CHAPTER 12

Defense Contract Audit Agency Proposal Reviews

The Defense Contract Audit Agency (DCAA) proposal review criteria are established in the DCAA Contract Audit Manual (DCAM), Chapter 9. The focus of that DCAM chapter is on the review of costs; however, the chapter includes guidance on the administrative aspects of proposal reviews. A contractor’s proposal might comply with the Federal Acquisition Regulation (FAR) but will still be subject to a review by either the Defense Contract Management Agency (DCMA) or the DCAA. Each of these organizations has published guidance to its reviewers on how to evaluate contractor proposals.

The DCAA guidance is more explicit and detailed than that of the DCMA. This guidance, as discussed in this chapter, should be used in conjunction with the guidance generally offered throughout this book. The purpose of describing and discussing the DCAA guidance is not to instruct on how to prepare a proposal, but rather to alert readers of the potential issues that could be encountered during a DCAA proposal evaluation.

DIRECT LABOR

Direct labor costs consist of estimated direct-labor hours priced at estimated direct-cost rates. For time-and-materials and labor-hour contracts, hours may not need to be estimated, because only rates are negotiated and hours are provided in the solicitation.

Basis of Estimate

DCAA classifies estimates into (1) estimates developed primarily from historical direct-labor costs and (2) estimates developed primarily from the application of technical data. The method used to arrive at an estimate will depend on the nature of the procurement and the extent of the contractor’s experience with the labor requirements of the proposed contract. When a contractor is proposing on a follow-on contract, the labor estimate should be based on previous labor experience, adjusted for expected changes for future work. When the contractor is proposing on a research and development contract or a production contract for which the contractor has no previous cost experience, the reviewer should expect the labor estimate to be based on technical data.

Many techniques may be used for estimating labor requirements and costs within these categories. Selection of the most appropriate estimating technique will produce reasonable and accurate labor estimates. Labor cost estimates based on historical data are generally developed through one of these methods: (1) comparison, (2) unit method, (3) factor method, and (4) cost- and time-estimating relationships. Labor cost estimates based on technical data generally use: (1) the judgment and conference method, (2) probability approaches, and (3) standard time methods.

According to DCAA, the most common types of data used in preparing labor cost estimates are: (1) actual costs for the same or similar item or activity; (2) labor standards with adjusted historical efficiency factors; (3) standard cost with forecast adjustment factors; and (4) tentative, judgmental, or rough estimated hours.

Labor Categories

This aspect of DCAA guidance is likely overtaken by consistency requirements, in that the guidance implies some flexibility in setting categories but concludes that the reviewer must evaluate the direct-labor cost estimates within the classification framework used by the contractor. The reviewer should be alert for possible deviations from the applicable cost accounting standards (CAS), inconsistencies in the classification and treatment of labor costs, and inconsistencies in the development of labor rates applicable to individual cost estimates. Inconsistencies are likely to occur in the treatment of nonrecurring, contingent, or special labor cost items. Deviations can result in duplication of labor costs within the estimate by inclusion in both the direct and indirect labor categories.

Labor Cost Data

Factors that affect the productivity of labor normally will not be the same today as they were last week or last month. It is not sufficient to use labor costs accumulated in the past, adjusted only for changes in the labor rate, or to use the labor cost for the last job lots produced; the last job lots may well include labor cost incurred over an extended period of time. The cost data used in the estimate should be based on current experience, adjusted for anticipated reductions, modernization of manufacturing processes and practice, or other variations, and developed in accordance with the applicable CAS. This guidance is often ignored by DCAA reviewers, who instead—inappropriately—rely solely on historical costs.

The objective in evaluating the base used by the contractor for the projection of a direct-labor cost is to arrive at an amount which would represent today’s cost for performing each direct-labor task. In the case of standard costs, this occurs when the current normal variance, rather than the average variance over an extended period, is used as the base. Plant and personnel records should be reviewed for changes in labor efficiency or pay rates that would not be reflected in current cost data. A relatively simple check would be to compare the most recent cost for individual labor operations with that used by the contractor in developing its estimate. This last point brings the reviewer back to actual costs.

The DCAA reviewer is advised that the first step in evaluating labor estimates is to determine and assess the basis used to estimate costs. The contractor’s proposal is expected to identify the sources of data, the estimating methods, and the underlying rationale used. The contractor should analyze and use historical experience where appropriate. If the labor-estimating technique applied makes use of historical data, these steps generally should be performed:

1. Identify the historical data used to develop the labor cost estimate.

2. Ascertain the reliability and accuracy of the data.

3. Evaluate the content of the data to ensure that it is representative and contains all costs that are purported to be there. (Compare supporting data to other sources of historical information such as operational staffing. Inconsistencies may indicate exclusions of pertinent historical data. Determine whether valid reasons exist for excluding data.)

4. Test for consistency of data over a given period. Look for accounting system changes, reclassification of costs from direct to indirect and vice versa, and consider the results of previous CAS audits.

5. Ensure that nonrecurring costs are removed from historical data. Pay special attention to manufacturing setup costs, which are lot-quantity sensitive.

6. Ensure that other nonrepresentative data are excluded. For example, some historical inefficiency may not be expected to recur. Likewise, some historical events are unique and should not be used as a basis for predicting future costs.

7. Make sure the data are current. Data that are too old may not reflect expected conditions (e.g., facilities, equipment, management, organization, modernization of manufacturing practices and processes, and staffing).

8. Ensure that historical data are obtained from the same facility where the proposed end-item or product will be manufactured.

9. Examine the relationship between lot costs and equivalent units produced. If the relationship is not consistent, it may indicate either changes in production (e.g., engineering design changes, make-or-buy changes) or inaccurate measurement of equivalent units in beginning and ending inventories.

Reviewers are advised that when evaluating the direct-labor cost estimate, they should ascertain whether the contractor, in arriving at the labor cost projection, considered seasonal, learning, and other factors that cause trend fluctuations and analyze the historical labor data covering a sufficient period of time and in sufficient detail (e.g., by departments, production centers, or processes) to disclose seasonal trends. It should not be assumed that past trends will continue; rather, the reviewer should judge whether the conditions that produced the current trend are likely to continue and, if so, how such conditions will affect future costs.

Other Considerations

When the current estimate provides for nonrecurring costs, the reviewer should weigh the probability that the costs will materialize. If it is considered likely that the cost will be incurred, the reviewer should evaluate the reasonableness and allocability of the costs. If it appears unlikely that the costs will be incurred, they should be questioned.

Cost reductions resulting from prior engineering changes and included in recorded costs should be evaluated in estimating costs of follow-on procurement. The reviewer should determine that the costs of expected engineering changes that will be priced as contract changes are not provided for in the current proposal.

The reviewer should ascertain the types of labor that the contractor normally classifies as setup time costs and review the method of accounting for such costs before evaluating the estimates of direct labor for setup time. Adequate segregation of setup costs by categories such as departments, jobs, product lines, components, and operations will enable the reviewer to make comparisons between the estimated setup time and costs for new procurements and the actual time and costs for previously produced products of the same or similar type; and between a specific estimate and the actual setup time costs.

In evaluating the estimate for setup cost, the reviewer should determine whether an approximate optimum number of items are scheduled for each production run and whether the estimated number of setups is reasonable. He or she should also consider factors affecting the size and frequency of production runs. These include the length of time over which delivery is to be made, the number of production lines, the number of production shifts, production scheduling, machine utilization, production capacity, tooling requirements and the tools available, and competing demands for the use of production facilities.

Applicability of the Labor Cost Data

Reviewers are advised that cost data used should be directly applicable to the proposed contract. When the estimate is for the continued production of a product currently or recently produced, the applicability of cost data can be determined by examination of operation sheets and production schedules and plans. When appropriate, contractor personnel should be interviewed to ascertain probable significant changes in engineering production methods and the effect those changes might have on current cost data.

When an evaluation indicates that significant technological changes have occurred since the cost data were accumulated, adjustment of experienced costs is necessary before projecting the experience cost pattern. Adjustment of the direct-labor cost experience is especially important when the estimate applies to a product that is relatively new or has been materially modified from one produced in the past. The reviewer should be alert to features of the contemplated production that might indicate a significant deviation from the normal labor pattern and to its effect on the cost data.

Variance in Direct-Labor Cost Estimates

The reviewer is advised that variances between estimated and actual cost are generally a consequence of either human error or changed circumstances. They can result from: (1) careless accumulation of supporting data, (2) incorrect design information, (3) unexpected delays causing premiums to be paid for overtime, (4) unexpected processing problems requiring deviation from the manufacturing plan, (5) failure to rework preliminary estimates to produce an accurate finished estimate, (6) reliance upon estimators who are not familiar with job processes, (7) making a “guesstimate” and then “padding” it to protect against unanticipated costs, (8) failure to consider all quantities being built, and (9) inappropriate use of learning curves or other techniques.

This audit guidance seems to use unconventional terminology or significantly misplaced discussion. The term variance in accounting terminology refers to the difference between actual costs and standard costs under a standard cost system. However, here the DCAM seems to be addressing variances that presumably exist at the time of proposal evaluation. If the work is not yet performed, there is no accounting variance to determine. It would appear that this guidance is directed to reviewing historical cost data for the purpose of adjusting differences between prior estimates and actual cost data.

Estimates Based on Technical Data

Specific areas in which the reviewer may make inquiry, either in anticipation of coordinating with the technical representative or in conducting the audit independently, include a review of: (1) the labor-hour estimate, (2) operation time and shop methods, (3) operation time standards, and (4) the contractor’s labor productivity. Here, the reviewer is venturing outside his or her area of expertise in assuming the role of a technical specialist.

Evaluation of Direct-Labor Hour Estimates

Conditions influencing the contractor’s use of technical data to estimate labor hours include: (1) the elimination of supplementary assembly lines originally established to accommodate temporarily accelerated production schedules or other emergency measures; (2) the introduction of more efficient and cost-effective material issuing and handling procedures to eliminate or prevent bottlenecks and reduce work stoppage; (3) improved techniques in the training of employees; (4) more efficient transfers of employees between assembly lines, work areas, departments, shifts, and jobs; (5) modernization of manufacturing processes; (6) the introduction of new manufacturing machines, and (7) the introduction of special tooling. To determine whether labor-hour estimates reflect recently improved conditions, the reviewer should compare current labor operation sheets with those from previous periods and with those reflecting advance production schedules.

Operation Time Sheets and Shop Methods

When the contractor is unable to support its estimate with experience data, the reviewer should seek other justification from the contractor, such as technical determinations, to assist in appraising the reasonableness of the data and bases underlying the cost estimate. An evaluation of operation time sheets (or similar documents that reflect the estimated time required to perform each production operation) generally will, in the aggregate, provide a basis for evaluating a contractor’s estimated direct-labor hours. The reviewer should determine that the operation time sheets do not include as direct labor those operations that will be recorded as indirect labor and whether provisions for contingencies have been included in the estimate, especially in costing a new product.

Operation Time Standards

Operation time standards (i.e., the predetermined estimates of the time required to perform each operation) are usually reflected in operation sheets. These standards may or may not represent the same time factors used to develop the accounting standard direct-labor costs or the actual labor costs as recorded in the contractor’s cost-accounting records. To perform a more meaningful evaluation, the reviewer should determine the relationship between operation time standards and direct-labor standards established for accounting purposes.

The basis for establishing operation time standards may vary depending upon company policy. Contractors may base standards on the number of units which can reasonably be produced by an employee under normal or average operating conditions or may establish ideal operation time standards (i.e., standards based on nearly ideal conditions as a means of encouraging maximum productivity). The reviewer should analyze the contractor’s time study methods and other bases used to establish time standards for each operation and should also analyze factors other than operation time, such as provisions for rework, setup, and other nonoperational time which may have been included in the standards. Information of this type, such as the efficiency factors used to modify the operation time standards in arriving at the estimated number of direct-labor hours for a specific proposal, can be of value in appraising the reasonableness of cost data. Again, this is not a subject within the expertise of a reviewer; however, the reviewer may nevertheless make recommendations based on their limited knowledge of this technique.

Labor Productivity

Within limits, the productivity of direct labor, as measured by the quantity of product produced by a specified volume of labor, normally increases as production continues. The improvement may be due to the adoption of improved methods and tools or the increased efficiency of the individual worker. The amount of improvement per unit of product generally is high during the early part of the production cycle and decreases as production is stabilized, processes are refined, and additional experience is gained. After production has stabilized, the rate of improvement may not be measurable except over a substantial period of time.

When semiautomatic or automatic machines are used, production may become completely stabilized and the rate of improvement will approximate zero until a change is made in the product or in the production method. As production tapers off near the close of a period of stabilized production, labor productivity tends to decline toward a negative improvement rate. Reduction in production effort may be due to the wearing out of jigs and tools, the transfer of the more skilled workers to new jobs, or a slackening of effort by the remaining workers.

The reviewer’s primary interest in labor productivity is in measuring current productivity and past trends and determining the causes of past trends so that the likelihood of their continuance during the contemplated production period may be assessed. Causes and effects can be separately measured, provided the change is sufficiently pronounced and is not obscured by other factors. A change in tools or the introduction of a highly improved production process might be related to a specific reduction in the required labor hours, or a change in design might be related to an increase in labor hours. Factors that affect productivity operate interdependently, and it is difficult to evaluate separately the effect of any one factor. However, an overall measurement of productivity may be made by correlating labor hour requirements with related successive quantities of output. One method of measuring the overall change in productivity is by the use of the improvement or learning curve.

Evaluation of Estimated Direct-Labor Rates

Direct-labor rates used to estimate direct-labor costs may be at expected individual or expected average rates. The latter rates may be either separately estimated for each proposal or pre-established for pricing many proposals submitted over a given period of time. There is wide variation in the methods and extent to which contractors combine the various direct-labor grades and functions and associated pay rates for the purpose of cost estimating. Variations arise because of differences in the type, size, and importance of labor operations; in the type and arrangement of production facilities; in the manner and extent of departmentalization; and in the type and dollar values of government and commercial contracts and products.

Uncompensated Overtime

In the evaluation of direct-labor rates—both individual and average—consideration should be given to hours worked in excess of eight hours per day or 40 hours per week by salaried employees, particularly in the evaluation of fixed-price proposals. Estimated labor rates may be based on the number of hours available during a year using an eight-hour day and a 40-hour week. However, evaluations of actual labor hours incurred may have determined that salaried employees generally work in excess of eight hours per day and 40 hours per week. The estimated direct-labor rates used should therefore reflect the total hours the employee is expected to work during the year.

Federal Acquisition Regulation (FAR) 37.115, Uncompensated Overtime, does not encourage the use of uncompensated overtime. Instead, the FAR discourages the use of extensive uncompensated overtime by treating proposals with significant uncompensated overtime as more risky during the contract award process. Its associated solicitation provision, FAR 52.237-10, is to be inserted in all solicitations valued above the simplified acquisition threshold for professional or technical services to be acquired on the basis of the number of hours to be provided. FAR 52.237-10 defines uncompensated overtime as “hours worked in excess of an average of 40 hours per week by direct charge employees who are exempt from the Fair Labor Standards Act.” Service contracts are usually awarded on the basis of the tasks to be performed rather than the number of hours to be provided. However, if a service contract is awarded on the basis of the number of hours to be provided and the contractor proposes uncompensated overtime hours, then this solicitation provision requires the contractor to identify in its proposal the uncompensated overtime hours and rates. This includes uncompensated overtime hours in indirect pools for personnel whose regular hours are normally charged directly.

This FAR provision also requires that: (1) the contractor’s accounting practice for estimating uncompensated overtime be consistent with the accounting practice for accumulating and reporting these hours, (2) the contractor include a copy of its policy on uncompensated overtime with its proposal, and (3) the contracting officer conduct a risk assessment and evaluate any proposals received that reflect such factors as unrealistically low labor rates that may result in quality or service shortfalls and unbalanced distribution of uncompensated overtime among skill levels and its use in key technical positions.

Reviewers should notify contracting officers of any apparent noncompliance with the FAR requirements—specifically, if the contractor proposes uncompensated overtime hours but fails to identify the number of such hours and corresponding hourly rates. Reviewers should also notify contracting officers if the contractor fails to submit with its proposal a copy of its policy addressing uncompensated overtime.

Individual Employee Labor Rates

Individual rates may be used when the persons who will perform the work under the proposed contract are known. A determining factor in the award of a contract may be the expertise of specific individuals and their agreement to perform the work under the contract. In other cases, individual rates may be used when the procurement being audited requires a caliber of employees whose pay rates are not representative of the average rates paid within their labor classifications. Although the use of individual rates in cost estimating will produce precise results, average rates within labor classifications are generally employed for practical purposes. Either approach may result in reasonable estimates, provided a consistent practice is followed, and deviations will not affect proper recovery of anticipated costs.

Average Labor Rates

The development of average labor rates by contractors may include a single plantwide average or a separate average rate for a function, grade, labor category, cost center, department, or production process. The use of average rates is generally warranted, because within each unit of an operating plant there is usually a labor norm and cost pattern for each production situation and associated group of workers. Average rates, properly computed and applied, will express the labor norm and equalize the effect of the indeterminable factors usually associated with other methods.

The use of average rates is preferable, for example, when the contractor is unable to project with any degree of reliance: (1) the identity of those who will perform each operation and correspondingly the individual rates of pay; (2) the exact production processes to be used, particularly when the contractor has no applicable experience; and (3) the precise labor requirements.

The inclusion of inapplicable types or quantities of labor in the computation of an average rate is not in itself reason for rejecting the rate. The reviewer should determine whether the inclusion significantly distorts the average from the probable norm for the contemplated production.

It would be improper for a single average to combine equal quantities of high- and low-cost labor if they were not to be used equally in production, or to compute an average group of pay rates without weighting—that is, without regard to the number of employees receiving each wage. The use of weighted averages is necessary to give proper effect to all factors.

The reviewer should determine the effect of proposed personnel actions on the estimated average hourly labor rates, whether actions that have a material effect on these rates are in accord with the normal personnel policy, and whether resulting rates are reasonable.

The reviewer should determine whether consideration has been given to the terms of all current wage agreements and prospective changes. In evaluating agreements that provide for changes based on cost-of-living indices, the reviewer should analyze current and past trends and determine their future significance. Information contained in the labor rate reports published by the Bureau of Labor Statistics, Department of Labor, and by state and local agencies may also furnish data for this type of analysis.

It is not practicable for the reviewer to isolate and measure the precise effect of every personnel action on average hourly rates. Merit increases, promotions, and changes in size and composition of the labor force occur continually, are interrelated, and have a cumulative effect on average hourly rates. The reviewer should determine the composite effect of the personnel actions and determine whether any overall current average hourly rate trends exist that will continue during the contemplated production period or whether new trends are likely to develop. The major factors should be analyzed and the trend indicated by each type of action determined even though the effect of each action on the average labor hourly rate cannot be measured directly.

Changes in the size and character of the labor force affect average pay rates. These changes accompany increases or decreases in production volume. A material increase in volume usually will result in a decrease in the average rate because of new hiring at a lower entrance level or at rates below the average. The opposite result can be expected when production volume decreases. The first groups of employees to be separated are generally in the lower pay levels of their respective labor classifications. The possible effect on labor cost of a contractor’s plans to increase or decrease the labor force because of changes in production volume can be estimated by correlating past changes in the number of personnel and changes in the average pay rates for each plant unit or labor class. In evaluating planned changes in the number of personnel, a further correlation might be made of the labor force or labor payroll with production volume, as measured by units, cost of sales, or other means.

When evaluating average labor rates, the reviewer must consider multishift and overtime operations. Premium payments for multishift and overtime may have a direct effect on the average direct-labor hourly rates, depending on the method used in classifying and distributing costs. When premium payments are recorded as overhead, they should not be reflected in the average direct-labor hourly rate. When treated as part of the direct-labor charge, premium payments should be segregated from average direct-labor hourly rates. If not segregated, fluctuations in the amount of premium pay will tend to distort any trend or other data developed in analyzing changes in the regular pay rates.

In summary, factors the reviewer should consider in evaluating proposed average labor rates include: (1) the reasonableness and acceptability of the labor classification; (2) the probability that relatively the same grades of labor will be used in performing the contract as were used in developing the estimate, and the probable effect of any material deviations; (3) the accuracy and propriety of the method used in computing the averages; (4) the impact on the average rates of projected increases or decreases in the general level of labor costs; and (5) the significance of any deviation from past practices in developing the rates, their application, or the normal and proposed methods of distributing costs when incurred.

Pre-Established Labor Rates

Pre-established rates are not common and create potential difficulties with the Truth-in-Negotiations Act. Nevertheless, DCAA reviewers are advised that some contractors may estimate labor rates for use in computing the estimated direct-labor cost portion of all proposals to be submitted during a specified period of time. The contractor may estimate the production labor hours for a contract and compute a cost estimate by applying an average labor rate for each manufacturing department, production function, or type of labor. This procedure is inexpensive and is workable because: (1) it recognizes a continuing uniformity in the manufacturing process within a plant, which has considerable validity, especially when separate rates are used for each production function; and (2) it promotes consistency in estimating methods and compliance with applicable CAS.

Labor rates are not applicable to all businesses or to all labor conditions or manufacturing processes within a business. The customary use of labor rates by a contractor in developing direct-labor cost estimates does not make their applicability automatic. There are definite limitations on the use of such rates. Their use is based on the assumption that the manufacturing process is relatively stable and prior labor usage patterns will not change significantly in the future. The use of labor rates must be examined in each case to determine whether the contemplated production methods and requirements parallel the conditions of labor usage presupposed in the development of the rates, or whether conditions that indicate the rates should be modified or rejected are present. This appraisal must be made even though the rates have been approved on an overall basis by government procurement activities.

Labor Usage

The reviewer usually can expect, in the absence of indications to the contrary, that production labor norms will be applicable, insofar as factors such as pay differentials for unskilled labor, longevity, efficiency, piece work premium, and shift premium are concerned. The same assumptions cannot be made for factors such as pay differentials for skilled workers, specialists, technicians, engineers, and others. Usage patterns vary, and variations may arise due to the nature of the production involved. The reviewer therefore must consider both current usage and future labor plans. The proposed and probable labor patterns for production under the contract must be considered. The reviewer must also consider the consistency of those patterns with other plans for the prospective production period; the availability of the various classes of labor; and the normal methods of using, assigning, recording, and charging the labor costs to commercial and government products and contracts. Significant deviations from the normal pattern should be supported by adequate justification for the reviewer’s consideration in evaluating the estimates.

Trends of Labor Rate

The current average hourly rates paid for each labor classification may be used by contractors as a starting point in computing future rates. These should be verified by examining current payroll records. The average rates should be adjusted for any planned or expected changes in the wage scale and any trends that may be present in the historical pattern or that can be expected to carry forward into the contemplated production period. This will require an analysis of the historical labor and payroll data for a period of time sufficient to disclose any trend that may be present.

The period to be covered by the analysis cannot be predetermined. Seasonal and longer-term fluctuations generally require that experience factors be examined for a minimum of two business years. A longer period may be necessary in special circumstances. However, the use of a longer period will not necessarily increase the validity of the trend data developed, because changes in organizational structure, size, or composition of the labor forces; general economic conditions; and other factors affecting the rates may be encountered over a long period. These factors may not be appropriate for consideration when estimating rates for future periods.

DIRECT MATERIALS

Estimating direct material costs is a critical step in production contract proposals. In addition to the inherent difficulties in estimating, material cost data are often a moving target in that new prices for materials develop between the time the proposal is prepared and when price agreement is finally reached.

Bill of Materials

A properly prepared bill of materials generally will provide a sound basis for estimating direct material costs. The bill of materials will usually contain a detailed listing of the required types and quantities for each raw material and for each component and part. It may also include allowances for expected losses (e.g., defects, spoilage during processing, scrap generated), common supply items (welding rods, nuts, bolts, washers), or other additives to the basic material requirements. When it contains only the basic material requirements, attrition factors stated as a percentage of material costs may be applied to provide for expected costs of material losses and common supply items. Common attrition factors address scrap, rework, spoilage, pilferage, droppage, inventory adjustments, and similar conditions. The reviewer needs to ensure, however, that the estimated costs supporting these loss allowances or loading factors are not also included in the contractor’s indirect cost estimates.

A bill of materials can usually be provided for an end product or any subassembly. The most common sorts are:

Part number ascending/descending order

This bill of materials is sorted by ascending/descending part number showing total quantity required for each part of an end item. A detailed report may give further information, including where the part is used.

Assembly/subassembly (Christmas tree)

This bill of materials is hierarchical and lists major assemblies followed by the various levels relating to subassemblies. It is often referred to as a Christmas tree because of its pyramidal or Christmas-tree shape.

Proposed bill of materials component unit prices should be based on the total production schedule quantity requirements (i.e., for multiple contracts being performed simultaneously or for both production and spares) when appropriate.

Quantity Estimates

When the estimate relates to a follow-on procurement and previous experience exists, the audit should include but not be limited to these actions:

  •  Obtain the engineering bill of materials that supports the contractor’s proposal. An engineering bill of materials is preferable to a manufacturing bill of materials due to its correspondence to engineering drawings. If the reviewer intends to select a manual sample of parts, an ascending or descending bill of materials with prices is usually necessary. Higher-assembly information must be part of this bill of materials or available in a supplemental document to ensure that the lower-level parts are identified and verified to their appropriate higher assemblies. For an electronic bill of materials, the part numbers may be in ascending/descending order or assembly/subassembly order.

• Determine that the bill of materials is current and that, based upon the applicable specifications, it reflects all anticipated changes in the unit quantitative requirements.

  •  Prepare a sampling plan. Select for evaluation either a random stratified sample or dollar unit sample of parts. Although the sample should be designed to validate bills of material quantities to engineering drawings, the sample should also be used to validate pricing to the extent that this is practical.

  •  Obtain detailed engineering drawings for the sampled parts. Separate engineering drawings may not be available for purchased parts, but may be available as part of the next-higher assembly drawing. Also, an initial bill of materials may be incomplete and contain undefined parts which do not have engineering drawings. This may result in a reviewer’s rejecting the proposal as not being adequately supported.

  •  Compare sample part quantities and specifications (e.g., dimensions, tolerances) on engineering drawings to the bill of materials and note any discrepancies.

  •  Identify how the contractor calculated part quantities and the number of parts to be produced from raw material. Pay special attention to the contractor’s use of rounding when calculating raw material factors. Verify the accuracy of the contractor’s calculations by working through several part estimates and note any discrepancies. This is generally beyond the expertise of a reviewer, who is advised by the DCAM to seek government technical personnel support for such estimates.

When the estimate relates to a completely new product, the contractor may have only rough sketches or design prints for a prototype. The types and quantities of required materials may have been developed primarily based on the personal experiences and judgments of contractor personnel. Such estimates should be given close scrutiny because errors that duplicate material items are often found. Estimates for completely new products require the use of technical specialists.

Operations Time Sheets

An operations time sheet usually includes a description of the discrete manufacturing operations and associated times necessary to build the part and may disclose material quantity, tools, fixtures, and labor standards. They are a main source of labor information. However, they may also be used as a substitute for a bill of materials for cost estimating purposes. Care should be taken when operations time sheets are used in conjunction with bills of material to ensure that costs are not duplicated.

Engineering Drawings

Material requirements are normally determined from engineering drawings. These drawings illustrate and provide the essential information needed to design and manufacture a product. This information includes: (1) physical characteristics, (2) dimensional and tolerance data, (3) critical assembly sequences, (4) performance ratings, (5) material identification details, (6) inspection tests, (7) evaluation criteria, (8) calibration information, and (9) quality control data.

Sources for Pricing

Sources of cost information for pricing components include: (1) standard costs, (2) previous purchase order prices adjusted for quantity differences, (3) current vendor quotations, and (4) current order placement prices. Standard costs are not as common as they once were due to difficulties in maintaining current standards. Nonetheless, standard cost systems are still used extensively in certain environments.

In evaluating the contractor’s pricing procedure, the reviewer should consider:

  •  The sources used to arrive at the prices for each element composing the total direct material estimate or the priced bill of materials. When the source is standard costs, determine whether the variance factor applied is realistic compared to past and current experience and considering probable future trends. When prices are developed from previous purchases, identify the source of the prices (e.g., stock record cards or purchase orders) and ascertain that the prices used are current and appropriate for the estimated quantity required. When prices are developed from current vendor quotations, determine the extent of bid solicitations and the reasonableness of prices submitted.

  •  Contractors generally maintain inventories of the parts and components incorporated into regularly manufactured products. Inquiries should be made to ascertain the extent that available inventory has been considered in deciding the source of proposed material. When parts included in the inventory are to be used in the fabrication or production of items included in a proposal, verify the unit costs applicable to the inventory.

  •  Regardless of the source used, compare the prices in the proposal with (1) those quoted by competing suppliers for comparable quantities, (2) recent quotations for the same or similar items, (3) costs incurred by the contractor for the same or similar items, and (4) the cost of any available inventory not specifically identified to other contractual requirements.

  •  The consistency with which the material pricing sources are used. When a variety of material pricing sources are used in costing the bill of materials, consistency in estimating procedures is not possible unless guidelines closely define the governing factors. This becomes apparent when the contractor has a recurring, substantial dollar proposal volume. Closely scrutinize the propriety and reasonableness of material price estimates when there are inconsistencies in estimating procedures.

Purchasing Procedures

Economical buying practices generally result in the lowest prices for maximum quantities consistent with need, required quality, and delivery schedules. The contractor’s purchasing practices should be tested for reasonableness of quantity, quality, and the prices of direct materials, not only for parts in inventory but also for parts required to be purchased under the proposed procurement.

When current vendor quotations are used to support the contractor’s direct material cost estimate, determine the extent to which the contractor followed economical buying practices. Vendor quotations should be examined to determine whether they were submitted in response to the procurement under consideration and whether prices are appropriate in light of required quantities and specifications. When effective competition does not exist, as in the case of sole-source vendors, the contractor’s source for estimating material prices should be given close analysis.

Procedures employed by a contractor for evaluating subcontractor estimates may include using engineering departments to prepare independent estimates for comparison with subcontractors’ price quotations and field audits of subcontractors’ quotations by company audit personnel or independent public accountants. The reviewer must determine whether the contractor’s procurement procedures are adequate when planning the extent of testing and evaluation.

The reviewer must also consider the result of operations audits of any related areas in making this appraisal. The contractor is usually concerned with obtaining the best subcontract prices available so that its proposed price will be competitive. However, if the prime contract proposal is non-competitive, give special attention to determining the adequacy of the contractor’s procurement procedures.

The contractor is required to include the results of subcontract reviews and evaluations with its own submission of cost or pricing data. However, unstated in the DCAA guidance is that if such analyses do not exist, they cannot be included in the proposal. Furthermore, because of time constraints, the contractor might not complete the analyses of subcontracts prior to submitting its own proposal. In these cases, the reviewer should ensure that reasonable schedules are planned to accomplish them and evaluate other actions by the contractor to assess the prices that its vendors have proposed.

When a contractor’s basic procedures are deficient, actual procedures do not conform with prescribed procedures, or current data are not sufficient to provide a satisfactory basis for evaluating the reasonableness of the subcontract estimate, further testing of major subcontracts may be necessary. This may be done by reviewing the available data at the contractor’s plant or by arranging for an assist audit of the subcontractor’s submission.

When there are historical data on similar subcontracted components, the contractor should analyze its experience, determine the applicability of its experience to the subject procurement, disclose the analysis, and reduce its proposal if appropriate. The fact that reductions are not definite does not excuse the contractor from preparing an analysis or submitting such information as cost or pricing data.

The responsibility for contractor purchasing reviews now rests with the DCMA. References in the DCAM to purchasing system aspects were generally made obsolete by the assignment of this responsibility to the DCMA.

Previous Purchase Order Prices

The contractor may use prices paid for the same items in previous purchases to estimate the material cost of follow-on procurements when current vendor bids have not been obtained. The reviewer should determine the extent to which: (1) recent purchase orders were selected to obtain applicable prices and adjusted where necessary to reflect price trends, (2) purchase order prices selected are for comparable quantities required for the follow-on procurement, (3) quantity discounts were given when increased quantities are to be purchased, and (4) consideration has been given to eliminating high start-up costs.

Company-Produced Components

Under certain circumstances, contractors may propose materials and supplies based on price rather than cost when they are sold or transferred between any division, subsidiary, or affiliate of the contractor under common control. If the audit discloses items that are improperly based on price rather than cost, appropriate adjustments should be made to eliminate the intracompany profit (plus any inapplicable indirect costs).

Pyramiding of Costs and Profit

According to the DCAM, most major programs require the use of subcontractors, not only to obtain facilities and skills which may not be available within the upper-tier contractor but also to broaden the procurement base and meet requirements for utilizing small business. However, the reviewer should be alert to instances where a proposal may be excessive because of unreasonable pyramiding of costs and profits. This may occur between divisions, plants, or subsidiaries of a company or between subcontractors and upper-tier contractors—which is, of course, covered by FAR 31.205-26(e).

The contractor’s procurement program should be reviewed to determine whether the planned subcontracting pattern is reasonable. The reviewer should not limit his or her considerations to first-tier subcontracts but should coordinate with reviewers at subcontractor locations to disclose unreasonable pyramiding of costs or profits at any of the levels of the procurement chain where significant costs are involved. This latter guidance is inappropriate, because the regulations do not dictate subcontracting matters but relay on: (1) the government purchasing office for monitoring and (2) FAR provisions that require a periodic government review of previous subcontracting decisions.

Items may be drop-shipped direct to the upper-tier contractor’s plant, or they may pass through the subcontract plant for minor additions, changes, or testing that could be done more economically and as well at a lower- or an upper-tier contractor’s plant. Contrary to the implication that the additive costs of this should be less, DCAA demands that drop-shipped materials must be included in cost allocations bases without abatement.

Reviewers are advised to be aware of purchases by an upper-tier contractor of items that are identical or similar to items being purchased by the government and that could more economically be supplied as government-furnished property. This is not a DCAA role but rather the role of the government purchasing office that would have access to information on what government-furnished property might be available.

The entire DCAM discussion of pyramiding of costs and profit is not reflective of regulations and accepted practices. This topic is a potential procurement process issue and not an audit issue.

Subcontract Decrements

Vendor quotations and contract prices are subject to frequent change. These changes occur when: (1) vendors agree to make voluntary price adjustments and refunds in the event that purchases exceed predetermined levels, (2) vendors agree to reduce a competitive quote, or (3) profits become excessive. The relevance of the latter is negligible, because only rarely do vendors lower prices because the profits were “excessive.”

If significant amounts of these changes are attributable to inefficient prime contractor purchasing practices, the reviewer should recommend that corrective measures be taken: (1) improve the prime or upper-tier subcontractor’s purchasing practices and (2) recognize the impact of the changes in cost proposals. The reviewer at the prime or upper-tier subcontractor level should also advise the reviewer at the (lower) subcontractor level to reappraise the subcontractor’s estimating procedures. This guidance has little impact on the task at hand (e.g., evaluating a proposal). This relates to purchasing systems reviews or audits, which are independent of a proposal evaluation.

Information concerning patterns of reductions from quotes to actual prices paid may be useful in evaluating a cost estimate. Information about historical reductions is cost or pricing data and should be disclosed to the government. In addition, Department of Defense (DoD) FAR Supplement (DFARS) 215.407-5-70(d)(2)(ix) requires contractors to use historical experience when appropriate (the latter two words, when appropriate, are often omitted in DCAA reviewer application). Contractors should, therefore, analyze the pattern of historical reductions, determine its applicability to the subject procurement, disclose the analysis, and reduce proposed cost, if appropriate (again, if when appropriate).

If there is a pattern of price reductions, review the prime contractor’s or upper-tier subcontractor’s analyses of quotes and subcontract prices. The reviewer should determine whether the contractor considered the pattern in estimating material and subcontract costs and evaluate the method used to analyze the price reductions. The contractor may apply a decrement to cost estimates based on patterns that are company-wide, program-wide, contract-specific, or vendor-specific. The reviewer should ascertain what cost data were used to develop the decrement factor and confirm that the factor is properly and consistently applied to vendor-quoted base costs.

Significantly, if the contractor has failed to use experience adequately in estimating costs, the reviewer is advised that it may be necessary to develop a decrement for use in evaluating material estimates.

Residual Inventories

When pricing a follow-on contract, consideration should be given to the ownership and value of residual materials from preceding government contracts that are usable on the proposed contract.

Where the preceding contract is a closed cost-type contract, the residual materials normally will be government-owned and, if their use is contemplated, should be included in the proposal at no cost if the use of that material is approved by the contracting officer. However, the contractor should propose residual material from an open cost-type contract at actual cost and again only if approved by the Contracting Officer.

Where the preceding contract was fixed-price and subject to price adjustment, terms of the settlement should be evaluated to determine ownership. If government-owned, residual materials should be included in the proposal at no cost. According to the DCAM, if contractor-owned, the material should be included at the lower of actual cost and current market price. This pricing guidance is biased in favor of the government and could lead to a contractor’s refusing to use this material on government work. From a fairness standpoint, this approach is about as equitable as pricing at the higher of actual cost or market price—something the government would not accept.

Scrap, Spoilage, and Rework

The estimated cost of scrap and spoilage (often referred to as attrition in order to include all aspects of material loss) may be included in proposals by contractors as a direct cost, as a percentage factor applied to some other base cost, or as a part of indirect cost. However, the guidance does not mention the fact that application as a percentage of cost attrition requires historical cost records.

Reviewers are advised to consider the economy and efficiency of the contractor’s operations. When the experienced scrap, spoilage, and rework costs on previous procurements for the same or related products are available, utilize these data in evaluating the reasonableness of the current estimate. As a general rule, scrap, spoilage, and rework costs are higher during the early stages of a contract and decrease progressively as production techniques improve. The reasons for high costs should be analyzed and an appraisal made of the probability of their recurrence. Information of this type can usually be obtained from scrap committee reports or departmental efficiency reports.

Special attention should also be given to the contractor that purchases parts from surplus or salvage dealers, especially where the contractor has declared a parts surplus and then repurchases similar parts at a later date.

Process loss is the difference between the amount of material required at the beginning of a process and the amount used for the finished part: that is, the material lost during the manufacturing process. Scrap loss is defective material. Process loss may be estimated using an overall factor, or separate factors for major subelements (e.g., trim loss, chip loss, excess casting material). Bill of materials quantities for items manufactured from raw material (e.g., sheet metal, bar stock, composite) frequently are adjusted to include process loss factors.

As with scrap, the reviewer should determine whether: (1) the contractor’s accounting procedures give proper recognition to process loss material generated under government contracts, (2) the loss is potentially significant, and (3) the method of estimating process loss is consistent with the accounting method for the proposed contract and complies with the CAS. When historical data on process loss are available, the reviewer should use this data to evaluate the current estimate. As a general rule, process loss rates should not vary significantly from previous contracts unless a new process or different material is introduced.

Obsolescence and Inventory Adjustments

Obsolescence and inventory adjustments may be included in cost estimates as percentage factors applied to a cost base or as a part of indirect cost. In determining the reasonableness of the contractor’s costs for obsolescence and inventory adjustments, the reviewer should consider:

  •  Whether the treatment of those costs for accounting and estimating purposes complies with the applicable CAS. This includes determining whether the estimates are valid for the method employed and whether the treatment given the costs will result in an over-recovery by the contractor.

  •  The percentage factors derived from past experience as a basis for estimating costs of obsolescence and inventory adjustments. The reviewer should ascertain the period used as the base and whether the contractor considered: (1) the exclusion of nonrecurring and abnormal write-offs and (2) transfers of obsolete material to back productive inventory.

  •  The factors which may have caused obsolescence. The reviewer should ascertain, distinguish, and evaluate the reasons for obsolete material. Obsolescence may result from engineering changes or from material purchases in unreasonable quantities because of inadequate purchasing or recordkeeping procedures.

The reviewer is to determine the reasonableness of the obsolescence factor contained in the cost proposal. Faulty procurement practices, inadequate records, inefficient storekeeping, or lack of standardization may result in unreasonable obsolescence estimates. When the charge for obsolescence appears unreasonable, the reviewer should recommend elimination of the unreasonable portion from the estimated costs. If the evaluation indicates faulty procurement practices, the reviewer should recommend corrective action to improve the contractor’s procurement practices and procedures.

When obsolescence is caused by engineering changes, evaluate the loading factors based on current conditions. For example, when firm specifications have not been developed and the item to be made is in the development stage, the contractor’s cost estimate may contain a relatively high obsolescence factor; on the other hand, the contractor’s proposal should not include an obsolescence factor if the contemplated procurement is for an end item for which specifications are firm and no further change is contemplated. When circumstances justify the inclusion of a loading factor for obsolescence because of engineering changes, the reviewer should determine that over-recovery will not result because of inconsistencies in procedures followed in estimating and accounting.

Material Cost/Quantity Curve

Using an improvement curve is generally associated with evaluating direct labor–hour estimates, but may also be used in evaluating the estimated prices of direct material parts and components as a material cost–quantity curve. Factors that may contribute to improvement in the direct material cost per unit include: (1) job familiarization, which reduces the amount of scrap and rework loss; (2) lower prices as purchase volume increases; and (3) introduction of new sources and new aspects of material quality after the initial stages of test and experimentation.

The reviewer should consider the use of improvement curves for plotting vendors’ prices for parts and components that are repetitively purchased. The plotting of quantities (unit or cumulative) versus billing prices may develop patterns which can be useful in arriving at reasonable prices to be paid for follow-on purchases. In evaluating the direct material cost portion of a prime contractor’s proposal, the reviewer may also plot previous related total material cost experience on log-log paper to ascertain whether a measurable rate of improvement in the material cost per unit has occurred. The reviewer should ascertain whether the contractor’s material cost estimate falls within a reasonable range of the cost indicated based on a possible or probable continuation of the experienced improvement rate. When the contractor’s total direct material cost forecast or forecasts of costs of selected components are significantly higher than the probable costs (based on a continuation of the related experienced material cost patterns), ascertain the reasons for the excess.

OTHER DIRECT COSTS

Audit objectives when auditing other direct costs are to determine whether:

(1) the contractor’s classification is proper; (2) the underlying data in support of the estimates are valid, current, and applicable; (3) the costs as reflected in the estimates are reasonable; (4) costs were estimated using acceptable procedures applicable in the circumstances; and (5) the contractor has properly considered all factors that might bear on the validity of the estimated costs.

Some contractors consider other direct costs as directed wholly toward the production of complete end products and, consequently, do not include these expenses in cost estimates for spare parts. Others contend that spare parts production has an impact on both the types and amounts of these expenses; therefore, they provide such estimates in spare-parts proposals. Regardless of which method is followed, the reviewer should determine the propriety of other direct costs for either end products or spare parts and verify that the method of treatment complies with disclosed practices and other CAS requirements.

Percentage and Conversion Factors

The topic of percentage and conversion factors basically concerns the acceptability of cost-estimating relationships. Packaging, field service, and various types of engineering and tooling costs may be estimated by applying a percentage to some other basic cost or conversion factors (e.g., direct-labor hours, or staffing per month) to estimates of required direct-labor hours or staff-months. In auditing conversion factors applicable to, for example, direct-labor hours per staff-month, the reviewer should ascertain whether the contractor considered excluding time for holidays, vacations, sick leave, idle time, and similar items of an indirect nature.

Percentages and conversion factors may be applied separately for each estimate, or they may be submitted or proposed periodically for incorporation in all proposals. In either instance, and notwithstanding previous agreements, the reviewer should evaluate the propriety of percentage and conversion factors for applicability in the current proposal.

Accounting Data

Contractors’ accounting records, which provide reserve accounts for other direct costs based on the quantity of end products produced or shipped, may be used in evaluating estimates. When reserve accounts are maintained, credit entries are based on estimated amounts per unit applied to the quantity of end products produced or shipped. Debit entries are made for the expense actually incurred. An analysis of these reserve accounts should assist in determining the reliability of the contractor’s prior estimates. Large credit balances may indicate overestimating and large debit balances may indicate underestimating of actual costs.

Analytical Techniques

Various analytical techniques can be used in evaluating the reasonableness of other direct costs. Graphic analysis usually is an appropriate evaluation tool for studying experienced cost patterns as they relate to various types of other direct costs. Time-series charts are useful for depicting the experienced movement of expenses or percentage factors related to some base cost over a period. Scatter charts are used to show linear relationships of a specific other direct cost to some other volume base to which it bears a close correlation.

The DCAM advises that comparative analysis technique may be applied by using available engineering data, budgets, loading charts, previous proposals for similar items, and industry standards and experience as reference points.

When the contractor’s proposal contains significant engineering or tooling direct-labor hour estimates, the estimates can be compared with related staff-hours specifically identified with the directly chargeable total plant engineering or tooling labor base used in the computation of the proposed engineering or tooling overhead rates. When the use of analytical techniques discloses significant differences, the reviewer should obtain further information from the contractor in support of the estimate. When differences cannot be adequately justified, the audit report should contain appropriate comments and recommendations.

Travel and Subsistence

Travel and subsistence costs usually include the costs of transportation and per diem (lodging, meals, and incidental expenses) incurred by personnel while in travel status. When these are included as other direct costs, the estimate usually is based on the contemplated number of trips, places to be visited, length of stay, transportation costs, and estimated per diem allowance. Questionable estimates for this cost may arise from such errors as:

  •  Projected per diem rates that exceed allowable per diem costs after escalation for expected inflation. Per diem rates are set forth in the federal travel regulations established by the General Services Administration for the continental United States; the joint travel regulations (specifically, volume 2) established by the DoD for Alaska, Hawaii, Puerto Rico, Northern Marianna Islands, and territories and possessions of the United States; and the Department of State standardized regulations for locations not covered by either of these (FAR 31.205-46(a) and Public Law 99-234).

  •  Transportation rates projected in excess of lowest customary standard, coach, or equivalent air fare offered during normal business hours.

• Projected transportation costs for personnel to be transferred computed by using other than proper departure points.

  •  Mileage allowances projected in excess of actual needs.

  •  Excessive number of projected trip costs to a government activity or subcontractor location for engineering coordination because the required number of trips and/or the length of stay have been overstated. A comparison of the current estimate with experienced costs of prior procurements of a similar nature indicates that the current estimate is unreasonable.

INDIRECT COSTS

The audit considerations in evaluating estimated indirect costs are similar to those in the audit of historical costs, because many estimates are based on historical costs. This guidance statement reveals that even though estimates are best if not based exclusively on historical costs, DCAA’s preference is for the use of historical cost data. The reviewer should consider the use of graphic analyses and statistical techniques in evaluating estimated indirect costs. These techniques alone do not provide a basis for firm forecasts of costs; however, in appropriate circumstances, they can provide a basis for ascertaining whether estimated costs are within a cost range of what can reasonably be expected in the future.

Anticipated Future Operations

Evaluation of indirect cost estimates requires consideration of anticipated future operations of a contractor on estimates and budgets. To determine what may be reasonably expected to occur, the reviewer should use analyses and projections of historical cost patterns and related data. This guidance appears contradictory in that it advises reviewers to evaluate future events based on whether or not the event happened in the past.

According to the DCAM, other methods of satisfying the audit objectives include reliance on certified final contractor overhead submissions, the work of internal or independent reviewers, or CAS compliance audits—none of these are acceptable to DCAA in practice. This guidance is convoluted: When audits of historical costs are not reasonably current and other methods of satisfying the audit objective are not available, the report should be qualified.

In a bit of good advice, the DCAM advises reviewers that it should not be assumed that historical cost patterns and the results of overhead audits for prior years will continue without change. The reviewer must consider contemplated changes that may influence the projections. Examples of changes and possible effects are provided in the DCAM:

  •  A change in the accounting policies governing the treatment of certain indirect expenses may include reclassification of expense from direct to indirect and new methods of accumulating and allocating indirect cost. Changes of this nature may affect the estimates for indirect costs and the computation of indirect-cost rates.

  •  A change in management objectives as a result of economic conditions and increased competition may occur. For example, in the past, management may have placed emphasis on a program to increase sales, whereas it now emphasizes a program to reduce costs. The auditor should ascertain the programs management is stressing and determine that possible results have been considered.

  •  A change in manufacturing processes and practices may occur. Changing manufacturing operations can affect the flow of cost. Modernization changes may affect estimates for indirect cost and the computation of indirect-cost rates. For example, technological modernization can include acquisition of expensive new machinery that increases depreciation costs and the overhead pool. This new machinery may require fewer labor-hours and result in reduction of a direct-labor base for allocating overhead.

The reviewer should be alert for changes to manufacturing processes and practices that can highlight accounting system weaknesses and should consider whether: (1) the accounting system accurately assigns costs to products and equitably allocates costs; (2) the accounting system allocates costs to develop future product technology to existing products which receive no benefit; (3) the accounting system reflects savings resulting from technological improvements, and (4) the accounting system integrates relevant data collected by newly implemented information systems.

Overall Indirect Costs

The reviewer should review selected accounts included in the indirect-cost pools to evaluate the reliability of specific estimates. In evaluating projections, the reviewer must consider historical cost patterns and the probable effect of anticipated changes. The reviewer should consider: (1) indirect costs questioned in prior periods, especially those expressly unallowable; (2) indirect costs of a nonrecurring nature; (3) indirect costs that are usually recovered as direct charges or in separate loading factors, such as packaging or obsolescence; (4) indirect costs which show significant differences between historical cost and estimated cost; (5) indirect costs of a semi-variable or variable nature which do not show significant differences between historical cost and estimated cost despite a significant change in volume and (6) indirect cost of a nonvariable nature which show significant variations between historical cost and the proposed estimated cost.

Indirect Labor

In evaluating indirect-labor cost estimates, the reviewer should analyze variable, semivariable, and nonvariable classifications of indirect labor in a current representative period. The ratios of each category to direct labor should be computed and compared with similar ratios for estimated cost. Projections of indirect-labor requirements and the related costs can also be compared with manpower budgets. Indirect-labor wage rates may be verified by reviewing personnel or payroll records. When projected costs include wage increases, the reviewer should ascertain whether the proposed increases have been approved by management and are in accordance with applicable agreements.

Indirect Material

It is desirable to differentiate the treatment of the nonvariable, semivariable, and variable components of indirect material cost contained in the contractor’s projection. Ratios of these expense classifications to appropriate bases should be computed only when practical. To further facilitate evaluation, similar ratios can be computed from historical cost data. Categorizing the recorded indirect materials into these classifications requires that the reviewer exercise judgment in determining whether the additional evaluation effort needed for this type of analysis is warranted.

Payroll Taxes and Fringe Benefits

After establishing the estimated total direct and indirect labor requirements, the reviewer should evaluate related payroll costs. The provisions of union wage agreements and the possible effect of anticipated wage negotiations should be evaluated to establish the validity of employee benefit costs included in the cost estimate. The reviewer should be aware in evaluating the estimate for payroll taxes that assessments cease upon reaching the taxable pay ceiling. The extent of labor turnover will influence the projections for payroll tax estimates; when turnover is low, the cost will be semivariable in nature, when the turnover is high, the cost may be more variable in nature. The reviewer should evaluate rates for unemployment insurance to determine if the estimate reflects possible adjustments in the rate.

Pension and retirement plan costs frequently are related to payroll costs. In evaluating the reasonableness of pension and retirement costs, the reviewer should perform these steps:

1. Determine that the amount projected is in accordance with the company plan.

2. Ascertain that the pension plan has been approved by the Internal Revenue Service (IRS) and the DoD, if required.

3. Determine that proper adjustment has been made for any reversionary credits that may be due.

4. Determine that when rates are based upon actuarial data and have recently been revised or are scheduled to be revised, the effect of the new rates has been considered.

5. Verify that the contractor has used the pension plan’s long-term valuation interest rate to estimate the pension plan’s actual return on assets in computing the projected pension costs and in determining whether the projected pension costs will be limited by the assignable cost limitation (i.e., the actuarial value of assets exceeds the actuarial accrued liability plus current normal costs). Much of this guidance is obsolete, because most contractors have abandoned expensive defined-benefit pension plans.

6. Review the history of the contractor’s estimating procedures to determine whether forward-pricing projections for previous years have exceeded actual pension costs for those periods. If the history indicates a pattern of excess pension projections that is attributable to substantial actuarial gains, then an analysis of the effect of the actuarial assumptions on the forward-pricing projections should be performed.

Depreciation

The contractor’s forecasts for depreciation should be evaluated using IRS guidelines as recognized by current DoD instructions and in CAS 404 and 409, where applicable. The reviewer should evaluate the necessity for new acquisitions, review the contractor’s capital replacement or acquisition policy, and ascertain whether: (1) acquisitions have been approved by management; (2) actual commitments have been made; and (3) proper consideration has been given to lead time, installation costs, and rearrangement expenses.

Rent

Estimated costs of rental of machinery and equipment should be compared with costs incurred for rentals. Rental agreements should be evaluated to ascertain expiration dates and renewal and purchase options. The reviewer’s attention is particularly directed to FAR 31.205-36 for guidance in determining the reasonableness and acceptability of rental costs (including the sale and leaseback of facilities).

Corporate or Home-Office Assessments

Indirect-cost forecasts made by an operating division will usually include the anticipated home-office assessment to that division. The reasonableness of the assessment should be evaluated on the basis of services to be rendered or available to the operating division. The bases of assessment should be evaluated to determine that all components of the company bear an equitable share. An accurate determination at the operating level may prove difficult and may include prorating of unallowable home-office and corporate expenses.

When the amounts involved are significant, an assist audit of home-office expenses should be requested. When feasible, the home-office reviewer should arrange for the periodic audit of forward-pricing home-office rates applicable to operating divisions that have a significant amount of government business. The results of the audits should be forwarded to the reviewers at the operating units for their use in evaluating proposals.

Price Escalation

There are essentially two ways that contract prices can reflect the impact of inflation over the contract performance period. In the most widely used method, the proposed contract price includes current estimates of wages and prices that are expected to be experienced during contract performance. The preferred bases for current estimates are forecasts of future wage and price indices prepared by qualified, professional economists. Their predictions are based on econometric computer models of the US economy that consider a large number of factors influencing wages and prices.

Alternatively, the contract proposal may be priced without escalation and an economic price adjustment (EPA) may be proposed. This arrangement is appropriate when there is serious doubt about the stability of future market or labor conditions during an extended contract performance period. When such expectations are not included in the contract price and they can be separately identified, they may be covered by an EPA contract clause.

Use of EPAs has increased, primarily because of potential inequities that fixed-price contracting can produce in periods of economic uncertainty. Such adjustments are intended to protect both the government and the contractor from the effects of abnormal wage and/or price changes, which could cause significant losses or “windfall gains” for reasons beyond the control of the contracting parties.

FAR 16.203-1 specifies three basic types of EPAs; FAR 16.203-4 addresses applicable contract clause coverage. The first type provides for adjustments based on established prices and is known as the index method. It is used where basic commodities and commercial items (i.e., steel, aluminum, brass, bronze, copper, and standard supplies) constitute a major portion of the contract work. Price adjustments are based on an increase or decrease from a specified level in published or established prices of either specific items or price levels of contract end items. This is the preferred method.

The second type provides for adjustments based on the contractor’s experienced labor or material costs and is commonly referred to as the actual cost method. This type of adjustment is used when there is no major element of design engineering or development work involved and one or more identifiable labor or material cost factors are subject to change. Price adjustments are based on an increase or decrease in specified costs of labor or material actually experienced by the contractor during performance of the contract. This is not a preferred method for contractors, because it requires an audit.

The third type is referred to as the cost index method. It is used when there will be an extended period of performance and the amount subject to adjustment is substantial. Although many variations can be developed, one approach is to select representative Bureau of Labor Standards labor and material indices and project them into the future. Price adjustments result only if the actual indices are outside a defined range surrounding the projections.

Techniques to evaluate costs and prices subject to EPAs are dependent on: (1) the appropriate contract clause, (2) the contractor’s accounting system, and (3) other factors relevant to the proposed acquisition. The evaluation techniques used in the audit of an adjustment under an EPA clause should be selected to ensure that: (1) economic factors already contained in the original price proposal are not duplicated, (2) the base period of the contract clause is the same period used to establish the base price, (3) the contemplated clause is the most appropriate for the anticipated contract environment, (4) the contractor’s accounting system is capable of identifying and segregating the specific economic costs subject to adjustment from those attributable to qualitative or quantitative changes, (5) an adjustment will be made for only those economic changes beyond the control of the contractor, and (6) that the aggregate price of increases will not exceed 10 percent of the original contract price for the EPAs, based on established prices and actual cost.