The Importance of Internal Controls Over Labor Costs

Over the past two days, we've discussed the concept of division of duties (also called segregation of duties) as a component of internal controls over labor costs. We discussed the importance of the division of duties between those who review and approve employee time charges and those who prepare the payroll. We discussed the importance of the division of duties between those who review and approve employee time charges and those who are responsible for meeting budgets. The basic premise for internal controls is to reduce the chance that irregularities will occur. If you're a regular reader of this blog, you know that we comment on the results of fraud investigations quite often. And one thing that many of these fraud cases have in common is that the companies (or the Government organization) either lacked basic internal control systems, had internal controls in name only (they were not in compliance with the controls they had established), were ineffective for what they were intended to accomplish, or were easily circumvented.

Why so much attention to labor costs? Here's how DCAA (Defense Contract Audit Agency) characterizes of labor costs in its Contract Audit Manual (see CAM 5-902):

Labor costs are usually the most significant costs charged to Government contracts, and usually comprise the indirect cost allocation base, or the largest element in the base used for allocating indirect costs. Historical labor costs are often used to estimate labor for follow-on or similar item Government contracts. Unlike other cost items however, labor is not supported by third party documentation such as an invoice, purchase order, or receipt. Contractor personnel have complete control over the documents or devices of original entry, whether they consist of timecards, electronic media, or some other means. Responsibility for accuracy is diffused throughout the contractor's organization. Consequently the risks associated with the accurate recording, distribution, and payment of labor are almost always significant.

If you have ever been the recipient of a DCAA audit, you probably know that auditors spend most of their time testing indirect expenses for allowability under FAR Part 31 cost principles. Auditors might also pop in and perform random "floorchecks" to test the veracity of labor charging practices. Auditors rarely spend any time at all looking at materials cost and if they do, its rather superficial. We don't ever recall where a contract auditor verified that a vendor was a legitimate company and not a shell company. Audit procedures just don't go to that level of detail for material costs. That's not the case for labor costs. When it comes to labor costs, the contract auditors will test for ghost employees, labor mischarging, managing to budgets, and potential over-staffing. Contractors having a mix of cost-type and fixed price contracts will be scrutinized more than contractors that have all of one kind or another - just because the risk of mischarging from an overrun fixed-price contract to a cost-type contract is higher. What to avoid increased scrutiny by the Government? Implement strong internal controls.