Overcharged Overhead
Federal contractor Charles Stark Draper Laboratory, Inc. is a not-for-profit entity based in Cambridge, Massachusetts. Recently, Draper entered into a settlement agreement with the U.S. Government to resolve allegations that it “improperly overcharged the government under federal acquisition regulations (sic) for certain overhead costs.” The costs were recorded in 2016, and were identified during government audit.
The government alleged that Draper “improperly billed the government for costs associated with internal projects that Draper called ‘Opportunity Investments.’” It’s not clear exactly what Draper’s Opportunity Investments were. Were they akin to contractor Independent Research and Development (IR&D) efforts? Or perhaps they were internal projects intended to result in process efficiencies and/or cost reduction. We don’t know.
But we do know that Draper’s “Opportunity Projects” were audited, and the audit asserted that “Many Opportunity Investment projects were not of interest to the government, or Draper lacked sufficient documentation to justify the costs.” Readers are reminded of FAR 31.201-4, which discusses the concept of allocability. Costs may be allocated under one of three methods; the method that seems germane here is the notion that a cost is allocable to a government contract if the cost “benefits both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received …” In other words, when challenged, a contractor must be able to describe the beneficial relationship between the costs it has incurred and the amount(s) allocated to its government contracts.
We don’t know if Draper’s contracts contained additional DFARS cost principles, or if those cost principles were related to the “Opportunity Projects.” Assuming yes and also assuming that the Opportunity Projects were akin to IR&D projects, then DFARS 231.205-18 requires a “major contractor” (as defined in that cost principle) to analyze its IR&D costs for efforts “of potential interest to DoD.” IR&D expenses that are not of potential interest to DoD are not allowable costs with respect to contracts that contain the DFARS IR&D cost principle.
Again, there’s a lot we don’t know about the situation. However, the DoJ press release did offer the following additional information—
The audit also found that Draper lacked sufficient internal accounting controls concerning Opportunity Investments. When the Department of Defense requested additional information about the costs flagged by the audit, Draper, for months, did not reveal that it lacked documentation to support charging some of the Opportunity Investments to the government.
That additional bit points to some other issues that Draper allegedly had. First, most everybody should understand that DCAA probes for internal controls in most (if not all) of its Business System audits—including audits of a contractor’s accounting system. (We’ve written about that aspect of accounting system audits on this blog.) If a contractor does not have robust (and documented) internal controls, then it will likely not do particularly well in its audits.
Second, Draper (allegedly) didn’t tell the government auditors that it lacked documentation to support the allocation of its Opportunity Investment project costs to its government contracts. Readers are reminded that FAR 31.201-2 (“Determining Allowability”) states—
A contractor is responsible for accounting for costs appropriately and for maintaining records, including supporting documentation, adequate to demonstrate that costs claimed have been incurred, are allocable to the contract, and comply with applicable cost principles in this subpart and agency supplements. The contracting officer may disallow all or part of a claimed cost that is inadequately supported.
We don’t know the total dollars involved, but we do know that Draper settled the allegations for $3.5 million (not counting unallowable attorney fees). Gosh, we wonder how many internal controls could have been established and documented for that kind of money?
So there you go. Draper’s costs were subject to disallowance on a variety of potential bases. As always, our intent here is not to castigate Draper, but instead to provide an opportunity for our readers to learn from Draper’s mistakes, so as to avoid their own.
New Definition of Commercial Item
The FAR was recently revised, via a final rule, to implement Section 836 of the FY 2019 NDAA. Essentially, the final rule splits the current definition of “commercial item” (found at FAR 2.101) into two definitions: “commercial product” and “commercial service.”
Before we get to deep into the weeds, let’s note that the FY 2019 NDAA directed that the new definitions become effective 01 January 2020. The fact that it took the FAR Council an additional nineteen months beyond the statutory requirement is evidence that the FAR rule-making process is broken. But you already knew that, so let’s move on.
As the promulgating comments noted
… the amendment to separate ‘commercial item’ into ‘commercial product’ and ‘commercial service’ does not expand or shrink the universe of products or services the Government may procure using FAR part 12, nor does it change the terms and conditions with which contractors must comply. … This rule does not create new solicitation provisions or contract clauses. This rule merely replaces the term ‘commercial item(s)’ with ‘commercial product(s),’ ‘commercial service(s),’ ‘commercial product(s) or commercial service(s),’ or ‘commercial product(s) and commercial service(s)’ in the FAR including in part 52, as appropriate. This rule does not impose any new requirements on contracts at or below the SAT or for commercial products, including COTS items, or for commercial services.
Essentially, then, the revision is about semantics only. A commercial product is still defined by one of six definitions—the same definitions that were always in FAR 2.101. A commercial service is still defined by one of two definitions—the same definitions that were always in FAR 2.101. Nothing has really changed, except for “bifurcating” the definition into two separate definitions.
If nothing changed, then why did it take so long to promulgate the final rule? That’s a question that only the FAR Council can answer.
If nothing changed, then why did Congress, the Section 809 Panel, and the FAR Council decide to make the change? Well, according to the public law and the promulgating comments:
… ‘acquisition workforce has faced issues with inconsistent interpretations of policy, confusion over how to identify eligible commercial products and services’. [Sic.] Bifurcating the definition of ‘commercial item” into ‘commercial product’ and ‘commercial service’ is a way to provide clarity for the acquisition workforce, which may result in greater engagement with the commercial marketplace.
Thus: no amount of training could help the Federal acquisition workforce with understanding the difference(s) between products and services. It literally took an Act of Congress to create two definitions where only one had existed before. The Act of Congress was necessary because contracting officers didn’t understand the FAR. What this says about the acquisition workforce, and the training thereof, we’ll leave to the imaginations of our readership.
While this in an important change—because the definition of commercial item (or commercial product and commercial service) is critical—it is not any kind of substantive change. Kind of like when TINA became whatever it’s called now (Truthful Cost or Pricing Data). Nobody calls it what it’s called now: everybody calls it TINA. Why? Because we’re trying to communicate with each other.
Similarly, no matter what you’ll be calling it going forward, it will always be “commercial item” to the people who’ve been dealing with it for years. For example, we don’t see DCMA’s “Commercial Item Group” (CIG) changing its name to “Commercial Products and Commercial Services Group” (CPACSG) … but who knows? Maybe they’ll surprise us and make the change.
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The Wages of Fraud: A Follow-Up
More than a year ago, we first wrote about the issues at Bradken. As we discussed at the time, the corporate structure of Bradken was interesting, but the bottom-line was that its US subsidiary, based in Tacoma, Washington, had for some time been “the U.S. Navy’s leading supplier of high-yield steel for naval submarines.” As a subcontractor, Bradken provided castings to Navy prime contractors for use in fabricating submarine hulls.
For thirty years, Bradken produced castings that had failed lab tests and did not meet the Navy’s standards. The fraud started well before the company’s acquisition by foreign ownership and continued for a decade after the acquisition. Bradken settled its civil False Claim suit for $10.8 million, and the company entered into a deferred prosecution agreement with respect to the criminal charges it was facing.
As part of its Deferred Prosecution Agreement, Bradken agreed to make a public statement. We wrote about that public statement in a follow-up article. We believe that public statement is well worth reading, and we recommend you follow the link to it.
While the company was settling its legal liabilities, its former Director of Metallurgy, Ms. Elaine Thomas, was facing her own legal issues. She was charged with Major Fraud against the United States. On November 8, 2021, Ms. Thomas pleaded guilty to “defrauding the United States by falsifying test results that measure the strength and toughness of steel used in U.S. Navy submarines.” She will be sentenced in February, 2022. She faces “up to 10 years in prison and a $1 million fine,” according to the DoJ press release.
When we first wrote about this situation, we were careful to make sure it was clear that the Ms. Thomas had only been accused of fraud, because everybody is entitled to be considered to be innocent until proven guilty in a court of law. However, now that Ms. Thomas has pleaded guilty, we can dispense with the niceties and call her what she is: a fraudster.
This article at TheDrive.com, written by Thomas Newdick, adds some details to the story. Newdick’s article quotes Thomas’ attorney as saying, “she regrets that she failed to follow her moral compass — admitting to false statements is hardly how she envisioned living out her retirement years.” Well, then. That makes it all better, doesn’t it?
Newdick’s article adds—
Exactly what drove Thomas to falsify the results of the strength tests is still unclear, but according to the Justice Department, she thought it was ‘stupid’ that the Navy demanded the tests be carried out at -100° Fahrenheit. As a result, the department contends, Thomas changed the results to false positives in some cases.
Interestingly, the Newdick article adds commentary about other problems facing the Navy’s submarine program, and he notes that the problems lay unnoticed for several years before discovery—which ought to concern everybody. However, the article ends on an optimistic note, in which Newdick writes, “… after this fiasco, the Navy will surely be keeping an especially close eye on the production quality of structural components needed to ensure these powerful submarines perform according to their exacting specifications.”
We shall have to see whether or not the Navy has learned any lessons from this—and other—contractor fraud cases.
Proposed Rule Would Require TWO Incurred Cost Submissions
The 2017 National Defense Authorization Act (NDAA), also known as Public Law 114-328, required the Department of Defense to change the way it managed contractor IR&D and B&P expenses. Section 824 required:
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Contractor IR&D expenses allocated to DoD contracts must be reported separately from other contractor indirect expenses
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The current limitations found in the DFARS IR&D/B&P cost principle, that limits allowable costs to those found to be of interest to the DoD (via one of seven possible avenues) were eliminated in favor of “a CEO determination that IR&D expenses will advance the needs of DoD for future technology and advanced capability.”
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Existing DFARS cost principle language governing B&P cost allowability, which seemed to imply that contractor B&P expenses must also be of interest to DoD, was revised to eliminate that requirement
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In addition, contractor B&P expenses allocated to DoD contracts must be reported separately from other contractor indirect expenses.
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The DCAA must revise its Annual Report to Congress format to provide—
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a summary, set forth separately by dollar amount and percentage, of indirect costs for independent research and development incurred by contractors in the previous fiscal year
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a summary, set forth separately by dollar amount and percentage, of indirect costs for bid and proposal costs incurred by contractors in the previous fiscal year
Link to the 2017 NDAA language here.
Importantly—
Regulations prescribed under subsection (a) may not include provisions that would infringe on the independence of a contractor to choose which technologies to pursue in its independent research and development program if the chief executive officer of the contractor determines that expenditures will advance the needs of the Department of Defense for future technology and advanced capability as transmitted pursuant to subsection (c)(3)(A).
Now, in 2021, the DAR Council has promulgated a proposed rule to implement the 2017 NDAA requirements. Let’s look at it. The proposed rule—
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Adds language at DFARS 231.205-18(c) to require contractor CEOs to determine that IR&D expenditures will advance the needs of DoD for future technology and advanced capability.
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Adds a requirement for major contractors to include a statement in their submission to the Defense Technical Information Center (DTIC) that the CEO of the contractor has made the determination required by 10 U.S.C. 2372. This statement serves as evidence for DoD, when determining whether IR&D costs are allowable. The proposed rule notes that major contractors are already required to upload IR&D activities in DTIC in order to provide DoD with information on the progress of these activities; so this rule adds a requirement for those major contractors to include a statement in the DTIC input that the CEO determination has been made.
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Since the list of seven activities of potential interest to DoD was deleted, the requirement for the DCMA ACO to compare the IR&D activities uploaded in DTIC to the list of seven IR&D activities of potential interest to DoD no longer exists. Therefore, DFARS 242.771-3(a) is proposed to be modified to remove DCMA responsibilities for determining if an activity is of potential interest to DoD.
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Adds language to clarify that IR&D and B&P costs will be reported independently from other incurred indirect costs in a new paragraph at DFARS 231.205-18(c)(iv).
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Decouples IR&D and B&P by stating “IR&D and B&P” instead of “IR&D/B&P” throughout the text. However, for the purposes of calculating the threshold that requires major contractors to submit IR&D activities and statements regarding the CEO determinations in DTIC, the rule does not change the calculation, which combines IR&D and B&P, to ensure the definition of “major contractor” remains the same.
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DFARS 242.771-3(c)(1) is proposed to be modified to change the content of the communication from DoD to contractors from the “planned or expected DoD future needs” to the “planned or expected needs of DoD for future technology and advanced capability.” In addition, the responsibilities of the Office of the Under Secretary of Defense for Research and Engineering are expanded to include providing on the DTIC website communities of interest on DoD's future needs. An email address for additional information is also provided.
Importantly, the proposed rule adds a contract clause at DFARS 252.242-70XX, Independent Research and Development and Bid and Proposal Incurred Costs, which requires all contractors with noncommercial awards exceeding the simplified acquisition threshold to provide an incurred cost submission of IR&D and B&P costs for the prior Government fiscal year to a website for DCAA to access.
We’ve thought about that final requirement. Why couldn’t the DAR Council just modify the Allowable Cost and Payment contract clause (52.216-7) to require an additional schedule in the contractor’s annual proposal to establish final billing rates? After all, there are already about two hundred zillion schedules; what’s one more? But then we realized that many defense contractors don’t have any cost-reimbursable or T&M contracts; they are 100% FFP contractors—especially the smaller subcontractors. If the DAR Council simply modified the 52.216-7 clause, then many defense contractors wouldn’t be reporting their IR&D and B&P expenditures. Thus, the new contract clause makes a kind of sense, given Congressional direction.
If implemented as a final rule, the proposed language will require almost all defense contractors to submit an incurred cost submission. Some will be submitting their final billing rate proposals (which are not incurred cost submissions, but whatever) as they have always done. Now they will have an additional (real) incurred cost submission to submit for their B&P and IR&D project expense detail. So they will have two annual submissions to make. Other defense contractors, who have not had to submit anything before, will now have to submit one—the B&P and IR&D incurred cost submission.
Fun times ahead!
And what will DCAA do with the new submissions they receive? According to the Public Law and the proposed rule, they will have to aggregate the data and report summary-level statistics to Congress each year. Will the auditors want to use those submissions as audit leads? Well, they’re not supposed to—but we’ll have to see. Historically, DCAA as an agency has a rather poor record of resisting temptation to use information received for one thing as an audit lead for something else. But we can be optimistic, right?
Another thing that occurs to us is that there will need to be a standard submission format. If DCAA lets contractors do their own thing, then they’ll have trouble aggregating the data they receive. The current language of the (draft) contract clause is fairly permissive. It states—
… the Contractor shall—
(1) Report to [website TBD] a consolidated spreadsheet of all independent research and development (IR&D) and bid and proposal (B&P) costs incurred by the Contractor during performance of any DoD contract in the previous fiscal year, beginning October 1 through September 30; and
(2) Submit this report no later than December 31 of each year.
(b) IR&D and B&P incurred costs shall be reported separately and shall be reported by costs attributable to—
(1) The Department of Defense (non-foreign military sales);
(2) Foreign military sales; and
(3) Other.
We’re going out on a limb here, and will bet the existing permissive language becomes more prescriptive when the rule is finalized. The proposed clause language is also ambiguous, conflating the government fiscal year with a contractor fiscal year. Finally, the proposed language requires submission by 31 December but the (for a calendar year contractor), final costs won’t be known for at least six months after that date. We’ll also bet some of those details are caught in the final rule. At least, we hope they will be. You can help make that happen by submitting comments, which are due by not later than 29 November. The address for submission of comments is found in the proposed rule.
In summary, there are going to be a lot of defense contractors who now have to submit the new IR&D and B&P incurred costs reports. Many of them will have never submitted an incurred cost report before. We predict confusion. And perhaps more work for government contract accounting consultants.
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