Cost Allocation Methods in Government Contracts Explained

Introduction

Carrying out business transactions with the US Federal Government is a complicated task; however, it can also 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 such as GTEs (Government Trading Enterprises) that function within competitive markets, managers' cost allocation decisions will probably not be an important matter for complaints divisions (Commonwealth Competitive Neutrality Complaints Office, 1998). Rather, independent enterprises cover total costs when they earn commercial rates of medium-term return on assets.

When complaints divisions or other entities that implement competitive neutrality must compare an enterprise's earnings with its costs, various challenges surface. Ascertaining the cost of resources utilized by an agency's business division is not easy in all cases. For example, what portion of an agency's corporate services is attributable to its commercial division? Various techniques exist to measure enterprises' costs, with considerably variable outcomes (Commonwealth Competitive Neutrality Complaints Office, 1998). 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 — that is, ascertaining whether a governmental enterprise has been underpricing its services and products. This obligation does not entail taking into account broader resource allocation problems that stem from the context of competitive neutrality. To evaluate how to gauge whether a GTE holding a statutory monopoly within certain markets has been adhering to competitive neutrality principles, for example, this study does not raise the question of whether the monopoly itself is justifiable. More generally, it simply accepts the existing governmental role of providing both non-commercial and commercial services, without gauging whether it is rational for a government to participate in its present range of activities. Nevertheless, such general aspects are certainly significant from an efficiency standpoint — indeed, some are dealt with under other competition policy areas. Hence, this paper's findings concerning the costing and pricing of government-provided commercial services ought to be recognized as relating to a single facet of improving how governments carry out business activities, rather than being viewed as a blueprint for effective service provision to the public.

Literature Review

Decision-making is typically carried out by adopting linear models in order to avoid complexity. In cost accounting, indirect labor cost is usually allocated to the cost object — that is, 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 approaches 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, in which case the ABC strategy or conventional procedure presents proper overhead estimates. However, indirect labor variability and range can result in indirect labor costs that are not wholly proportional to direct labor hours. When indirect labor cost functions prove non-linear upon initial analysis, one must exercise caution while determining how to allot overheads. Chiang (2013) recommends an additional classification of costs into fixed and variable costs. The variable group may be allocated based on relevant product measures such as direct labor hours, whereas fixed costs ought not to be allocated at the product level. Rather, they may be addressed under general profitability analysis and regarded as a portion of overall costs covered by income.

The choice of cost calculation technique proves important to the determination of both actual product profitability and the calculation of items such as client costs. Conventional cost computation techniques frequently produce misleading information. Research has provided several examples of large corporations discontinuing their traditional techniques and implementing the novel technique of Activity-Based Costing (ABC) (Kumar & Mahto, 2013). ABC claims to capture the economics of the manufacturing process better than conventional unit-based cost systems, thus offering more precise cost information. Kumar and Mahto's (2013) review indicates that the ABC model may be employed across all kinds of businesses. Its implementation has proven successful across several large firms, including those in industry, the public sector, and institutional settings. ABC adoption has given rise to several organizational reforms, including closer linkages between operational functions and management accounting. Because ABC and other costing systems are dynamic, it follows that as corporate environments change, ABC must be updated and sustained accordingly. Furthermore, ABC can create visible champions of certain services and products within an organization by making cost relationships more transparent.

Thomassen and colleagues (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 argued cost savings associated with PPPs. As PPP contracts are generally extended over long periods — in their study, twenty-five years — the contract unavoidably proves incomplete in several respects. During the contract duration, unexpected events may transpire, such as technical advancements and innovations. The public entity desires that bidders account for this while planning for maintenance and operational costs. However, private entities tend to perform their calculations using current solutions assumed to maintain the same effectiveness for the entire duration of the contract, viewing all efficiency gains as profits. This represents a case of how ambiguities make it difficult for public entities to acquire efficient contracts that can protect against private players who prefer alternatives that improve their own utility. The lengthy contract duration, coupled with ambiguity, complicates contract design in its ex-ante phase and forms a significant source of transaction costs within the tendering process. PPP tendering-related transaction cost levels are typically overlooked or understated. By demonstrating the real transaction costs and complexity associated with PPP tendering, both private and public sector players may acquire a better understanding of what their involvement in such competitions entails.

The main cost accounting task involves indirect cost allocation to cost items. For allocating these common, 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 cost drivers should be chosen, with two or more applied. The decision regarding the kind and number of cost drivers to be utilized is therefore crucial. Cost drivers must be optimal in number, as skewed outcomes result when too many cost drivers are employed. It is widely understood that utilizing a larger number of drivers offers more precise outcomes, provided that the right drivers are also employed. Services that universities must offer today have grown increasingly diverse, and indirect costs make up a growing share of these institutions' overall expenses. A single cost driver does not suffice in the case of high indirect costs and service diversity, since it can result in entirely distorted outcomes. Drivers should therefore be chosen with care, balancing correctness, accuracy, and measurement expenses.

Peng and colleagues (2014) developed mathematical models for the analysis of equity allocation in PPP ventures by comparing models with and without considering the impact of the "contracts as reference points" theory. If reference point reliance is not assumed, the ideal allotment of participants' investment share is determined by the risk taken, expected 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 can select a dynamic investment ratio to guard against significant risk. However, when the reference point is considered, the satisfaction level of PPP participants determines whether the system's overall utility attains its maximum value. The equity allocation's satisfaction effect impacts PPP participants' utility, meaning the psychological dimension must be taken into account during decision-making. While this study considers total surplus as its objective function, this may result in a more complex decision process. Typically, both private and public sectors seek to maximize personal utility when making decisions; thus, a game-theoretic model may prove more relevant for describing their decision processes.

Findings: Cost Allocation in Practice

Two basic kinds of cost allocation techniques exist. Direct costs involve a relatively simple technique, since direct costs are traceable to a single venture or contract. The challenge linked to achieving compliance 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 highly subjective and complex. Because this is an area that commonly leads to confusion for new and even experienced governmental contractors, the following sections explain how indirect costs are allocated to ensure Defense Contract Audit Agency (DCAA) compliance.

Direct vs. Indirect Costing

The foremost area requiring mastery is a clear understanding of the terms "indirect cost" and "direct cost." After defining these terms, the contractor should code them consistently. One important point to remember is that contractor definitions and accounting practices — rather than governmental authorities — guide what constitutes indirect and direct costs. Direct costs denote all costs identifiable to a single cost objective. They are generally necessary for or even demanded by the performance of a contract. "Cost objective" is a regulatory term that may encompass contracts, activities, undertakings, or contract line items (Chan, 2003). It may also encompass individual indirect ventures such as proposals and bids, or independent research and development (R&D) ventures, the costs of which are billed to the indirect cost account.

Once the contractor establishes these definitions, it must apply consistent cost charging — coding costs either to indirect accounts or directly to cost objectives. Consistency is essential: inconsistency will create compliance failures with the DCAA and will also distort indirect rates.

Conclusion

According to the CPA, prices for services and products supplied by major governmental enterprises ought to reflect "full cost attribution." However, it does not provide any additional guidance on what cost attribution entails in practice. Full cost is not a precise term. For independent governmental enterprises, full enterprise costs are straightforward. Under the fully distributed cost (FDC) technique, overall enterprise costs are allotted across all non-commercial and commercial outputs. Direct costs are allocated to individual outputs, whereas joint and indirect expenses are averaged over all outputs.

Consequently, cost bases for individual outputs cover a share of direct capital costs as well as those indirectly utilized in output production. The latter might, for example, cover a share of the capital costs of an organization's corporate service functions. This underscores the importance of selecting appropriate cost drivers and allocation bases — decisions that directly affect both pricing accuracy and regulatory compliance for government contractors.

Chan, J. L. (2003). Government accounting: an assessment of theory, purposes, and standards. Public Money & Management, 23(1), 13–20.

Chiang, B. (2013). Indirect labor costs and implications for overhead allocation. Accounting & Taxation, 5(1), 85–96.

Commonwealth Competitive Neutrality Complaints Office. (1998). Cost allocation and pricing: CCNCO research paper. Commonwealth of Australia.

Holland, N. L., & Hobson, D., Jr. (1999). Indirect cost categorization and allocation by construction contractors. Journal of Architectural Engineering, 5(2), 49–56.

Kumar, N., & Mahto, D. G. (2013). Current trends of application of activity-based costing (ABC): A review. Global Journal of Management and Business Research Accounting and Auditing, 13(3).

Peng, Y., Zhou, J., Xu, Q., & Wu, X. (2014). Cost allocation in PPP projects: an analysis based on the theory of "contracts as reference points." Discrete Dynamics in Nature and Society, 2014.

Thomassen, K., Vassbø, S., Solheim-Kile, E., & Lohne, J. (2016). Public-private partnership: Transaction costs of tendering. Procedia Computer Science, 100, 818–825.

Toompuu, K., & Põlajeva, T. (2014). Theoretical framework and an overview of the cost drivers that are applied in universities for allocating indirect costs. Procedia — Social and Behavioral Sciences, 110, 1014–1022.