CONTRACTOR COST ACCOUNTING

CONTRACTOR COST ACCOUNTING PURPOSE AND SCOPE This teaching note explains certain key concepts of cost or managerial accounting, describes the types of cost accounting systems, and how the systems are used by government and commercial contractors. DISCUSSION The information supplied by the cost accounting system provides the data necessary for important management decisions particularly those related to product pricing, cost control, inventory valuation, and resource allocation. Generally, the data generated by the cost accounting system is extremely sensitive and is frequently closely held, even within the company. For example, cost accounting reports typically provide detailed proprietary data relating to the costs of manufacturing and selling each product. In the commercial marketplace, customers do not have a legal right to see such cost accounting data. In the defense environment, however, internal cost accounting data of defense contractors is an area of significant concern for the customer (i.e., the military buyer). DoD has much greater interest in and knowledge about the internal cost structure of suppliers than does a commercial customer because DoD negotiates many contracts based on the contractor s cost rather than a free market price mechanism. Realistically, the financial interest of defense contractors is generally best served by charging (consistent with Government regulations) as many costs as possible directly to contracts and structuring indirect cost pools in a way that properly allocates maximum costs to Government contracts. Therefore, it is essential that Government personnel be familiar with the contractor s cost accounting system in order to determine that the component elements of the negotiated price are fair and reasonable. There are three, equally important, cost concepts essential for understanding cost accounting in the defense industry. The concept of allowability, for example, is key within the realm of government contracting. Certain costs, by law or regulation, are unallowable or must be handled in a prescribed way. Interest expense is a prime example and about 50 others are listed in FAR, Part 31. This doesn t mean that a defense contractor can t incur unallowable costs; it simply means that the government will not knowingly pay for them. Another important cost concept is that of traceability. Some costs can be readily traced to the product or service for which they were incurred. The cost of the raw materials that ultimately go into an end item such as a tank, airplane, ship, or subsystem thereof is an example of one such direct cost. We know that other costs must be incurred in providing a product or service, yet the linkage between those costs

and the item delivered to the government isn t so clear cut. Vacation pay and employee health plan costs are examples. Such costs are classified as indirect. Since the government is keenly interested in paying a fair and reasonable price for what it buys, it has placed great emphasis on the question of direct versus indirect costs through legislation of cost accounting standards to which corporate management must adhere. Allowability and traceability are essentially cost reimbursement concepts in that they are aimed at determining what the government owes its suppliers. Whether a cost is allowable/unallowable or direct/indirect has little to do with cost incurrence by the contractor. Such classifications merely establish how the government will treat the costs when deciding what is a fair and reasonable price for the goods and services it buys. When we shift our focus from cost reimbursement to cost incurrence, we leave the realm of accounting and enter that of economics. Here we find another important concept--that of cost behavior. It has been observed that the level of some costs remains unchanged, regardless of the level of activity within the business firm. These costs are driven by managerial decision rather than the level or volume of production or sales. They are fixed in the short run and will be incurred whether or not the company manufactures and sells any products. Fixed costs carry very high risks, and as you might surmise, the managers of a firm whose sales are subject to a high degree of uncertainty might well be reluctant to saddle themselves with a heavy burden of fixed cost. Other costs vary proportionally with the level of production and sales. The costs of direct labor and materials are obvious examples. These costs are classified as variable since, while the additional cost incurred to produce and sell one more unit of output remains constant, the total cost incurred will vary with the level of activity within the firm. A variable cost will not be incurred unless there is activity. To understand how a cost accounting system works, you will need to be familiar with the basic vocabulary of cost accounting terms listed below: Cost objective Direct cost A contract, function, organizational subdivision, or other work unit for which cost data are desired and for which provision is made in the cost accounting system to accumulate and measure the cost of jobs, products, processes, capitalized projects, etc. Any cost that is identified specifically with a single cost objective. Direct costs are not limited to items incorporated in the end product as material or labor. Costs identified specifically with a contract are direct costs of that contract. All costs identified specifically with other final cost objectives of the contractor are direct costs of those cost objectives.

Direct materials Direct labor Other direct costs Indirect cost General and Admin istrative expense Standard cost Variable cost Fixed cost Includes raw materials, purchased parts, and subcontracted items required to manufacture and assemble completed products. A direct material cost is the cost of material used inmaking a product and is directly associated with a change in the product. Labor that is specifically identified with a particular final cost objective. Manufacturing direct labor includes fabrication, assembly, inspection, and test for constructing the end product. Engineering direct labor includes reliability, quality assurance, test, design, etc., which are readily identified with the end product. Costs for special facility rental, computer, reproduction, travel by direct personnel, consultants, etc. Any cost not directly identified with a single cost objective, but identified with two or more cost objectives. A grouping of indirect costs by a defense contractor is often referred to as an indirect cost pool. Any management, financial, and other broad type of expense incurred by or allocated to a business unit for the general management and administration of the business unit as a whole. A carefully predetermined cost that should be attained. A cost that changes with the production quantity or the performance of services. A cost that, for a given period of time and range of activity called the relevant range, does not change in total but becomes progressively smaller on a per-unit basis as volume increases.

Cost Systems There are two general types of cost systems used for accumulating actual costs: job order and process. Job Order Cost Systems Job order (also called job cost or production order) cost systems are used by companies whose products are readily identified by individual unit or production lot, each of which receives varying degrees of attention and skill. This system is used predominately by the defense industry where unique items are procured and where strong requirements exist for the timely monitoring of costs incurred. Other industries that commonly use job order accounting methods include aircraft, construction, furniture, and machinery. Large manufacturing companies using a job order system usually utilize departments for pinpointing the responsibility for cost accumulation and control. A department may contain several cost centers, which are the smallest segments of activity or area of responsibility for which costs are accumulated. For example, a machining department may contain various groups of machines such as lathes, punch presses, and milling machines; each group of machines may be regarded as a separate cost center with its own supervision. The individuals in charge of departments or cost centers should have the authority and responsibility for cost control. Basically, the cost accumulation process under a job order system conforms to the flow of direct materials through the production organizations and the conversion of the materials with labor and overhead into a finished product. Exhibit 1, Summary of Cost Flow, shows the flow of costs through typical cost accounts of a business using a job order system: 1. Costs of direct materials, direct labor, and indirect expenses (such as manufacturing overhead and general and administrative expenses) are accumulated as incurred. 2. As direct materials, direct labor, and indirect expenses are used, the costs are transferred to the Work-in-Process (WIP) inventory. 3. When the products are completed, the costs are transferred to Finished Goods inventory. 4. When the products are sold, the costs are transferred from Finished Goods inventory to Cost of Goods Sold. 5. At the end of the period, the Costs of Goods Sold are transferred into Profit and Loss Summary. 6. Sales are transferred into Profit and Loss Summary and the difference between sales on one side and costs on the other represents profit/loss for the period. Each job usually requires different kinds of materials, plant routings, labor

operations, skill levels, and times for completion. An essential feature of the job order accounting system is the attempt to record costs directly to specific jobs. In order to accommodate the prompt charging of materials to jobs and to aid in disclosing inventory shortages, job order systems require the use of perpetual or continuous inventory records rather than periodic inventory records. Although a job order cost system is designed to record the costs to specific units, a unit cost averaging process is required in some production processes. For example, the unit costs for items produced in a production lot could be derived by taking the accumulated costs for the lot and dividing it by the number of units produced. The Job Cost Sheet, as shown in Exhibit 2, is the key record in a job order cost system and is used to control product costs through a comparison of actual and planned costs. This record is maintained for each job and summarizes the direct materials, direct labor, and indirect costs of producing a given job. A file of uncompleted job cost sheets represents the detail of the Work-in-Process inventory. Stores requisitions are normally used to charge job cost sheets for direct materials issued to the production floor from a stockroom. Employee time cards or work tickets indicate the time spent on each individual job and are the source documents for charging job cost sheets for direct labor used. Department managers are usually kept informed of their direct material and direct labor performance by daily/weekly summaries of requisitions for materials and labor charged to their departments. Manufacturing overhead costs such as heating, air conditioning, taxes, depreciation, janitorial services, etc., cannot usually be specifically identified with physical units and cannot be determined exactly until the end of the accounting period. This is because various accounting adjustments and accruals are necessary to assign costs to the proper time period. Since management cannot wait until the end of the year to find out what each job costs, overhead is estimated at the beginning of the year and applied to each job worked on during the year. The basic idea of this approach is to use an average annual estimated overhead cost per unit without changing the annual rate in costing specific jobs from day to day and month to month. Actual manufacturing overhead costs are accumulated weekly or monthly for each department/cost center without regard to how the estimated overhead was applied to specific jobs. Although there may be monthly differences between actual and applied manufacturing overhead amounts, the final year-end amounts should be nearly equal. The difference between actual and applied overhead is recorded to each job as a year- end adjustment to the accounting records. Although job order costing requires considerable accounting documentation, it has several significant benefits: Every job produced bears its proper share of costs. Valuable information is provided to management to aid decisions for planning and control purposes. An accurate basis for future pricing decisions is established.

Process Cost Systems Process cost systems are used where identical units of a product are produced continuously and there is no difference in cost between units. The principal product is often a homogenous mass rather than a collection of distinct units. No useful purpose would be served by maintaining job orders for particular amounts of a product as the material passes through several stages of production. For example, in the refining of crude oil, each gallon of gasoline that is produced will be identical. Process costing is most often found in such industries as chemicals, oil, paints, food processing, rubber, steel, mining, and plastics. In process cost accounting, the costs are charged to processing departments, and the cost of a finished unit is determined by dividing the total costs incurred in each process by the number of units processed. When the manufacturing procedure requires a sequence of different processes, the output of Process 1 becomes the direct materials of Process 2; the output of Process 2 becomes the direct materials of Process 3; and so on until the finished product emerges. The product and associated costs flow from process to process or department to department in sequential order. In a factory with several processes, there may be one or more service departments that do not process the materials directly. Examples of service departments are data processing, power plant, and maintenance and repair shops. The costs of service departments are usually distributed monthly on some equitable basis to the processing departments. Standard Costs Standard costs may be used with either the job order or process type of cost accumulation systems and are most applicable in the production of a large quantity of identical or similar items. Standard cost systems use detailed estimates of each element of manufacturing cost entering into the finished product. For each product, specialists determine: the standard quantity of materials to be used the standard price of the materials the standard number of direct labor hours to be used the standard rate of pay for labor the standard manufacturing overhead rate. A wide variety of management skills is needed in setting standards as well as the joint effort of engineering, accounting, industrial relations, and other managerial areas. Time and motion studies of each operation are often made and the work force is trained to use the most efficient methods. Standards are usually tight enough that

operating people will consider the achievement of standard performance to be a satisfying accomplishment. Standards are revised on a periodic basis to reflect changes in the pre-determined standards resulting from changes in manufacturing methods, the addition of cost saving machinery, inflation, etc. For more effective control, standard costs may be used for each department or cost center in the factory. As work is done, actual costs incurred are compared with standard costs to reveal variances. Standard cost systems, therefore, enable management to determine how much a product should cost (standard), how much it did cost (actual), and the causes of any difference (variance) between the two. The most important result of a standard cost system is the variance analysis that shows areas of waste and areas of efficiency. Variances are termed favorable when actual costs are less than standard costs and unfavorable when actual costs are greater than standard costs. Management analyzes the significant variances to determine the cause and to take appropriate action. The total variance for an accounting period is usually made up of several variances, some of which may be favorable and some unfavorable. There may be variances from standards in direct materials costs, direct labor costs, and manufacturing overhead costs. Direct material and direct labor variances are divided into two categories: (a) price or rate; and (b) usage or efficiency. Price or rate variances are computed by multiplying differences in price by actual quantities. Usage or efficiency variances remove influences of price changes and are computed by multiplying differences in quantities by a standard price. The determination of standards and variances from standards for manufacturing overhead is more complex than for direct materials and direct labor. A standard manufacturing overhead rate is determined on the basis of the projected manufacturing overhead costs at 100% of normal production capacity, where this level of capacity represents the general expectation of business activity under normal operating conditions. Variances from standard for manufacturing overhead cost result (a) from operating at a level above or below 100% of normal capacity; and (b) from incurring a total amount of manufacturing overhead cost greater or less than the amount budgeted for the level of operations achieved. The first factor results in the volume variance, which is a measure of the penalty of operating at less than 100% of normal productive capacity, or the benefit from operating at a level above 100% of normal productive capacity. The second factor results in the controllable variance, which is the difference between the actual amount of factory overhead incurred and the amount of manufacturing overhead budgeted for the level of production actually achieved during the period. The use of predetermined standards and the analysis of variances from such standards provide management with an excellent means of establishing responsibility and controlling manufacturing overhead costs.

Increased Emphasis on Indirect Cost Management Indirect costs typically represent between one third to one-half of the costs of a contract. The increased use of computers and automation of production operations during recent years coupled with a declining business base has had a significant impact upon increasing indirect or overhead cost rates. Therefore, the allocation of indirect costs is an area that merits increased attention of both contractor management and the DoD. Currently, the improvement in the management of overhead costs, which is a complex and difficult task, is one of the primary initiatives of the DCMA. The indirect cost management concepts of causal or beneficial relationship and homogeneity are necessary for a thorough understanding of indirect cost allocation. These concepts are necessary to understand the indirect cost structure of large companies who are producing multiple products and services under numerous types of contracts. Government regulations do not specify any number of indirect cost pools. While some contractors may have only a few indirect cost pools, some may well have over onehundred such pools. The concept of causal/beneficial relationship means that indirect costs must be allocated to cost objectives in reasonable proportion to the beneficial or causal relationship of the pooled costs to the cost objectives. In simple terms, one chooses the method that best links the cost objectives with the indirect costs. This linkage is often referred to as an allocation base. When possible, the indirect costs should be allocated to the direct cost that caused the indirect cost to be incurred. An example of this causal relationship would be where the direct labor for employees working on a contract causes the indirect medical insurance costs for the employees to be incurred. Therefore, the indirect medical insurance costs should be allocated to the direct labor cost. A beneficial relationship occurs when indirect cost was not caused by any particular direct cost but the incurrence of the cost benefits the contract. For example, the accounting personnel performing general and administrative functions provide some benefit to contracts by preparing necessary reports or their work is necessary for the overall operation of the business. A clear example of a cost that does not meet the causal or beneficial relationship test would be bad debts expense. Government contracts do not cause bad debts to occur because the government pays its just debts. The incurrence of bad debts expense does not in any way benefit government contracts. Therefore, there is no causal or beneficial relationship. The concept of homogeneity requires that the contractor s indirect costs must be grouped into logical and homogeneous indirect cost pools. This requirement means that the cost of functions or activities which are to be pooled must have the same or similar beneficial or causal relationship to cost objectives. This concept of homogeneity is achieved if the activities or functions in the pool are the same or similar, if the activities or functions are unlike, but the relationship to benefiting cost objectives are

the same or similar, or if the final output of goods and services is the same or similar. An example of an indirect cost pool that would be considered to be homogeneous would be if a contractor accumulates costs relating to the activities of building ownership, maintenance, and utilities into one indirect cost pool, designated as Occupancy Cost, for allocation to contracts. Although the costs of these activities represent unlike costs, each of these activities has the same or a similar relationship to all contract work that is occupying space in the contractor s facility. On the other hand, assume that a contractor includes the indirect costs of machining and assembling activities in a single manufacturing overhead pool. The machining activity may not have the same or similar beneficial or casual relationship to contracts or cost objectives as does the assembling activity. In this case, the contractor s single manufacturing overhead pool is not homogeneous and separate pools would be required. The lack of homogeneity of singular indirect cost pools may occur when a contractor s activities are geographically dispersed. The use of separate indirect cost rates for each geographic location will normally produce more equitable allocations of indirect costs than the use of composite or company-wide rates. Off-site overhead rates should be based on eliminating from the overhead pool those types of indirect costs that do not benefit off-site activities. For example, occupancy costs may be eliminated from off- site pools because the contractor uses government facilities at the off-site location rather than his company owned facilities. From the government s perspective, it is generally contended that the subdividing of indirect cost pools provides more accurate cost information for government contracts. However, the number and type of cost pools should be governed by practical considerations. Some defense contractors have been very concerned about the proliferation of the number of indirect cost pools. While additional cost pools may provide better matching of costs incurred to benefits received to some degree, from the contractor s perspective, it may create a pricing problem due to the sensitivity of smaller pools to changes in volume. For example, if business volume shifts between several products in a contractor s plant with a single plant-wide manufacturing overhead rate, the changes in volume would cancel out and the overhead rate would not significantly change. However, if each product had its own indirect cost pool, then the several rates could vary significantly with business volume changes. In addition, it is more costly from an administrative standpoint to manage a large number of cost pools. It should be recognized that comparing indirect cost rates among different contractors can be very misleading since two similar contractors may have different rates for numerous reasons. For example, accounting systems may be totally different. One contractor may classify production control activities as indirect while another contractor may classify it as direct. One contractor may include purchasing and warehousing costs in a material handling indirect pool while another may have some of these costs in the manufacturing overhead pool and some in the general and administrative expense pool. Contractor s indirect rates may also vary because of the

variety in products produced or production methods used. For example, one contractor produces a product using a manual method while another contractor makes the same type of product in a highly automated facility. The automated contractor is likely to have a higher overhead rate because additional depreciation for the automated equipment, an indirect cost, is allocated against a smaller direct labor base. The automated contractor is likely to experience higher overhead rates than his less automated counterpart even though his total product cost may be lower. Facility ownership will also cause a significant difference in contractor s indirect rates. For example, one would expect a contractor operating in a government owned facility to have significantly less indirect expenses.facility ownership results in large indirect expenses for depreciation, property taxes, and maintenance expenses. The method of handling fringe benefits could cause very large differences in indirect rates as some contractors include these expenses in indirect cost pools while others may include them as a part of direct labor. Such differences between contractors make it important to remember that the Government s objective is not to reduce overhead rates but to reduce total costs. Although comparing indirect rates between contractors is misleading and complex, it may be useful to chart the trend of indirect rates of one contractor over time. Even this trend analysis could require adjustment for organizational, accounting system, manufacturing process, and business base changes. The primary reason for significant changes in indirect rates is a large variation in the business base. For example, in a declining business environment there will be less direct costs in the denominator of the indirect rate computation due to a decrease in business volume. Therefore, the rate has to increase. The decrease in volume may the result of decreases in government contracts, subcontracts, or commercial work. It should be recognized that indirect cost pools are made up of literally hundreds of various types of business expense accounts, therefore, there can be any number of reasons for changes in indirect rates. For example, rate increases could be caused by reasons as varied as increases in health care, early retirement incentives, idle facilities and excess capacity costs, increases in state and property taxes, overtime, etc. The most useful analysis would be one that looks at the indirect cost and cost trends in dollars rather than as rate trends.