Avoid "Courtesy Bids" - Government Considers Them to be Fraud Indicators

Although the number is down from a few years ago, the Government still performs audits of contractor compliance with TINA (Truth-in-Negotiations Act). These audits are also referred to as Defective Pricing audits. Under TINA, contractors have the affirmative duty to ensure that the cost or pricing data submitted to support a proposal to the Government is based on data that is current, complete, and accurate. Under current audit guidance, all instances of defective pricing are considered for possible fraud referral. That does not mean that all instances of defective pricing are ultimately reported as potential fraud - it means that the auditors will discuss among themselves and consult the DoD-IG's (Inspector General's) listing of fraud indicators to assess whether the submission defective cost or pricing data was laced with fraud.

The DoD-IG maintains a listing of Fraud Red Flags and Indicators on its website. DCAA auditors, as part of every audit they perform, are required to consult one or more of the indicator listings as pertinent to the particular audit they are performing. One of the fraud risk indicators for defective pricing is the contractor's use of vendor "courtesy bids".

In a published case study, DCAA reviewed the contractor's estimate for material pricing and found that the contractor's estimates for five of 40 parts selected for audit were based on courtesy bids. Vendors confirmed to the auditors that they issued courtesy bids when requested but they refused to do business with the contractor because of the complicated Government regulations that would have to be followed. The contractor used these courtesy bids to price the material, but later, purchased the parts from other vendors at lower prices.

Requests for competitive bids sent to vendors that a contractor knows will be either too high to be considered or does not meet contract specifications are not current, complete, and accurate cost or pricing data. The purpose of these bid solicitations is to create the appearance of competition and conceal secretly inflated prices included in the proposal.

Now here's the bottom line. According to the DoD-IG, such courtesy bids (also called complementary, or cover bids) are a form of bid rigging. Bid rigging occurs when competitors conspire to raise prices or keep prices artificially high when competitive bids are solicited prior to contract or subcontract award. Auditors will now be specifically looking for instances of courtesy bids. Contractors will do well to avoid even the appearance of incorporating them into cost or pricing data.

Inventory Management

One area that doesn't get a lot of attention in Government contracting discussions is the issue of effective inventory control. Inventory control is a significant management challenge at all companies, not just Government contractors, but at Government contractors in particular, the Government often ends up paying for inefficient inventory control - especially at contractors with significant cost-reimbursable effort. That is why sometimes, contract auditors will poke around and review contractors' inventory management policies, procedures, and practices. Ineffective inventory management results in too much inventory on-hand and where the carrying cost of inventory is significant, can represent a drain on company profits. Where the excess inventory becomes Government property (as in the case where purchases are made under cost reimbursable contracts), cost to the Government are increased.

There are a number of policies and procedures that a contractor can effect to help ensure effective inventory management. Most of these apply to non-Government contractors as well.

1. Test for indications of overbuying. Overbuying ties up funds in excess inventories. Excess inventories require investment of funds and do not contribute directly to current programs, projects, or deliverables.
2. When establishing inventory requirements, consider whether frequent change orders have the potential of obsoleting items. Obsolete items are often worthless.
3. Establish a program for standardization of component parts as a means of reducing the need for separate buying for individual contracts/projects/deliverables.
4. Examine the causes for items that become excess and obsolete. Examine the causes for items in short supply and adjust inventory purchases accordingly.
5. Determine whether there are effective procedures for evaluating repairability of production rejects. 
6. Determine whether there are effective procedures for disposing scrap. Are classification procedures adequate to determine what is usable, salvageable, or scrap? Are competitive bids secured for the sale of scrap?

Contractors do not want to lose money by tying up funds in excess inventory or by purchasing too much inventory that may become obsolete. The Government does not want to pay for it either.

What is Adequate Support for Material Purchases?

What kind of supporting documentation should a contractor be expected to maintain in support of materials and purchased parts? What kind of supporting documentation might a contract auditor request when auditing direct material costs? What are sound commercial practices for supporting documentation? What might the IRS require if they conduct an audit? The answer to each of these four questions is the same; a purchase request, vendor quotes, a purchase order, evidence that the items were received, a vendor invoice, and proof of payment.

After contract award, someone in the company has to decide what items need to be purchased. That person generates purchase requests. These requests should be tied back to build specifications or other contractual requirement. Purchase requests are forwarded to the purchasing department who performs due diligence in obtaining the best pricing. The purchasing department issues purchase orders to the selected vendors. The vendors fulfill the purchase orders, ships the items to the contractor, and sends the contractor invoices. The contractor receives the items it purchased and notifies Accounts Payable department that it has received the items.The Accounts Payable department makes a three-way match (purchase order, receiving document, and invoice) and schedules the payment. If there are any discounts offered, the contractor must take those discounts. Lost discounts are normally unallowable under Government contracts. Contract pays the invoice by check or by electronic transfer of funds.

The process we just described generates a lot of paperwork and auditors can and do request some or all of it to support the claimed costs. It is usually not sufficient to provide the auditor a ledger showing a tally of costs charged to a particular contract. Most auditors will dig a whole lot deeper in their quest to verify the allocability, allowability, and reasonableness of claimed costs. Contractors that don't maintain adequate documentation are at risk for having associated costs disallowed. Right now we are working with a contractor where the auditor has questioned the cost of a major material purchase for lack of documentation. It wasn't sufficient to physically show the auditor the item, and tie its serial number to an invoice. The contractor was missing the purchasing file which included evidence that the contractor obtained competitive pricing. The issue has now been elevated to the contracting officer. The auditor took a hard-line position and while that position might be justified, it may not have been a reasonable position.

So, do your homework, prepare you paperwork, organize and keep it handy. You never know when an auditor will come knocking expecting you to have it.

Material Costs - Part 3

For the past two days, we've been discussing the FAR Part 31 coverage of material costs and how those costs should be accounted for under Government contracts. Today we will conclude this series by discussing two final concepts; materials issued from inventory and materials acquired from affiliated companies, organizations, or subsidiaries.

When materials are issued from inventory, any generally recognized method of pricing such material is acceptable. It could be FIFO, LIFO, Weighted-Average, or something else. Whatever method is chosen however, must be applied consistently across the company. A contractor cannot use one method for Government contracting and another for commercial work. Additionally, the method must achieve equitable results. We've never encountered a situation where a selected methodology would not result in equitable results but we suppose it could happen. Suppose a contractor using the LIFO (last-in, first-out) method has three units in inventory at $100 each and buys a fourth for $1,000. The contract calls for one unit so under the LIFO method, the contractor charges the contract $1,000. The Government could look at that and think that there is some inequity in the practice. The ultimate decision will come down to the contracting officer's determination.

Allowance for all materials, supplies and services that are sold or transferred between any divisions, subdivisions, subsidiaries, or affiliates of the contractor under a common control shall be on the basis of cost incurred by that affiliate. In other words, the affiliate should not be charging a profit on the cost of the transfers.

There are exceptions however. Allowances may be at price (as opposed to cost) when three conditions are met:

1. It is the established practice of the transferring organization to price inter-organizational transfers at other than cost for commercial work of the contractor or any division, subsidiary or affiliate of the contractor under common control and
2. The item being transferred qualifies for an exception under FAR 15.403-1(b) and 
3. The contracting officer has not determined the price to be unreasonable.

Those exceptions listed under FAR 15.403-1(b) include:

• When the contracting officer determines that the prices agreed upon are based on adequate price competition
• When the contracting officer determines that prices agreed upon are based on prices set by law or regulation
• When a commercial item is being acquired
• When a waiver has been granted
• When modifying a contract for commercial items.

When commercial items are transferred at a price based on a catalog or market price, the contractor should adjust the price to reflect the quantities being acquired (e.g. provide for quantity discounts) and may also adjust the price to reflect the actual cost of any modifications necessary because of contract requirements.

Practically speaking, there is not too much that can go wrong when purchasing materials for a contract. Purchases are very straight-forward transactions. Contractor's need to ensure that they maintain an adequate paper trail that includes:

1. Purchase request
2. Purchase order
3. Receiving documentation
4. Vendor invoice
5. Payment records

Material Costs - Part 2

Yesterday we began a discussion on the FAR (Federal Acquisition Regulations) cost principle on Material Costs; FAR 31.205-26 by defining the types of material costs covered by the standard. Suffice it to say, that if the cost does not meet the definition as set forth in the standard, you need to find another cost principle to consider the allowability of costs. Too often, contractors and the Government try to force fit a particular cost item into a particular standard to proclaim allowability or non-allowability, whatever the case may be. Don't do it. Such arguments waste everyone's time.

So far, we have learned that material costs (as defined in the standard) are allowable under Government contracts along with the costs of getting them to the plant (or construction site) and that contractors can purchase more than the contract requirements to allow for spoilage, waste, etc, if reasonable and supportable, of course. Today we will focus on some of the prescribed accounting treatment.

Contractors must adjust the costs of material for income and other credits, including available trade discounts, refunds, rebates, allowances, and cash discounts, and credits for scrap, salvage, and material returned to vendors. Essentially, if the contractor derives any income, however represented, from purchasing materials, the cost of those materials must be reduced.

Secondly, the adjustments can be handled in one of two ways. The contractor can credit the contract(s) directly, or charge the credits to an indirect expense pool for allocating over a broad range of contracts.

Thirdly, if the contractor can demonstrate that its failure to take available cash discounts was reasonable, it does not have to credit the contract for lost cash discounts. Auditors, of course, cannot conceive of any situation where lost cash discounts are reasonable and indeed, modern Accounting software helps to ensure that available discounts are readily and easily identified. However, there could be situations where not taking discounts is reasonable.

Fourth, reasonable adjustments arising from differences between periodic physical inventories and book inventories may be included in arriving at costs. Those adjustments must be made to the proper period. This most often involves write-downs of inventory. Its rare when physical inventory exceeds book.

Tomorrow, we will discuss materials issued from inventory and materials transferred between divisions.

Material Costs - Part 1

Whenever "material costs" are discussed, it is usually in the context of a contractor's purchasing system - a system that should be designed and operated in such a manner as to ensure that the contractor (and therefore the Government) is obtaining fair and reasonable pricing of the materials it buys or the subcontracts it awards. DFARS (DoD FAR Supplement) 252-244-7001 lists 24 different criteria that contractors must meet in order to have an adequate purchasing system.

But beyond the 24 criteria found in DFARS, there are provisions in FAR Part 31 cost principles that concerns the allowability of material costs. In the context of FAR 31.205-26, material costs include not only the cost of the item(s) but the total cost to get those parts to the contractor's facility. These include::

1. Raw materials
2. Parts
3. Sub-assemblies
4. Components
5. Manufacturing supplies
6. Inbound transportation
7. In-transit insurance

The next provision that FAR adds is a reminder that allowable costs not only include the material items that go in to the end product, but also include (FAR states that contractors "shall include"):

• Reasonable overruns
• Spoilage
• Defective work

This is important because contractors many times overlook these elements and auditors, when they see them in a proposal, try to question the costs (e.g. why are you proposing 13 windows for this building when the specs call for only 12?). For proposal purposes however, its a bit tricky to prepare defensible estimates of what these costs will be. Obviously, historical experience is the best indicator but many companies will not have the ability to accumulate and calculate such factors. Alternatively, there might be some industry standards available to approximate these loss factors.

Tomorrow we will review how FAR requires contractors to account for material costs.

Trade Discounts

The cost of materials under Government contracts seems pretty straight-forward. Contractors purchase raw materials, parts, sub-assemblies, components, and manufacturing supplies. Sometimes these costs are charged to inventory and other times, directly to the contract. The "reasonableness" of the prices are assured through the contractor's purchasing policies, procedures, and practices. There is, however, one little provision found in FAR 31.205-26 (Material Costs) that contractors often overlook. That provision states that contractors must adjust the cost of material for income and other credits including, among other things, available trade discounts.

Trade discounts are offered by vendors to encourage customers to pay early. They can be found on vendor invoices under the "Terms" section. For example, the term "2/10, N30" means that the customer may deduct two percent off the invoice if payment is made in 10 days. Otherwise, the full amount is due in 30 days.

Contractors are required by FAR to deduct available trade discounts from the cost of materials whether they take the discount or not. Many contractors do not take available discounts and charge their Government contracts the full amount of the invoice. Auditors are well aware of this practice and often spend a fair amount of time reviewing invoices for material costs, looking for lost discounts.

There is some relief available when the discounts are lost "without fault or neglect on the part of the Contractor, or lost through fault of the Government." If one of those events happen, the payment clauses require that contractors notify the Contracting Officer and give the reasons (see, for example, FAR 52.232-7). We heard of a case where the Contracting Officer excused the contractor from adjusting material costs for lost discounts because the vendor invoice did not arrive at the Contractor in sufficient time for it to take the discount.

Contractors should review their policies and procedures to ensure compliance with this FAR cost principle.

Purchase, Existence, and Consumption

Material costs are usually significant for any production type contract. Contract auditors have a special review they perform annually whenever material costs are significant on cost-type contracts. This is a mandatory review as well, meaning that the auditor must perform the review before approving final costs on a contract. It is also required to be performed annually. The purpose of the special evaluation is to verify that purchased direct materials were in fact received and ascertain that they were

• needed for the contract
• purchased in reasonable quantities
• purchased at prudent prices
• used on the contract, and
• properly accounted for as to initial charge, transfer in or out, and residual value.

These reviews are a bit different from traditional audits in that the auditor will draw a sample of materials charged to Government contracts and then physically locate all items in the sample. The auditors will also obtain purchase orders for the sampled items and trace those purchase orders to receiving reports. Contractors that cannot physically locate sampled material items are at risk for internal control deficiencies and perhaps having some billings temporarily suspended.

To determine whether the item was needed for the contract, the auditor will compare purchase requisitions or purchase orders to contract requirements and/or bills of materials. Good internal controls would have all three of these documents (purchase requisitions, purchase orders, and receiving reports) prepared by different personnel.

Purchases should be made at optimum quantity levels. Contractors should not buy too few at a time and lose out on quantity discounts. On the other hand, sometimes, buying too many of a quantity will result in lower prices based on available quantity discounts.

When materials used on a contract come from inventory (as differentiated from purchasing directly for the contract) the auditor will be very interested in inventory valuation methodologies.

Audits of Direct Costs - Material

Most Government contractors are familiar with the FAR (Federal Acquisition Regulations) requirement to submit annual incurred cost submissions. These submissions set forth contractors' calculations of final indirect expense rates (e.g. fringe benefits, overhead, General and Administrative, etc) as well as tabulate direct costs by contract. During the audit of incurred cost submisisons, auditors are testing for allowability, allocability, and reasonableness of both direct and indirect costs. This sometimes surprises contractors, especially because so much of the focus of the submission is on indirect costs. However, at the conclusion of the audit, the auditor is attesting to the propriety of both direct and indirect costs incurred during the fiscal year under audit.

The auditor's examination of transactions and procedures in reviews of material costs charged to cost-reimbursable contracts must be sufficient to support an opinion on the allowability, allocability, and reasonableness of those costs. In performing the overall testing, the auditor will likely consider the following with respect to material costs:

• Was it needed for the contract?
• Was it charged and billed in a reasonable relationship to its use in the manufacturing process.
• Was it considered properly for make or buy
• Was it purchased in reasonable quantity
• Was it purchased at a reasonable price?
• Was it used on the contract?
• If contract subject to CAS (Cost Accounting Standards), were the charges in compliance with CAS.
• Was it accounted for properly as to initial charge, transfer in or out, and residual value.

Additionally, audit guidance also instructs auditors to be alert for purchases from "related" suppliers or subcontractors, preferential treatment, and unwarranted sole-source purchases.