Cost Allocation and Government Contracts

Cost Allocation in Government Contracts

Abstract

The main cost accounting task involves indirect cost allocation to cost items. For allocating these common or overhead, or indirect costs, the basis chosen is cost drivers. Choosing cost drivers proves crucial to the formulation of costing methodology. To enhance allocation credibility and accuracy, the most relevant drivers of cost should be chosen, with two or more of these applied. Hence, the decision regarding the kind and number of cost drivers that must be utilized is crucial. Cost drivers must be optimal in number since skewed outcomes result if too many cost drivers are employed. 

Introduction

It is a complicated task to carry out business transactions with the US Federal Government; however, at the same time, it may be intensely fulfilling. Competitive neutrality aims at achieving efficient resource allocation between private and public enterprises. It calls for governmental businesses to establish rates that cover expenses, at the very least (which includes return on invested capital and every applicable tax and charge), termed by the CPA (Competition Principles Agreement) as ‘full cost attribution.’ When it comes to independent enterprises like GTEs (Government Trading Enterprises) that function within competitive markets, managers’ cost allocation grounds will probably not be an important matter for complaints divisions (Commonwealth Competitive Neutrality Complaints Office, 1998). Rather, independent enterprises cover total costs if they earn commercial rates of medium-term return on assets.

If complaints divisions or other entities that implement competitive neutrality have to compare an enterprise’s earnings with costs, various challenges surface. Ascertaining the cost of resources utilized by an agency’s business division isn’t easy in all cases. For example, what portion of the corporate services of an agency is attributable to its commercial division? Various techniques exist to measure enterprises’ costs, with considerably variable outcomes (Commonwealth Competitive Neutrality Complaints Office, 1998). Thus, for each technique, the judgments or decisions to be made and data requirements vary. The CPA allows individual jurisdictions to exercise competitive neutrality based on their respective agendas.

This paper revolves around pricing and cost allocation, in line with responsibilities established for complaints divisions under the CPA (i.e., ascertaining whether a governmental enterprise has been underpricing its services and products). But the above obligation doesn’t entail taking into account more general resource allocation problems that stem within the context of competitive neutrality. To evaluate how to gauge whether or not a GTE having statutory monopoly within certain markets has been adhering to competitive neutrality principles, for example, this study doesn’t raise the question of whether the monopoly is justifiable. More generally, it simply accepts the existing governmental role of providing non-commercial and commercial services, failing to gauge whether it is rational for a government to participate in its present series of activities. Nevertheless, such general aspects are certainly of significance from the point of view of efficiency. Indeed, some are dealt with under other competition policy areas. Hence, this paper’s findings concerning government-provided commercial service costing and pricing ought to be overtly recognized as being linked to a single facet of improving how governments carry out business activities, instead of being viewed as the blueprint of effective service provision to the masses.

Literature Review

Decision-making is typically done by adopting linear models to avoid complexity. In cost accounting, indirect labor cost is usually allocated to the cost object (i.e., services or products) based on direct labor hours. Conventional cost allotment techniques assume a linear linkage between the cost allocation basis and costs, which proves challenging when allocating overheads where multiple product lines exist, each demanding a different quantity of resources (Chiang, 2013).

Chiang’s (2013) model relates indirect labor cost to direct labor hours using diverse ways that might not be wholly captured through preset average rates for overhead allocation. Under special conditions, indirect labor overheads exhibit linear associations with labor hours. Here, the ABC strategy or conventional procedure presents proper overhead estimates. But indirect labor variability and range result in indirect labor cost that isn’t wholly proportional to the direct labor hours. In non-linear indirect labor cost functions after the initial analysis, one must exercise caution while ascertaining how to allot overheads. Chiang (2013) recommends an additional classification of costs into fixed and variable costs. The latter group may be allocated based on relevant product measures like direct labor hours. But the former ought not to be allocated at the level of the product. Rather, it may be covered under general profitability analysis, being regarded as a portion of overall costs covered by income.

Choice of cost calculation technique proves salient to the determination of both actual product profitability and calculation items such as clients. Conventional cost computation techniques frequently offer false information. Research efforts have provided several examples of large corporations doing away with their traditional techniques and putting into operation the novel technique of Activity-Based Costing or ABC (Kumar & Mahto, 2013). The technique claims to capture the manufacturing process’s economics better than conventional unit-based cost systems, thus offering more precise cost information. Mahto and Kumar’s (2013) review indicates that the ABC model may be employed in all kinds of businesses. Its implementation has proven successful, and several large firms have utilized it, including industries, public sector organizations, and institutions. ABC adoption has given rise to several institutional reforms that stem from its adoption process, including closer linkages between operational functions and management accounting. ABC and other costing systems are dynamic; thus, it may be established that with corporate changes and changes in the business environment, ABC must be updated and sustained. Lastly, in transferring a more explicit image, ABC can make people champions of certain services and products.

Thomassen and coworkers (2016) aim at comparing transaction costs within the context of public-private partnerships (PPPs) with those involved in typical investment project procurements and contrast them with PPP-connected argued cost savings. As PPP contracts are generally extended over long periods (in this instance, twenty-five years), the contract unavoidably proves incomplete in several ways. In the contract duration, unexpected events may transpire (e.g., technical advancements and innovations). The public entity desires that the bidders consider this while planning for maintenance and operational costs. But the private entities were performing their calculations using current solutions that have the same effectiveness for the entire duration of the contract. They view all gains in efficiency as profits. This represents a case of how ambiguities render it hard for public entities to acquire efficient contracts which can protect against private players who prefer alternatives that improve their utility. The lengthy contract duration, coupled with ambiguity, complicates the contract plan in its ex-ante phase and form significant transaction cost sources within the tendering process. PPP tendering-related transaction cost levels are typically overlooked or understated. By demonstrating the real transaction costs and complexity that revolve around PPP tendering, private and public sector players may be able to acquire a better sense of what their involvement in such competitions gets them into.

The main cost accounting task involves indirect cost allocation to cost items. For allocating these common or overhead, or indirect costs, the basis chosen is cost drivers. Choosing cost drivers proves crucial to the formulation of costing methodology (Toompuu & Põlajeva, 2014). To enhance allocation credibility and accuracy, the most relevant drivers of cost should be chosen, with two or more of these applied. Hence, the decision regarding the kind and number of cost drivers that must be utilized is crucial. Cost drivers must be optimal in number since skewed outcomes result if too many cost drivers are employed. It is widely understood that utilizing a larger number of drivers offers more precise outcomes; the right drivers should also be employed. Alternatively, it is also understood that an optimal number of cost drivers ought to be utilized. Services that universities have to offer in the present day have grown increasingly diverse.

Further, indirect costs make up a growing share of these institutions’ overall expenses. Therefore, one must bear in mind that a single driving factor for cost does not suffice in the case of high indirect costs and diversity of services since it can result in entirely distorted outcomes. Therefore, drivers should be chosen with great care and total awareness, with a compromise between correctness, accuracy, and measurement expenses.

Peng and colleagues (2014) came up with mathematical models for the analysis of PPP ventures’ equity allocation issue by comparing models without considering the impact of the “contracts as reference point” theory. If reference point reliance isn’t assumed, the ideal allotment of participants’ investment share is determined using the risk taken, expectation profit, the significance of the investment, and venture profit. In the case of a risk-averse government, the ideal contract ought to be flexible so that the government selects a dynamic investment ratio for defending the great risk. However, considering the reference point, the level of satisfaction of PPP undertaking participants determines whether or not the system’s overall utility can attain its maximum value. The equity allocation’s satisfaction impact PPP undertaking participants’ utility. Therefore, the psychological aspect must be taken into account when making decisions. This paper considers the totality of surplus as its objective function. But this might end in a more complex decision process. Typically, the private, as well as public sectors tend to maximize personal utility while making decisions. Hence, the game model might prove more relevant when describing their decision processes.

Findings

Two basic kinds of cost allocation techniques exist direct costs: a simple technique since direct costs are traceable back to one single venture or contract. The challenge linked to the attainment of adherence is mainly concerned with system configuration to ensure contract-level cost accumulation (Peng et al., 2014; Thomassen et al., 2016). The other kind of allocation entails the spreading of indirect costs across several ventures, a technique that is both very subjective and complicated. As this is one domain that commonly leads to confusion for fresh and even experienced governmental contractors, the following findings explain how indirect costs are allocated to ensure Defense Contract Audit Agency (DCAA) adherence.

I. Direct vs. Indirect Costing

The foremost area that one needs to acquire mastery over is being clear concerning the terms ‘indirect cost’ and ‘direct cost.’ After defining these terms, the contractor should code them consistently. One salient point to remember is that accounting practices and contractor definitions guide indirect and direct costs rather than governmental authorities. Direct costs denote all costs identifiable to a single cost objective. They are generally needed or even demanded the performance of a contract. ‘Cost objective’ represents a regulatory word that may encompass contracts, activities, undertakings, or contract line items (Chan, 2003). Furthermore, it may encompass individual indirect ventures like proposals and bids or independent R&D ventures. Such costs are billed to the indirect cost account.

After the contractor establishes the above definitions, it becomes consistent cost charging or coding to either indirect accounts or directly to the cost objectives. Consistency is essential as inconsistency will fail and issues with the DCAA. Additionally, it will also distort indirect rates.

II. Indirect Cost Pools

After establishing indirect and direct cost definitions, the contractor needs to create or sustain homogenous pools of indirect cost, as the government labels it. The term ‘homogenous’ implies that indirect costs are segregated into reasonable groups of accounts with similar associations with the base being managed. For ensuring adherence, contractors need to undertake cost accumulation into homogenous pools of indirect cost. Usually, a total of 3 such pools are constructed, one for overheads, the second for fringe costs, and the third for general and administrative expenses. This is a standard arrangement. But the majority of small enterprises can work with even two of the above pools, namely, fringe costs and general and administrative costs, since most such enterprises find it challenging to define overhead costs. Having three pools potentially requires “splitting hairs” and segregating costs into general and administrative costs and overhead costs (Peng et al., 2014). In such instances, only two pools suffice. The cost structure is all dependent on processes and organizational structure.

Understanding cost pool groups’ definitions will prove useful for facilitating ascertainment of what the right structure ought to be.

Fringe costs are quite simple, encompassing personnel-linked costs like payroll taxes, compensated leave (sick leave, holidays/vacations, etc.), and fringe benefits like health insurance.

Overheads are defined as indirect support expenses incurred while supporting operations and direct manufacturing. These costs are closely connected with projects, though not allocable to a single contract or undertaking (e.g., supplies consumed or utilized in processes though not allocable to a single contract or venture). To sum up, it is associated with manufacturing or operations, though not allocable to a single product/service, order, venture, or contract.

General and Administrative (G&A) costs are costs incurred for an enterprise’s overall functioning or operation. They aren’t identifiable to anyone product/service, order, venture, or contract (Kumar & Mahto, 2013), nor are they allocable to manufacturing or operations. They are vital to the general management and running of a firm and generally encompass the following functions: executive, sales, marketing, finance and accounting, IT, business development, and HR.

The final pool to take into consideration is that of unallowable costs. The majority of individuals fail to take this under indirect costs; however, it is, by definition, a key cost pool, crucial to accumulating and separating costs FAR 31.2 deems as unallowable. Contractors ought to create and maintain cost accounts concerning all kinds of unallowable costs. Most contractors commonly maintain a single unallowable costs pool and one for individual indirect cost pools, mostly overheads. This is vital to fulfilling the requirement of including unallowable overheads in the General and Administrative allocation base.

III. Allocation Bases

This is a highly subjective matter and exposed to substantial government-contractor debate in the industry. It is also highly controversial. It is prudent to acquire DCAA support of indirect cost allocation bases and pools for avoiding issues (Chiang, 2013; Holland & Hobson, 1999). Indirect costs are required to be equitably allocated. In the case of contractors bound by the CAS, some allocation bases are established, with additional limitations. In the present day, fixed costs make up a huge indirect cost component; thus, activity bases work effectively. Whatever the case, a second condition has been established for several years, namely, the chosen allocation base ought to form the groundwork representing the allocable cost pool’s or enterprise’s overall activity. DCAA is firm in its stance here (Toompuu & Põlajeva, 2014). Consequently, though somewhat irrelevant in the contemporary era, prior theories remain fully effective, and contractors are required to conform to these rules.

That said, the widely acknowledged allocation bases are:

Overhead Pool. This captures indirect costs supporting direct manufacturing or operations. But these aren’t traceable to any one contract, product/service, venture, or order. Several examples of costs amassable into the overheads pool exist, including indirect labor, rent, utilities, training, supplies, quality assurance, and equipment depreciation of tools and instruments utilized in several projects (Chiang, 2013).

General and Administrative Pool. General and Administrative costs represent those incurred in overall business management or operations. As such, these costs may not be linked to any single product/service, project, order, department, or contract. They generally relate to areas benefiting the whole company, like executive management, legal, sales and marketing, finance and accounting, HR, corporate culture, business development, and IT (Chiang, 2013).