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Explain a Contractor’s Estimation and Accounting System

A contractor’s accounting system consists of the methods and records used to identify, assemble, analyze, classify, record, and report a contractor’s transactions, assets, and liabilities (Defense Contract Management Agency (DCMA), 2019). Conversely, a contractor’s cost estimation system refers to the policies, practices, and procedures for generating cost data and other data included in cost proposals that are submitted to the government in the expectation of obtaining contract awards (DCMA, 2019). An adequate cost estimation system should maintain a consistent approach, utilize sound estimation techniques, make use of appropriate source data, and follow established procedures as per the federal acquisition regulations (FAR) (DCMA, 2019). A good accounting system needs to be well-designed to prevent mistakes and provide reliable accounting data (DCMA, 2019). The adequacy of a contractor’s accounting and cost estimation systems determines whether or not they receive a contract offer. This research paper seeks to determine what the literature identifies as the primary characteristics of an adequate accounting and estimation system.

Background to the Study

The requirements for effective cost estimation and accounting systems for government contractors are covered in the Federal Acquisition Regulations (FAR). FAR 15.407-5 acknowledges that acceptable contractor cost estimation systems benefit both the contractor and the government by increasing the reliability and accuracy of individual proposals. For this reason, contractors are required to subject their cost estimation systems to regular audit reviews geared at assessing their reliability. The auditor is to record results of such reviews in a report that also indicates deficiencies and corrective action. Significant deficiencies not corrected by the contractor are a consideration in subsequent proposal negotiations for government contracts. Similarly, the need for an adequate cost accounting system is emphasized in FAR 31.201-1. This provision requires the contractor to accurately capture all direct and indirect costs allocable to the contract, while properly adjusting for applicable variances. The FAR provisions point to the importance of maintaining an adequate cost estimation and accounting system, thereby providing a rationale for this study.

Literature Review

Factors Influencing Accuracy of Cost Estimates

Researchers have carried out multiple studies to identify the factors influencing the adequacy of project cost estimation and accounting systems. Although studies focused specifically on government contractors are limited, a lot of literature is available on cost estimation and accounting in projects generally. In one such study, Hatamleh et al. (2017) distributed a questionnaire to 265 construction project managers to identify the factors that influence the accuracy of cost estimation systems. The study findings showed that the accuracy of cost estimation systems is influenced by several factors including: past pricing experiences, project complexity, how well the scope of the project is defined, the accuracy and reliability of cost information, the cost estimation techniques adopted, and availability of historical data (Hatamleh et al., 2017). Another study conducted by Arif et al. (2015) to analyze the factors influencing the accuracy of cost estimates in construction projects found that that obtaining timely input from subcontractors as well as material manufacturers and suppliers significantly helped to increase the accuracy of cost estimates.

Factors Influencing Quality of Accounting Systems

The accuracy of cost estimates largely depends on the effectiveness of the accounting system (DCMA, 2019). The Defense Procurement and Acquisition Policy (DPAP) identifies several qualities of a good accounting system including: alignment with generally accepted accounting principles applicable to the contractor, proper segregation of direct and indirect costs, a logical and consistent method of allocating indirect costs to cost objectives, exclusion from costs charged to government contracts of amounts not allowable under FAR Part 31, allowing for progress payments, and segregation of preproduction and production costs (DPAP, n.d.). The aspect of segregation of direct and indirect costs is further emphasized in a study by Fitrios (2016), which sought to identify the factors affecting the quality of accounting information from 42 Indonesian hospitals.

Knowledge Gaps

Evidently, a lot of literature exists on the determinants of effective cost estimation systems. However, most studies focus on projects in general, without specific focus on government contracts. This research applies the concepts obtained from the literature review to the context of government contracts.

Findings

From the conducted literature review, one could deduce crucial insights on the characteristics of an adequate cost estimation and accounting system. An adequate cost accounting system for a contractor would have the following qualities: a) align with generally accepted accounting principles (GAAP) and FAR; b) properly and accurately segregate direct and indirect costs; c) consistently and logically allocate indirect costs to cost objectives; and d) segregate pre-production from production costs (DCMA, 2019; DPAP, n.d.). The accounting system forms the basis of future cost estimation and hence, a good accounting system increases the likelihood of obtaining accurate cost estimates (DCMA, 2019). Thus, an effective accounting system is one of the requirements for an effective cost estimation system. Other crucial features of an adequate cost estimation system include: a) it provides for the use of historical accounting information, b) the contractor integrates information from other relevant management systems, c) the system employs scientifically-proven cost-estimation techniques, d) the system identifies the sources of data and rationale used in developing estimates, e) the system provides for the timely detection and correction of errors, and f) the contractor assures that personnel have adequate training on cost estimation (DCMA, 2019).

Conclusion

Based on the above findings, this research makes several conclusions. First, the effectiveness of a contractor’s accounting system determines the accuracy of their cost estimates and hence, how good their cost estimation system is. The auditor thus needs to assess the effectiveness of the contractor’s accounting system, including how well it segregates direct and indirect costs, allocates indirect costs to cost objectives, and aligns with generally accepted accounting principles.

Summary

This research sought to identify the features of an effective cost estimation and accounting system. Data was collected through a systematic review of literature focused on cost estimation and cost accounting in projects. The study found that a good accounting system accurately segregates direct and indirect costs, logically allocates indirect costs to cost objectives, and aligns with generally-accepted accounting principles applicable to the contractor. At the same time, an effective cost estimation system makes use of accurate accounting data, takes into account historical accounting information, employs scientifically-proven cost-estimation techniques, integrates data from all relevant management systems, and allows for the early detection of errors. It is prudent that auditors investigate these areas when assessing the effectiveness of a contractor’s cost estimation and accounting system.