Audits of Direct Costs - Labor

The overall objective of audits of contractor annual incurred cost submissions is to render an opinion on the propriety of costs charged to flexibly priced (e.g. CPFF, CPIF, FPI, T&M, etc) Government contracts. The audit procedures include tests of both indirect and direct costs. Many contractors have the mistaken impression that auditors are only reviewing indirect rates during the incurred cost audit. This is understandable because so much of the standard incurred cost submission is focused on the development of indirect cost pools and their allocation bases. But, at the end of the audit, the auditor is expressing an opinion on both direct and indirect costs charged or allocated to contracts. Last Friday, we discussed the primary audit objectives for material costs. Today, we discuss the audit of direct labor costs which is usually, far more significant, in terms of dollars, than are material costs.

A significant part of the audit of labor costs occurs before the incurred cost submission is prepared and submitted. These are the Government's infamous floorchecks (or, observations of work areas). These are unannounced visits to contractor facilities to interview employees and compare timesheet entries with work actually being performed. Floorchecks are a major component of the audit of direct labor costs. Floorchecks are performed in “real-time”, that is, concurrent with the actual work being performed. The purpose of a floorcheck is to verify that contractors have policies and procedures to ensure the propriety of labor costs being charged to Government contracts. Deficiencies disclosed in a floorcheck are often the result of poor internal control systems or compliance issues. Deficiencies could lead to payment withholds, as discussed previously in this blog.

In addition to floorchecks, auditors will perform other procedures as part of the audit of the incurred cost submission. These procedures are developed after a risk assessment of the situation. Larger contractors warrant more attention than smaller ones. Likewise, contractors with a high percentage of flexibly priced contracts are a higher risk than ones with low percentages. Depending on the results of the risk assessment, the auditor might include some or all of the following areas for substantive testing:

• Evaluation of labor cost charging and allocation
• Evaluation of payroll preparation and payment
• Evaluation of compensation levels
• Evaluation of personnel policies and procedures
• Evaluation of overtime, extra-pay shifts, and multi-shirt work (often times, these are limited by contract terms)
• Evaluation of uncompensated overtime
• Evaluation of labor standard cost systems and sole proprietors’ and partners’ salaries
• Evaluation of quantitative and qualitative utilization of labor