable.

If you've capitalized IR&D costs that you hope to amortize over future Government work, you need to ensure that it is specifically spelled out in your contract(s).

Deadline Approaching for Contractors to Enter Independent Research and Development Costs into Government Database

Back in January 2012, the Department of Defense amended its FAR Supplement (DFARS) to require "major" contractor to report their Independent Research and Development costs and information into a Government database, in order for those costs to be allowable. You can read about the change and who it affects by clicking here.

There was a lot of confusion over the implementation of the new rule so in February of this year, the Director of Defense Procurement and Acquisition Policy (DPAP), deferred reporting of 2012 and 2013 costs until the end of contractor fiscal year 2014. Read the DPAP deferral memo here. A key point of this memorandum is the communication that there is no expectation of reconciliation between the cost information in the database and the costs claimed in the incurred cost submission, only that the claimed project was in fact, entered into the database, updated annually, and updated when the project is completed.

DCAA (Defense Contract Audit Agency) recently issued its own guidance on the subject. The memorandum provides guidance to auditors on how they should handle various scenarios when contractors do not comply with the reporting requirement.

For audits of incurred cost, if the contractor fails to input its IR&D information into the Government database, the costs, according to DCAA, are expressly unallowable. Auditors should question whatever IR&D costs have been claimed and go so far as to recommend penalties. Further, if the costs are significant, the auditor should consider citing the contractor for noncompliance with CAS 405, Accounting for unallowable costs.

For internal control reviews such as an audit of the accounting system, the auditor should consider whether the contractor's failure to input IR&D data into the Government database, rises to the level of a system deficiency.

Either one of these possibilities should encourage contractors to comply with the regulations. Remember, contractors have until the end of their fiscal year 2014 to comply. For contractors whose fiscal years end on June 30th, the deadline is just a few days away.

Deferred Research and Development Costs

Yesterday we discussed a little-known, seldom invoked, and rarely controversial cost principle prohibiting losses on other contracts to be charged to a Government contract (read it here). Today we want to discuss a similarly obscure cost principle - this one concerning deferred research and development costs. The cost principle is found in FAR 31.205-48 and in some respects is similar to the losses on other contracts cost principle in that contractors may not charge overruns to any other Government contract.

Research and Development Costs (R&D) must be distinguished from Independent Research and Development Costs (IR&D). IR&D costs are paid for with company funds and the definition and other coverage is contained in FAR 31.205-18. R&D costs, on the other hand, are of the same type of technical effort described in FAR 31.205-18 but are paid for (sponsored) by a grant or required in the performance of a contract.

Deferred IR&D costs are allowable so long as the contractor meets the criteria listed in FAR 31.205-18(d)(1); when a contractor has developed a specific product at its own risk in anticipation of recovering the development costs in the sale price of the product provided that:

1. The total amount of IR&D costs applicable to the product can be identified;
2. The proration of such costs to sales of the product is reasonable;
3. The contractor had no Government business during the time that the costs were incurred or did not allocate IR&D costs to Government contracts except to prorate the cost of developing a specific product to the sales of that product; and
4. No cost of current IR&D programs are allocated to Government work except to prorate the cost s of developing a specific product to the sales of that product.

Deferred R&D costs, on the other hand, are never allowable under Government contracts. When costs are incurred in excess of either the price of a contract, or amount of a grant for research and development effort, the excess is unallowable under any other Government contract.

Conditions Influencing Contractor Labor Charging Practices - Part 2

In yesterday's posting, we began a series on risk factors that contract auditors consider when beginning any evaluation of labor costs. Unfortunately, the tone of the audit guidance and the prevailing attitude of many auditors presuppose that Government contractors will deviate from accurate labor hour recording when certain conditions exist. That's not the case at all. Nevertheless, all auditors, whether they be contract auditors or financial statement auditors, will develop a set of risk factors to help them determine how much attention, focus, or testing they need to devote to certain areas.

Yesterday we discussed the first two factors, contract mix and overrun contracts. Today we'll address two more, restructuring costs and significant increases in labor accounts.

Restructuring Costs

Most companies, at one time or another, will go through some form of restructuring - it just goes with the ebb and flow of business cycles. In the DoD world, the Department attempts to cap the amount of costs that can be charged to its contracts for restructuring activities (DFARS 231.205-70). As actual restructuring expenditures near the negotiated restructuring cost ceiling, there is a risk that restructuring costs may be mischarged to other accounts. The auditor is advised to determine if the incurred and projected restructuring costs are near or in excess of the negotiated ceiling.

Significant Increases in Direct/Indirect Labor Accounts

This heading should probably read "significant changes" instead of "significant increases". Downward trends are just as "interesting" to an auditor as upward trends. Auditors are fond of trend analysis. Trend analysis may disclose instances where charges to direct or indirect labor accounts have increased significantly. Auditors are required to perform sufficient analysis to determine the nature of the increase (or decrease). The auditor should evaluate changes in procedures and practices for charging direct/indirect cost for consistency with generally accepted accounting principles, the applicable contract cost principles, and any applicable Cost Accounting Standards requirements.

The auditor should also perform comparative analysis of sensitive labor accounts. When the comparative analysis indicates a possible misclassification of direct labor cost or some other condition that cannot be adequately explained, the auditor should pursue the matter further, (e.g. the contractor may be misclassifying direct contract costs to selling and marketing or IR&D/B&P costs.) Analysis in this area may satisfy the man­datory annual audit requirements relating to changes in charging direct/indirect cost (MAARs 7) and analysis of sensitive labor accounts (MAARs 8). An example of a sensitive labor account is standby labor. Standby labor is generally defined as the unproductive time caused by and limited to idle time, capability retention, and waiting for special customer security clearance.