STUDENT GUIDE. CON 170 Fundamentals of Cost & Price Analysis. Unit 5, Lesson 4 Understanding Rate Applications

Transcription

1 STUDENT GUIDE CON 170 Fundamentals of Cost & Price Analysis Unit 5, Lesson 4 Understanding Rate Applications January 2017 CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 1

2 STUDENT PREPARATION Required Student Preparation Read FAR/DFAR/PGI , 42.7, and Planned Academic Time Required: 3.5 hours Student performance will be informally evaluated during class discussions, and formally evaluated on Exam 2 CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 2

3 Lesson Presentation So far, in Unit 5, we have covered: Lesson 1, Cost Analysis, Key Players in Cost Analysis, and Understanding Contractor Business Systems Lesson 2, Cost Analysis - Direct Costs (deep dive into Direct Costs) Lesson 3, Cost Analysis - Indirect Costs (deep dive into Indirect costs) Now we re ready to look at how those indirect cost rates are actually developed and practice applying those rates to given procurement scenarios. We will also see how sensitive those rates can be to fluctuations in business volume. By the completion of Lesson 4, you will be able to understand exactly how an indirect rate is calculated, how indirect rates and direct costs comprise the total cost objective of a contract, and why it is so important that all contracting professionals are informed about the rate process. The foundation for a company s indirect rates can be traced back to the budget development cycle. As we learned in the last lesson, the indirect rate reflects the relationship between a pool of related indirect costs to its base of related direct costs. A notional flowchart and timeline is presented in the next slide, which describes the general process contractor s use to estimate indirect rates. Before a contractor s fiscal year begins, contractors typically work through a cycle of forecasting their revenues, and estimating their costs to do business. As illustrated above, estimating indirect rates typically begins with a sales forecast (May through July in this example, with both Business and Corporate segments). After setting their sales goals, the contractor s individual cost centers will develop their cost estimates to produce and sell to meet the goals. That cost information is CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 3

4 rolled up through revenue centers and profit centers and is eventually combined for a corporate review. This organizational chart is typical example of a corporation s structure. Corporations are often investment centers, or home offices, managing a conglomeration of companies, or profit centers, reporting profit. Individual companies, or segments, report to a home office, corporation, or group having responsibility for profit and/or producing a product or service. Within any individual segment having responsibility for profit will be an individual or organization responsible for revenue such as a marketing or sales department. Also within any individual segment will be a group of individuals or organizations responsible for operations with various middle managers these individuals are often responsible for maintaining or controlling the support centers whose expenses make up the various indirect cost pools. At the very bottom of the organization are cost centers responsible for making or delivering a product or service these are typically the direct labor forces whose labor hours or wages/salaries make up the allocation base(s). Organizations typically undergo an annual budget process to ensure they have sufficient resources to maintain operations for the coming year(s). Middle management will project their budget needs (pool support expenses) for the coming year(s) based on their planning needs. With all this information, you are now ready to practice calculating some indirect costs rates and applying them to a given scenario in order to develop a total cost objective on the following couple of pages. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 4

5 Exercise: Calculation and Application of Rates Learning Objective Describe the difference between the application of a Total Cost Input base G&A and a Value Added base G&A. Given a proposal evaluation scenario, calculate a Government total cost objective. Introduction This exercise will require the student to calculate indirect rates and appropriately apply them in a given scenario. Assessment This activity is not scored or graded. Student Instructions: Calculate as directed in the following questions. Cost Accounting Exercises, ABC Company: 1. Compute the ABC Company plant-wide indirect rates. Based on their total sales forecast for the coming year, the ABC Company is expecting to incur $75,000 in material and subcontracts, $100,000 in direct engineering labor, and $50,000 in direct manufacturing labor. The company s total expected indirect overhead expense of $187,500 consists of: $7,500 in indirect material expenses; $80,000 in indirect engineering expenses; $100,000 in indirect manufacturing expenses. They also have $41,250 in general and administrative (G&A) expenses. Assume the company uses direct material and labor costs to allocate their respective overheads and a TCI base (total cost input - i.e. all direct and indirect overhead cost) to allocate G&A expense. Mat. O/H Expense Pool Allocation Base Rate (Pool Base) Eng. O/H Mfg. O/H G&A CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 5

6 2. Compute the expected total cost for contracts A and B. Assume an experimental prototype contract (A) is expected to require $25,000 in material and subcontracts, $80,000 in engineering direct labor and $10,000 in manufacturing direct labor. A production contract (B) is expected to require $50,000 in material and subcontracts, $20,000 in engineering direct labor and $40,000 in manufacturing direct labor. Prototype Contrac t A Production Contract B Material $25,000 $50,000 Mat O/H Engineering $80,000 $20,000 Eng. O/H Manufacturing $10,000 $40,000 Mfg. O/H Sub Total (Prod) G&A Total Cost Value-Added vs. Total Cost Input? There are two common methods for allocating G&A overhead pools they are commonly referred to as TOTAL COST INPUT (TCI) or VALUE ADDED (VA). Although we ve told you that VA and TCI are the two most common allocation bases used with the General & Administrative overhead pool, we haven t discussed when one approach would be more appropriate than the other. The official answer to that question can be found within CAS 410: (2) Value-added cost input shall be used as an allocation base where inclusion of material and subcontract costs would significantly distort the allocation of the G&A expense pool in relation to the benefits received, and where costs other than direct labor are significant measures of total activity. A value-added cost input base is total cost input less material and subcontract costs. So, the risk that DCAA might find that a contractor s G&A base generates distortion or unequitable G&A charges on Government contracts is one reason a company may select to use a VA allocation method rather than a TCI allocation method. Additionally, a contractor that relies extensively on subcontractor effort could find that their TCI based rate will add G&A expense to subcontract costs that are already nearing excessive pass-through thresholds. A competitive CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 6

7 source selection may also reveal that using the TCI approach would put a contractor at a price disadvantage on opportunities that require a significant material and subcontract effort. For these reasons, it is important to understand how to calculate using both methods. Ultimately, a company can use either method, but they must be consistent in their application, using the same method for all contracts. 3. Assume the contractor uses a value added base to allocate G&A (i.e. TCI less material and subcontracts). Compute the new G&A base and resulting rate using the VA methodology. TCI Base (all direct and indirect costs) Less Material & Subcontracts Value Added Base G&A Expense G&A Rate (expense pool/va base) - % CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 7

8 This was our answer to #3 above. Let s see how using a VA methodology effects both contracts: Using TCI Prototype Contract A Production Contract B Material $25,000 $50,000 Mat O/H 10% $2,500 $5,000 Engineering $80,000 $20,000 O/H 80% $64,000 $16,000 Manufacturing $10,000 $40,000 Mfg. O/H 200% $20,000 $80, Sub Total (Prod) $201,500 $211,000 G&A 10% $20,150 $21,100 Total Cost $221,650 $232,100 Total for Contracts A + B = $453,750 Using VA Contract A Contract B Sub Total (Prod) $201,500 $211,000 Less Material ($25,000) ($50,000) Value Added Base $176,500 $161,000 $21,572 $19,678 Total Cost $223,072 $230,678 $1,422 increase from TCI to VA methodology ($1,422) decrease from TCI to VA methodology $221,650+$1,422 = 223,072 $232,100-$1,422 = $230,678 Total for Contract A + B = $453,750 As you can see, no matter what G&A methodology is used, the company will still recoup the same amount. The primary difference is that those contracts that have more material & subcontracts will absorb less of the G&A expense and vice versa. As long as a company is consistent in their application method, they can use either. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 8

9 Cost Accounting Exercise, XYZ Company: 1. Compute the XYZ Company plant-wide indirect rates. Based on their total sales forecast for the coming year, the XYZ Company is expecting to incur $69,375 in material and subcontracts, $120,000 in direct engineering labor, and $80,000 in direct manufacturing labor. The company s total expected indirect expense of $350,255 consists of: $8,325 in indirect material O/H expenses; $117,600 in indirect engineering O/H expenses; $168,000 in indirect manufacturing O/H expenses; and $56,330 in general and administrative (G&A) expenses. Assume the company uses direct material and labor costs to allocate their respective overheads and a TCI base (total cost input - i.e. all direct cost plus all indirect overhead cost) to allocate G&A. Mat. O/H Expense Pool Allocation Base Rate (Pool Base) Eng. O/H Mfg. O/H G&A CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 9

10 2. Compute the expected total cost for contracts A and B using a TCI base G&A. Assume an experimental prototype contract (A) is expected to require $13,875 in material and subcontracts, $96,000 in engineering direct labor and $20,000 in manufacturing direct labor. A production contract (B) is expected to require $55,500 in material and subcontracts, $24,000 in engineering direct labor and $60,000 in manufacturing direct labor. Prototype Contract A Production Contract B Material Mat O/H Engineering Eng. O/H Manufacturing Mfg. O/H Sub Total (Prod) G&A Total Cost What would the G&A rate and Total Cost be for each contract should the contractor use a value added (VA) base to allocate G&A? TCI Base (all direct and indirect costs) Less Material & Subcontracts Value Added Base G&A Expense G&A Rate (expense pool/va base) - % CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 10

11 Using VA % Contract A Contract B Sub Total (Prod) Less Material ($ ) ($ ) Value Added Base % Total Cost $ increase from TCI to VA methodology Total for Contract A + B = $ ($ ) decrease from TCI to VA methodology CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 11

12 In the previous exercises, ABC and XYZ Company, you distinguished between allocating G&A based on Total Cost Input (TCI) and Value Added (VA). Given the knowledge gained from those exercises, answer the following questions: 1. All things being equal, a G&A rate based on, will always be higher because the allocation base is with the subtraction of materials and subcontracts. 2. Any particular company may consider the majority of their G&A expenses to be more associated with the labor function than they do the material function. For example, the majority of their expenses may be human resource related or consist of fringe benefits. Consequently, such a company may consider a allocation base to be better (provide allocations with less distortion) for them. 3. If there is volatility in material prices (which would be included in a TCI base) you would expect the G&A rate to also be. In such a market environment, a G&A rate would be more stable. 4. Disparity may exist in the company-purchased material content of products for some customers. Perhaps some customers provide their own materials. If the company s G&A expenses are more related to the labor function than they are the material function, then a G&A rate allocation runs the risk of resulting in a distortion by allocating G&A to the contract(s) having higher company-purchased material or subcontracts content. 5. Companies are free to choose either method for allocating G&A. Once they choose, they have to use this method for all customers, across all contracts. 6. T or F. All customers will suffer (i.e. pay more) with companies that use the higher VA rates. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 12

13 More Practice with Cost Allocation Bases: 7. A company has $10M in a Use and Occupancy secondary pool which has the rent, utilities (one meter), and security (one guard patrolling the entire premises) for a single facility. Using the graphic below (which depicts the company s building and property), what percentage of the $10M would get allocated to the production overhead pool, the engineering overhead pool, and the general and administrative expense pool using Square Footage as an allocation base. 8. Bases available for allocating engineering overhead include and An engineering supervisor earns a salary of $300,000 and charges her salary completely to the engineering overhead support pool. Her entire job is to supervise two (2) teams of identical size (six persons each) who are working on two separate projector projects A and B, clocking their time directly to their respective projects. Assume each team works an equal number of hours (12,480 hours each) on their respective projects, but one team is much more senior than the other with an average hourly rate of $100/hour vs. an average rate of $50/hour for the junior team. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 13

14 a. How much of the engineering supervisor s salary would be allocated to each projector project A and B, should engineering overhead be allocated on the basis of Engineering Labor Dollars? b. How much of the engineering supervisor s salary would be allocated to each projector project A and B, should engineering overhead be allocated on the basis of Engineering Labor Hours? 10. Assuming the supervisor actually spends more time supervising the junior team, which methodology provides the greater distortion? CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 14

15 BASE IMPLICATIONS ON A RATE Even after completing all of the preceding questions, you may still wonder how a company would select TCI or the value added approach for G&A. You must realize that a company makes a decision about all bases and rates as they are developing their forecast for the following year. Generally, the TCI vs. Value Added decision centers around determining who benefits from the G&A expenses. Selecting the wrong approach means that certain customers are paying for more of the G&A expense than they rightfully should. A company cares about this because it means their proposals for those customers will be higher and unlikely to win the business in a competitive environment. However, there are occasionally times when it makes sense for a company to game the process. A company whose primarily business involves sole source contracts with the Government would be smart to select the method that assigns more cost to these non-competitive contracts. This would allow that company to have lower costs for any competitive contracts that they are also pursuing. The Government s defense from these tactics is to require the contractor to consistently utilize whichever approach they select. In theory, over time, the sole source contracts will be competed and there will also be other opportunities for the Government to be the recipient of the lower G&A costs. Recall Lesson 3 s instruction on the indirect rate calculation. This lesson emphasizes how a contractor s optimism or pessimism about their future business impacts the base and subsequently shapes the rate. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 15

16 With respect to indirect cost rates, consider these questions: If a contractor is competing for a contract in a competitive, cost reimbursement contract environment, would the contractor have an incentive to be optimistic or pessimistic about his future business base? Why? What if the contractor estimates wrong in this competitive, cost reimbursement environment? How can the Government mitigate the risks of this scenario? On the other hand, in a sole-source, fixed price environment, would a contractor tend to be more optimistic or pessimistic regarding its future business base? CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 16

17 All in all, while the base in a contractor s rate calculation is a judgement call, they generally want their rates to be as accurate as possible. The expenses behind indirect rates are real and must be recovered; overstated rates hurt a contractor s competitiveness in the long run. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 17

18 EXAMPLE OF AN INDIRECT RATE MISCONCEPTION Consider the following - A well intentioned program manager is driving his Contracting Officer to negotiate a lower indirect labor rate with a contractor. After all, in the PM s mind, a 200% overhead rate seems ridiculously high. The following example of an A&AS indirect rate illustrates how, if the Government does not understand how indirect rates are developed, we are not equipped to execute a good cost analysis. In an existing contract, the contracting officer notices the contractor s indirect rate is 200%, with the base of Direct Labor. Along with the profit, this yields a burdened, hourly labor rate of $ That 200% indirect rate seems like proposal padding to me! Says the Government team member. If the contractor can find a way to cut that down to 100%, that would save the Government a lot of money. After all, in this member s mind, this would yield a burdened, hourly rate as follows: From what we ve studied regarding indirect rates, does this seem logical? CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 18

19 Given what we ve studied about indirect rates being the relationship between pool costs and base costs, could the contractor come up with a way to lower their indirect rate, but still recover all of its costs? Let s see. The next two slides show how the contractor can actually pull fringe benefits out of its indirect expense pool, and account for the fringe cost in the base instead. This changes the ratio of direct and indirect costs, which lowers the indirect rate, but still allows the contractor to recover all of its direct and indirect costs. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 19

20 Thus, the contractor successfully lowered its indirect rate from 200% down to 100%. Did this really accomplish what the Government intended to achieve? Ultimately, the answer is NO, but with a competent understanding of how indirect rates are calculated, Government team members will have more realistic expectations in the future. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 20

21 INDIRECT BILLING RATES AND FINAL RATES The concept of indirect rate calculation also influences the amount of money contractors are paid during contract performance. Let s spend a little time now understanding the Rate Cycle process. It all starts when the Contractor submits a Forward Pricing Rate Proposal (FPRP) at the beginning of an accounting period. DCAA and DCMA take that proposal through a process that will ultimately lead to a Forward Pricing Rate Agreement (FPRA). In the interim, the contractor will submit their cost vouchers using Billing Rates that are initially aligned with their FPRP submission. However, those billing rates will be periodically updated throughout the contract. Ideally, each revision of the billing rates will move the contractor closer to their anticipated Actual and Final Overhead Rates position. This effort to refine these billing rates should minimize the under/over payment status that must be resolved with the final payment and when rates are finalized. For a little more about FPRAs, you may want to explore FAR and FAR ). An FPRA is a non-contractual agreement negotiated between the ACO (for the Government) and a contractor. There is no certification required at the time of an FPRA agreement and either contractor or the ACO may bail-out of the agreement at any time if circumstances warrant. However, a current FPRA must be used by all PCO s at least as the basis to start negotiations. Information about Billing Rates may be found at FAR Billing rates are used during performance of the contract on public vouchers (CR) and progress payment financing (FP). Billing rates are provisional in nature; final payment subject to final negotiated rates. Information on final indirect cost rates can be found at (FAR ). CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 21

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24 Exercise: Exploring Policy Initiatives and Guidance Learning Objective Explain why the external circumstances (contract type, competition) may bias a company s business base projections. Introduction This exercise will require the student to explore the regulations and other sources to find, identify, and explain current policy and guidance regarding the importance of rates and their application. Assessment This activity is not scored or graded. Student Instructions: Each group will review the policy memos included as Attachments 1 & 2 to this lesson as well as the FAR/DFARS/DFARS PGI to research and answer the following questions. You have 30 minutes to complete this exercise. Be prepared to discuss your answers with the group. Ensure you cite your references. 1. Review the DCMA Director s memo, dated 12 May 2011, (FPRR/FPRA) Expectations and answer the following questions: a. How many dollars, on an annual basis, of MDAP programs are being driven by the indirect cost rates? b. What percentage of the total cost is attributable to the rates? c. Will DCMA be negotiating FPRAs for the sake of getting an FPRA? 2. Review the memo regarding DCMA and DCAA Processes (4 Jan 2011). Of those two agencies, which one is responsible for issuing FPRAs/FPRRs and on what basis? 3. Per FAR , are PCOs required to use: a. FPRAs? b. FPRRs? CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 24

25 4. Do contractors monitor business base captured by contract awards after agreeing to an FPRA? 5. Under which circumstances would a contractor more quickly cancel an FPRA, when gaining unexpected business or when expected business does not materialize? Explain your answer. 6. How do you believe the Administrative Contracting Officer (another role for DCMA responsible for negotiating FPRAs) would react to the events outlined in Question #5 above? 7. Who would you expect (contractor or DCMA) to be better positioned to more actively monitor the business base and impact on rates? 8. Per FAR , FPRAs will be negotiated with contractors having volume of Government contract proposals. Why should the ACO invite cognizant contracting offices having significant interest to participate in negotiations? 9. Is it sufficient for the PCO to go ahead and use the rates represented as FPRAs by the contractor in their proposal? What would be gained by PCO talking to ACO? 10. Per FAR (c), should the ACO seek or accept a contractor s TINA certificate following the FPRA negotiations? If not, when do the FPRAs get certified? CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 25

26 Over/Under Application of Rates The last question in the previous exercise presented a situation that we briefly discussed earlier in this lesson. So let s take a closer look at the implications an unexpected change in business volume has on indirect rates. What would happen if one of the three (3) original contracts fail to materialize? Suppose all three are awarded and a fourth, unexpected, contract, K4, (also with $5M in manufacturing labor base) comes along. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 26

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28 Exercise: Understanding the Sensitivity of Bases and Rates Learning Objective Explain why the external circumstances (contract type, competition) may bias a company s business base projections. Introduction This exercise will require the student to analyze and explain the potential changes to a contract rate based on changes to the base of that rate. Assessment This activity is not scored or graded. Student Instructions: Using the discussion of over and under application of overhead rates, discuss and answer the following questions with your group. You have 30 minutes to complete this exercise. Be ready to discuss your answers with the class. 1. If all the contracts were flexibly priced, would the increase in the business base serve to eventually increase or decrease the billing rates, final rates, and final cost to the Government on all contracts, including the first three contracts already awarded? 2. If all the contracts are firm-fixed price, 100% of the overhead pool expenses originally estimated for the year have already been recovered by the first three contract awards. Will the application of the FPRA rate to a fourth contract result in a windfall profit? 3. Recall the kinds and types of costs typically found in the indirect cost pools, which include payroll taxes, fringe benefits, supervision, equipment, facility and occupancy expenses. a. As the contractor takes on additional work (and direct manufacturing labor to complete it), will there be some additional overhead pool costs needed to support that work? If so, would these expenses be considered fixed or variable costs? b. On the other hand, will other overhead pool costs remain the same? If so, would we consider these costs to be fixed or variable costs? CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 28

29 4. All overhead expenses contain both types of costs in the pool, but in different proportions depending upon the industry, company and individual pool. a. The higher proportion of costs in the pool, the increase in overhead costs will more closely match the application of the existing overhead rate. b. The higher proportion of costs in the pool, the increase in overhead costs will fall further below the application of the existing overhead rate. c. The remainder represents potential windfall profits depending on the negotiations, thus the opportunity is higher where there is a higher proportion of cost. CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 29

30 LESSON SUMMARY TLO: 5.4 Given a proposal evaluation scenario, calculate a Government total cost objective ELO(s): Summarize a company's typical rate cycle Explain the inverse relationship between base and rate Explain why the external circumstances (contract type, competition) may bias a company s business base projections Describe the difference between the application of a Total Cost Input base G&A and a Value Added base G&A Describe the difference between indirect cost applied on awarded cost and fixed price contracts CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 30

31 Attachment 1 CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 31

32 Attachment 1 CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 32

33 Attachment 2 CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 33

34 Attachment 2 CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 34

35 Attachment 2 CON 170, Unit 5 Lesson 4 Understanding Rate Applications Page 35