Fraud Continues to Plague Federal Procurement
We’d like to think that the continual flow of fraud-related stories emanating from our Federal procurement system is committed by a tiny minority of rogue Federal employees and greedy contractors who have taken advantage of weak internal controls and lax oversight, and that they are not at all representative of the vast majority of procurement activity that takes place every single working day, executed by people and companies who adhere to the highest levels of honor and integrity.
We’d like to think so, but we’re losing confidence in that point of view. Our perspective is being eroded by the flood of stories like the New Orleans levees giving way to Hurricane Katrina.
Let us recite the litany of such stories that are currently sitting in our in-box, polluting our Pollyanna point of view like an oil spill in the Gulf of Mexico.
The Federal Times reported—
A once-prominent Northern Virginia technology contractor is facing bribery charges accusing the firm of paying millions of dollars in kickbacks for contract work and using bogus references to gain entry into a government set-aside program — the latest development in the largest bid-rigging case in U.S. history.
Prosecutors said the company, Nova Datacom LLC, worked with former Army Corps of Engineers contracting official Kerry Khan, who agreed to steer business to the firm. Khan, who has pleaded guilty and awaits sentencing, received $7.5 million ‘directly and indirectly’ from Nova DataCom, according to charges.
Nova Datacom also submitted false information on educational backgrounds and experience in its application to the Small Business Administration in 2007 to win certification as an 8(a) small disadvantaged business and qualify for set-aside contracts, according to charging papers…
In outlining the case against Khan, prosecutors said the investigation involves more than $30 million in bribes, as well as plans to steer a contract worth more than $1 billion. …
Separately, prosecutors filed bribery and other charges against Min Jung Cho, who is listed in charging papers as the president of Nova DataCom and as the sister of the company’s chief technology officer, Alex Cho. Court papers show Alex Cho began cooperating in the investigation about two years ago.
While the Nova DataCom website isn’t active anymore, Internet archives show the company’s site included a section on corporate citizenship saying the business was ‘committed to holding ourselves to a higher standard of integrity and accountability.’ The company’s site also included a host of awards and recognitions, including a listing by the Washington Business Journal in 2010 for the top 50 fastest-growing companies.
In subsequent story, the Federal Times told its readers that Kerry Khan, “the mastermind of the largest bid-rigging scam in the history of federal contracting,” had “millions of dollars, mistresses in three states and a taste for high-end cars and liquor.” The story reported—
In all, Khan and his associates had illegally pocketed more than $30 million in kickbacks and bribes over almost five years. When authorities finally arrested Khan in October 2011, he had been planning an even bigger scheme to steer a nearly $1 billion federal contract. …
Other contractors — some real, others little more than front organizations — were involved, too, according to court records. Harold Babb, former director of contracts for Eyak Technology, has received more than seven years in prison for his dealings with Nova DataCom and Khan.
Here is how it generally worked: Contractors involved in the scheme submitted bogus invoices, which the Army Corps — with Khan’s help — paid out. In exchange, the money from those invoices went to payoffs and kickbacks through various businesses…
The kickback scheme involved a big Army Corps contract known as TIGER, for Technology for Infrastructure, Geospatial and Environmental Requirements. Until their arrests in fall 2011, Khan and others planned to steer another nearly $1 billion contract known as CORES, for Contingency Operations Readiness Engineering and Support, prosecutors said. …
By summer 2011, authorities had begun monitoring Khan’s cellphone. That is when they heard him discussing plans to make a $56,105 payment for a 2012 BMW 650i for a co-worker, who had agreed to chair a contract selection panel on a nearly $1 billion procurement Khan aimed to steer to Nova DataCom, according to records. …
How did this massive scheme, involving multiple conspirators and multiple contractors, work? The Federal Times reported—
But despite recent developments in the case, none of the newly filed documents shed light on one big unanswered question: How could such a scam have grown so big, so fast, without anyone noticing?
[U.S. Attorney for the District of Columbia] Machen declined to comment on specifics but said all contract fraud cases expose a lack of internal controls, and the Khan case is no different. …
Scott Amey, general counsel for the nonpartisan Project On Government Oversight, a watchdog group, said the case exposes a glaring lack of adequate administration and oversight of federal contracts. ‘The government’s limited access to contractor cost or pricing data and failure to conduct robust audits are part of the problem,’ he said. ‘We have to provide one or both of those tools at the pre- and post-award stages to ensure that taxpayers are not fleeced.’
In unrelated news, Federal contractor CDW-Government (CDW-G) agreed to pay $5.66 million “to resolve allegations” that it submitted false claims to the General Services Administration (GSA). Here’s a link to the DOJ press release. The DOJ press release stated—
The settlement resolves allegations that, during the period 1999 to 2011, CDW-G improperly charged government purchasers for shipping, sold products to the United States that were manufactured in China and other countries that are prohibited by the Trade Agreements Act, and underreported sales in order to avoid paying GSA its ‘Industrial Funding Fee,’ a fee based on total contract sales that is designed to cover GSA’s costs of contract administration. …
The allegations arose from a lawsuit filed in a federal court in East Saint Louis, Ill., under the qui tam or whistleblower provisions of the False Claims Act. Those provisions allow private individuals known as ‘relators’ to sue on behalf of the United States and to share in the proceeds of any settlement or judgment that may result. The relator in this case, former CDW-G sales representative Joe Liotine, will receive $1,585,892.56 of the total recovery as a statutory award. The relator may also be entitled to receive additional amounts from the defendant for attorneys’ fees and costs.
And speaking of false claims, here’s a link to another DOJ press release, announcing that—
Alabama-based Caddell Construction has agreed to pay to the United States $1,150,000 to settle allegations that it violated the False Claims Act by falsely reporting to the Army Corps of Engineers that it hired and mentored a Native American-owned company to work on construction projects at Fort Bragg, N.C., and Fort Campbell, Ky.
The press release provided additional details, which included the following—
The Army Corps contracted with Caddell between 2003 and 2005 to build barracks at the two bases. As part of the contracts, Caddell represented that it would hire and mentor Mountain Chief Management Services, a Native American-owned company, under the Department of Defense’s Mentor-Protégé and Indian Incentive Programs. The Mentor-Protégé Program reimburses companies for the time and cost of mentoring small disadvantaged businesses, while the Indian Incentive Program provides a rebate to contractors for subcontracting with Native American-owned businesses.
The United States alleged that from April 2003 to March 2005, Caddell falsely represented in its invoices and supporting documents that it was mentoring Mountain Chief and that Mountain Chief was performing work on the construction projects. According to the government, Mountain Chief allegedly was merely a pass-through entity used by Caddell to claim payments under the two programs, and didn’t perform the work or receive the mentoring services for which Caddell received payment.
Speaking of misrepresentation and false claims, here’s another announcement.
U.S. Attorney William J. Hochul, Jr. announced today that Raymond Testa, 60, of Rochester, N.Y., and Gerald Testa, 55, of Ontario, N.Y., were arrested and charged by criminal complaint with major fraud against the United States. The charge carries a maximum penalty of 10 years in prison, a $1,000,000 fine or both.
Assistant U.S. Attorney Craig R. Gestring, who is handling the case, stated that according to the complaint, the defendants own and operate Testa Construction Inc. Starting in approximately 2008, the brothers started a second business and represented it to be a Service-Disabled Veteran Owned Small Business, when in fact it was not. In order to qualify as a Service-Disabled Veteran Owned Small Business, one must be a veteran with a service connected disability. The complaint further alleges that the defendants applied for and received government contracts from the Department of Veteran Affairs, which were set aside for the Service-Disabled Veteran Owned Small Business program, totaling approximately $13,000,000, funding that they would not otherwise be entitled to.
But let’s be clear: fraud is found everywhere in the Federal procurement system and throughout government operations. Take Brandon Gauss, age 38, of Preston, Maryland, who was discussed in yet another DOJ announcement. According to the announcement—
Gauss … pleaded guilty late yesterday to theft of government property from the Goddard Space Flight Center, part of the National Aeronautics and Space Administration (NASA). …
According to his plea agreement, Gauss was a contract employee at NASA. As an engineering technician at the Goddard Space Flight Center, he had access to tools and other property NASA owned. From October 2011 through November 2012, Gauss stole tools and aluminum scaffolding belonging to the government, which he sold to pawn shops for cash. Gauss made over 60 visits to pawn shops throughout Maryland, including Baltimore, Anne Arundel and Queen Anne Counties, and received at least $16,974. The government has recovered some of the items, worth at least $29,736. Gauss admits that he owes the government at least $11,574.35, the money he received from selling the stolen materials the government has been unable to recover.
One more: here’s a story about the “Godfather at Camp Pendleton,” a DOD employee who was “arrested after extorting a $10,000 bribe.” The story reported—
The $10,000 was the first payment of a $40,000 bribe that was intended to influence who got a $4 million flooring contract at the Marine base, FBI Special Agent Darrell Foxworth said in a statement. Natividad “Nate” Lara Cervantes, 64, of San Diego, was taken into custody Thursday after the cooperating witness handed him the $10,000 in an envelope after the two met at a cigar lounge on Miramar Road...
Cervantes threw the manila envelope on the ground as federal agents approached … Cervantes supervises the Construction and Service Contracts Inspection Branch at Camp Pendleton, where he managed construction contracts, the complaint said.
In November, the cooperating witness told an FBI agent that Cervantes was extorting bribes going back to September 2008. … Cervantes said he ‘normally demands 3 percent of the value of the contract,’ but the witness could not pay that much. The witness made two $2,500 payments to Cervantes.
The witness told an FBI agent that Cervantes once said, ‘I am referred to as the ‘Godfather’ at Camp Pendleton.’ Cervantes said he controlled what is called the ‘laydown’ area on the base, where contractors set up their trailers, and determined what contractors got the best spots. …
At one point, Cervantes asked that his granddaughter be hired as a full-time administrative assistant, the witness said. …The witness also said Cervantes asked him to do free work on his downtown San Diego condominium.
We could continue reciting these sad stories of seemingly systemic fraud.
We won’t mention the recently unsealed FCA claim against Agave Bio Systems. We won’t discuss the former U.S. Army Captain who was just sentenced to serve 23 months in prison “for conspiracy to accept thousands of dollars in gratuities from contractors during his deployment to Baghdad, Iraq.” We won’t delve into the story of the “former contract employee” of the DOD who was recently sentenced to serve 35 months in prison for “his participation in a bribery and money laundering scheme arising from corruption in the award of defense contracts at Camp Arifjan.” (We’ve more than covered the cesspool of corruption that was Camp Arifjan—just type “Arifjan” into the site’s keyword search feature.)
It’s not just us. Even the mainstream source Defense Industrial Daily stated, “Sadly, this type of headline keeps coming.”
And as you may know, we normally don’t report the multitude of corruption cases that fall under the heading of healthcare fraud. If we reported those, we’d never, ever, report on anything else.
Seriously, WTF? When will our civil service and military leadership wake up and clamp down on internal controls and oversight? We are personally sick of reading, and reporting, the never-ending cascade of fraud-related stories coming out of our Federal operations and the procurement system.
Stop the insanity, someone.
Sikorsky Wins CAS 418 Case, But Other Contractors Lose
We have reported before on the ongoing saga of the dispute between Sikorsky Aircraft and the U.S. Government, wherein the Government has alleged that Sikorsky was in noncompliance with the requirements of CAS 418. We found five articles discussing this complex, contentious, and (in some respects) ground-breaking case before Judge Lettow at the Court of Federal Claims. We are not going to repeat the facts of the case here; we suggest you type “Sikorsky” into the site search feature and read them for yourself—particularly if you are dealing with CAS 418 and need to understand some of its intricacies.
On March 27, 2013, Judge Lettow issued his final decision.
Sikorsky won.
Judge Lettow found that Sikorsky was permitted, under CAS 418, to use direct labor dollars as the allocation base for its material handling indirect cost pool. He wrote—
The government failed to carry its burden of proof and did not demonstrate that Sikorsky violated CAS 418. The evidence presented at trial established that the management and supervision costs contained within the materiel overhead pool were insignificant relative to the entire pool, and therefore CAS 418–50(d) did not apply to Sikorsky’s allocation of its materiel overhead. Instead, Sikorsky was required to comply with CAS 418–50(e) when choosing an allocation base for its materiel overhead pool. In that respect, Sikorsky reverted to the third alternative base, a surrogate, because the first two bases were impractical. A proper surrogate would ‘var[y] in proportion to the services received.’ CAS 418–50(e)(3). The government did not establish that Sikorsky’s method of allocation, direct labor, was not an appropriate allocation method under CAS 418–50(e). The government did not adequately support its contention that direct materiel should have been used to allocate the materiel overhead pool, nor did it provide any evidence to establish that CAS 418 required the use of an alternate method of allocation involving the segregation of GFM-related costs in a distinct indirect cost pool. In contrast, the evidence presented at trial demonstrated that Sikorsky’s choice of a direct labor base complied with CAS 418–50(e) because direct labor varied in proportion to materiel overhead costs from 1999 through 2005 and thus was an acceptable means of measuring the resources consumed in connection with pool activities.
As may be gleaned from the foregoing, the decision seemed to be largely based on the findings related to a “battle of the statisticians” regarding whose linear regression identified the best allocation base for the material handling pool (or, as Judge Lettow called it for clarity, the “materiel” handling pool). The ironic part of that piece of the litigation is that Judge Lettow dismissed both statisticians’ findings, writing—
In this instance, because the dependent variable, materiel overhead costs, did not fluctuate greatly, there was not much variation to explain, and any statistical relationship between materiel overhead costs and direct labor or direct materiel costs was relatively unimportant. In short, the statistical analyses are of little value in determining whether a particular base was an appropriate allocation measure for materiel overhead costs
So while he largely dismissed the findings from the battle of the statisticians, he used those findings to conclude that the Government did not show that Sikorsky’s use of a “surrogate” cost allocation base violated CAS.
Which is nice for Sikorsky.
But the decision also contained troubling aspects that may prove problematic for other contractors. Those troubling aspects have to do with Judge Lettow’s finding that the Government’s claim was filed timely, and did not violate the Contract Disputes Act’s Statute of Limitations.
Judge Lettow’s conclusion is troubling in several respects. First, he found that Sikorsky’s cost impact analysis of its change in cost accounting practice (moving from a direct material dollar base to a direct labor dollar base), which was submitted to the Government in 2000, was insufficient to start the SoL clock running. He wrote—
… although Sikorsky’s cost-impact submission in 2000 sufficed to confirm the effect of the accounting change on existing contracts, the run-off of existing contracts and the advent of new contracts would provide a more significant test of the change. Through 2003, Sikorsky’s cost-impact proposal submitted in September 2000 still showed a net benefit to the government of $2.34 million. … At that point, DCAA’s auditor … was seeking further contemporaneous cost information from Sikorsky in 2003 to conduct an audit that would examine actual results in 2003 and look beyond that year to the future. In these specific circumstances, the government was under a duty to inquire, but it had no actual or constructive knowledge of a potential CAS violation at Sikorsky until the new information was gathered and assimilated.
[Emphasis added.]
The problem with the foregoing is that Judge Lettow elides the definition of “affected contract” and thus ignores the Court of Appeals (Federal Circuit) discussion of what that definition means with respect to cost impact analyses. We wrote about the topic here. We summarized the Appellate decision, and wrote—
Once the contract’s estimated cost and/or price had been renegotiated to include the cost impact, it was no longer an ‘affected contract’ and was properly excluded from the various cost impact analyses negotiated between the CFAO and the contractor.
Thus, the cost impact on future contracts would be irrelevant to the calculation of the impact to the Government from Sikorsky’s change in cost accounting practice, because those future contracts would be priced using the changed practice. Judge Lettow’s finding that the Government lacked sufficient information to know it had been injured, because the DCAA auditor did not have information regarding future cost impacts, was misplaced, in our view.
Similarly, the ASBCA held in a Raytheon case (No. 56701) that “the price adjustment for consideration here is limited to the CAS-covered contracts in effect at the time the accounting change was made.” Any possible cost impact to future contracts was dismissed by Judge Freeman as being “entirely speculative.” Judge Lettow’s conclusion seemingly contradicts both the ASBCA (which he was not required to follow) and the Court of Appeals (which he was required to follow). Accordingly, it’s a problematic and troubling decision in that respect.
The other troubling aspect of the decision is that Judge Lettow has departed from the ASBCA with respect to which party bears the burden of proof in asserting that a claim is untimely with respect to the CDA SoL. As we reported, Judge Melnick of the ASBCA wrote “By advocating in response to Raytheon’s motion that its decision is valid the government is effectively the proponent of our jurisdiction and therefore bears the burden of proving it under these circumstances.” In contrast, Judge Lettow wrote—
Sikorsky has not met its burden to show that the government had actual or constructive knowledge of a potential claim under CAS 418 prior to December 2002, and Mr. Colandro’s assertion of the government’s claim on December 11, 2008, was within the six-year statute of limitations prescribed by the CDA.
[Emphasis added.]
This would seem to be something that the two Contract Disputes Act fora would want to be aligned on. As it stands, ASBCA would now seem to be the forum of choice, since it puts the burden of proof on the party that argues for jurisdiction—which is very likely to be the government in the cases that concern the majority of contractors.
To sum up, this is a good result for Sikorsky, but not so much for other government contractors. We hope it’s appealed, because we think there are some potential errors of law that need to be corrected. Of course, Sikorsky will be unlikely to be the party that files the appeal, since it is the victor at the Court of Federal Claims.
|
The DFARS Proposal Adequacy Checklist
Well, it’s here.
We first brought this matter to your attention as part of an article on how DOD was gearing up to mount a concerted attack on the profit of defense contractors. When the DAR Council issued a proposed rule on the topic, we did a deep dive into it—and we didn’t like what we saw. As is our wont, we didn’t pull any punches, writing, “we start off with the proposition that this rule is unnecessary, overly bureaucratic, and possibly un-American.”
We didn’t like what we saw to such an extent that we were moved to submit our comments to the DAR Council for consideration as they finalized the language.
And now the final DFARS rule is here, issued on March 28, 2013. Coincidentally, it is also effective on that same date.
And we continue to dislike what we see. You want to know what we dislike about the checklist, please go check out the links provided above.
So no, we are not going to repeat our “concerns” about the final rule here. It’s final and our “concerns” are now moot. But we are going to devote some verbiage to complaining about the DAR Council’s cavalier treatment of public comments on the proposed language—including our own. We think the DAR Council did not adhere to the standards established by the Defense Federal Acquisition Regulation Supplement (DFARS) itself.
DFARS 201.301(b) states—
When FEDERAL REGISTER publication is required for any policy, procedure, clause, or form, the department or agency requesting Under Secretary of Defense (Acquisition, Technology, and Logistics) (USD (AT&L)) approval for use of the policy, procedure, clause, or form (see 201.304(1)) must include an analysis of the public comments in the request for approval.
That requirement is aligned with other statutory and regulatory requirements imposed on rule-makers of the Federal Acquisition Regulation (FAR) system. For example, FAR 1.301 states—
(b) Agency heads shall establish procedures to ensure that agency acquisition regulations are published for comment in the Federal Register in conformance with the procedures in Subpart 1.5 and as required by section 22 of the Office of Federal Procurement Policy Act, as amended (41 U.S.C. 418b), and other applicable statutes, when they have a significant effect beyond the internal operating procedures of the agency or have a significant cost or administrative impact on contractors or offerors. However, publication is not required for issuances that merely implement or supplement higher level issuances that have previously undergone the public comment process, unless such implementation or supplementation results in an additional significant cost or administrative impact on contractors or offerors or effect beyond the internal operating procedures of the issuing organization. …
(c) When adopting acquisition regulations, agencies shall ensure that they comply with the Paperwork Reduction Act (44 U.S.C. 3501, et seq.) as implemented in 5 CFR 1320 (see 1.106) and the Regulatory Flexibility Act (5 U.S.C. 601, et seq.). Normally, when a law requires publication of a proposed regulation, the Regulatory Flexibility Act applies and agencies must prepare written analyses, or certifications as provided in the law.
The foregoing references FAR 1.5. Looking at 1.501-2, we see the following—
(a) Views of agencies and nongovernmental parties or organizations will be considered in formulating acquisition policies and procedures.
(b) The opportunity to submit written comments on proposed significant revisions shall be provided by placing a notice in the Federal Register. Each of these notices shall include—
(1) The text of the revision or, if it is impracticable to publish the full text, a summary of the proposal;
(2) The address and telephone number of the individual from whom copies of the revision, in full text, can be requested and to whom comments thereon should be addressed; and
(3) When 1.501-3(b) is applicable, a statement that the revision is effective on a temporary basis pending completion of the public comment period.
(c) A minimum of 30 days and, normally, at least 60 days will be given for the receipt of comments.
Accordingly, both statute and regulation require that the public be given an opportunity to provide comments regarding proposed regulations. And the DFARS requires that those comments must be analyzed; the required analysis is to be provided to the USD (A,T&L) in the approval package. The clear inference is that the required analysis should be substantive and provide the USD (A,T&L) with meaningful input. The clear presumption is that the USD (A,T&L) should review the analysis prior to approving the final language of the proposed rule.
And it was in the foregoing that we believe the DAR Council blew it.
Allow us to provide evidence in support of our assertion, if you would. Consider the following comments and the responses from the DAR Council.
Comment: Two respondents stated that this new rule would result in increased costs that will ultimately be passed on to the Government and may be financially prohibitive to seeking other business.
Response: This provision results from a long history of incomplete proposals resulting in rework and lost time, and it aims to achieve cost savings by improving initial proposal submissions from contractors.
Comment: Several respondents believed that this checklist imposes additional reporting requirements on the contractor and note that many of the checklist items are not currently required for submission of certified cost or pricing data. One respondent noted that while this checklist adds the new requirements it appears to add no value to the contracting process.
Response: This rule does not impose additional requirements over what is already required under the conditions where certified cost or pricing data are required and these requirements are already covered by OMB Control Number 9000-0013. This provision is applicable to solicitations with an estimated value greater than the TINA threshold and that require certified cost or pricing data. This provision intends to increase uniformity across DoD, minimize local variations, and thereby decrease proposal preparation costs.
Comment: Several respondents suggested that the checklist is unnecessary and duplicative. One respondent noted that it is the offeror's responsibility to comply with the requirements of the solicitation and an offeror that is unable to submit a compliant proposal is likely to be noncompliant after award. The same respondent noted that this checklist is somewhat duplicative of the DCAA forward pricing adequacy checklist. Another noted that most of the checklist items already appear in FAR 15.408 at table 15-2 and suggested that the rule should require contractors confirm that their proposal complies with all applicable requirements of 15-2. Another respondent noted that this rule is: (1) Not compliant with Executive Order 12866 as there is no defined problem that this rule aims to solve; (2) the rule is inconsistent, incompatible and duplicative of what is already in Table 15-2; and (3) that this checklist only adds a layer of regulatory requirements. Show citation box
Response: This provision is a single, uniform tool that is applicable across DoD to address the inconsistent interpretations of Table 15-2. The intent of this provision is to increase uniformity across DoD, minimize local variations, and thereby decrease proposal preparation costs. The checklist created by this rule is a DFARS provision; any checklist that DCAA currently uses is outside the scope of this rule.
Comment: Several respondents stated that the proposed rule does not support the BBP Initiative and noted that the rule does not align with any of the 23 principal actions. The respondents believed that the proposed rule is contrary to the BBP Initiative to reduce nonproductive processes and bureaucracy.
Response: While this initiative predates BBP, it is consistent with the BBP's cost reduction initiatives.
Comment: Two respondents stated it would be wastefully time consuming and burdensome for offerors to disclose which pages of the proposal contain a judgmental factor applied and the mathematical or other methods used in the estimate. The respondents suggested a large percentage of the pages comprising the proposal would contain such information.
Response: Having contractors identify this information prevents miscommunication and misunderstanding, and it will save time in the proposal evaluation process.
We could continue with the recitation of comments and responses, but the litany would simply become repetitive. Clearly, the DAR Council was bound and determined to require contractors to fill out the proposal adequacy checklist and no amount of public input was going to dissuade them.
We are disappointed in the DAR Council’s cavalier treatment of the public comments (including our comments!) and we continue to believe that the new DFARS requirement adds little value while adding significantly to the costs of preparing proposals to the Defense Department.
The Strategy and Tactics of Cost Allocation Structures, Part 4
Part 1 of this series can be found here. We discussed why this is an important—nay, critical—topic for you, worthy of an investment of your time and expense.
Part 2 of this series can be found here. We discussed why you need input from a diverse group of stakeholders. You will want to solicit input from a number of diverse perspectives because your cost allocation decisions—including your decision regarding the emphasis you place on maximizing the amount of direct charges—can affect your corporate culture in perhaps unexpected ways.
Part 3 of this series can be found here. We discussed the importance of making sure the entity’s organization structure reflected how the entity was being managed. We also discussed the notion that precision is not a synonym for accuracy; and that the benefit of precise cost allocations is often not worth the price to be paid, in terms of additional administrative burdens and risks of noncompliance.
In today’s article we want to explore further the organization structure, albeit at a higher level than before. We want to discuss segmentation, as well as special types of organizational structures.
Before we get too deep into the subject at hand, we need to define some terms, using the definitions found in the Federal Cost Accounting Standards (CAS). You may not be subject to CAS coverage, but you should still know CAS—if only because most DCAA auditors will use CAS allocation standards as the “best practices” standard for evaluating your cost allocation practices. Plus, you will want to speak the auditors’ language, using appropriate terminology, when you support audits; that is its own “best practice” right there.
One can easily get confused about the CAS terminology applicable to organization structures. Some terms you need to know are:
Home Office – A Home Office is an office responsible for directing or managing two or more but not necessarily all segments of an organization. It typically establishes policy for, and provides guidance to, the segments in their operations. It usually performs management, supervisory, or administrative functions, and may also perform service functions in support of the operations of the various segments. An organization which has intermediate levels, such as groups or divisions or sectors, may have several home offices which report to a common “headquarters” or “corporate” home office. (See CAS 403, Definitions.)
Intermediate Home Office – A Home Office located at an intermediate level, such as Group, Division, or Sector. An Intermediate Home Office may be both a segment and a Home Office. (For example, it can be a segment of the Corporate Home Office for purposes of receiving Corporate allocations, and a Home Office with respect to allocating costs to the segments it manages.) (See CAS 403, Definitions.)
Segment – A Segment means one or two or more, divisions, product departments, plants, or other subdivisions of an organization reporting directly to a Home Office, usually identified with responsibility for profit and/or producing a product or service. The term includes Government-owned, contractor-operated (GOCO) facilities, and joint ventures and subsidiaries (domestic and foreign) in which the organization has a majority ownership (or control). (See CAS 403, Definitions.)
Business Unit – A Business Unit is any segment of the organization, or an entire business organization which is not divided into segments. (See CAS 410, Definitions.)
(You may note that the definitions for “segment” and “business unit” are remarkably similar. For purposes of this article, when we discuss allocations of centralized payments and service functions, and centralized management, from a home office, we will use the term “segment”. When we discuss allocations of segment management and other segment expenses to contracts/projects, we will use the term “business unit”.)
The first thing you’ve got to do is to identify your segments and home offices. This may be quite easy to do; then again, it may be painful and involve loud voices and fingerpointing. As is the case with so many cost allocation issues, the correct answer goes to the heart of your entity’s business strategy. First of all, note that the CAS definition does not align precisely with the requirements of SFAS 131 (ASC 280) or with the requirements of IFRS 8—both of which are concerned with information reviewed by the Chief Operating Decision Maker (CODM). Instead, CAS focuses on where the entity determines profit/loss “and/or” produces a single product/provides a single service. Consequently, your reportable segments for government contract cost accounting may differ significantly from your reportable segments for financial reporting purposes.
But in that difference lies freedom. For government contract cost accounting, you have the freedom to define your segments in manner that promotes compliance with applicable regulations. To state it another way, you have the freedom to reduce your risk of noncompliance by smartly structuring your segments. For example, you can structure your segments to keep your commercial operations the hell away from your government operations, so as to let your commercial operations do what they need to do in the way that works for them, while locking down your government operations so as to keep the government auditors happy.
And that’s the first choice: do you separate your government and commercial operations, or integrate them. Keep them separate, and you are largely deciding to have two separate infrastructures; integrate them, and you can find process efficiencies and cost savings.
In our view, the problem with separating the two types of operations is that—sooner or later—the commercial side is going to want to bid on a government or quasi-government job, or the government side is going to want to borrow labor from the commercial side. At that moment, the Berlin Wall you have carefully built and maintained will start to crumble, and now your commercial side is subject to those pesky and burdensome government rules. So if you suspect that will be the long-term result, you may as well go all-in now and just admit you’re a government contractor.
On the more positive side, having separate segments permits each segment to have its own unique cost accounting practices. You can also parse out CAS coverage by segment, with one (or more) segments being fully CAS-covered, while others are subject to Modified coverage or perhaps exempt from CAS altogether. This situation, if properly handled, can reduce your risk of CAS noncompliance and permit you to tailor your cost accounting practices to the needs of your operations.
However, you should also keep in mind that the more segments you have, the more Inter-Organizational Transfers you will also have. IOTs are difficult to account for, as we have discussed more than once on this site. As in many aspects of cost allocations, the more complexity you have, the more administrative burden you create—and the more your risk of noncompliance increases. It is important to strike the proper cost/benefit balance.
Remember, you do not need government approval for your organization structure and your definitions of your segments and home offices. This will be your management and cost allocation structure. Do not let government employees—especially DCAA auditors—substitute their judgment for yours. Your job is to comply with applicable regulations (including CAS where applicable), and once you’ve met that burden then you are good to go. We’ve seen far too many junior auditors try to opine on the propriety of contractors’ cost accounting structures (without any reasonable basis for doing so); and we’ve seen too many contractors cave in to those auditors’ comments without challenging them on the missing regulatory basis.
Some aspects of your organization structure can qualify for special cost treatment. Perhaps surprisingly, the DCAA Contract Audit Manual (CAM) permits flexibility in certain circumstances.
The first type of organization structure that can qualify for special treatment is a “special facility,” as that term is defined by the DCAA CAM at 7-300. Actually, to call the discussion a “definition” may be overstating the case. The CAM states—
Facilities to which this guidance is applicable cannot be specifically designated by name or type but rather must be determined by whether or not they meet certain basic criteria. The first criterion to be met is that the costs involved in the operation of each facility must be significant in amount with respect to the contractor's overall operations. The second criterion is that the facility benefits only a limited portion of the contractor's total workload. Wind tunnels and space chambers are representative of facilities which, if they meet the criteria above, would be subject to the guidance provided in this section.
For those “special facilities” discussed in the foregoing paragraph, as well as for certain Microelectronic Center (MEC) facility costs, the CAM permits three methods of allocating the facility costs to the benefiting work. Importantly, the CAM states that the requirements of CAS 418 do not apply to “special facilities” so you may be free to be creative—so to speak—in your cost allocation methodology. (But read the CAM first!)
Another type of organization structure that can qualify for special treatment is a “special business unit” (SBU). This is DCAA's term to de scribe a contractor subsidiary, division, or other form of business organization that is established to accomplish certain specific tasks or to gain a competitive advantage. The DCAA CAM states that a SBU “is not a distinct entity form,” and “therefore, the accounting for an SBU should follow the principles established for the actual entity involved and be consistent with the contractor's disclosed accounting practices.” Again, the term (and associated audit guidance) is somewhat ambiguous and it can encompass several different “flavors” of organization structure, including joint ventures and teaming arrangements. The CAM states (at 7-1804)—
An SBU is a segment of the establishing contractor since the SBU is either a subdi vision of that contractor or is controlled by that contractor.
(1) Some SBUs have employees hired and paid by the SBU who actually perform the required contract effort. These SBUs may also have their own assets and liabilities and have profit and loss responsibility. They are usually reportable segments for financial and tax purposes. These SBUs are often engaged in foreign military sales or direct commercial sales to foreign governments. These SBUs are usually formed to limit tax and /or legal liability.
(2) Other SBUs are more like joint ventures and teaming arrangements. These busi ness organizations have no employees and subcontract virtually all (over 90 percent) con tract effort to other contractor division s and/or outside subcontractor(s). Often these SBUs have little or no assets. This type of SBU may have been formed to gain competitive, cost, and/or technical advantages.
The guidance to auditors continues—
Basically, there are two types of cost advantages that SBUs can attain. The first type results from the fact that an SBU is a specialized contracting entity supported by one or more established contractor entities. The second type results from cost alloca tion practices that enable an SBU contract to significantly reduce, or altogether avoid, the amount of material overhead and G&A that the contractor would normally have to allocate to its subcontracts and/or interdivisional work. [However] f the cost allocation practices cause a significantly different allocation to a SBU contract than would have been allo cated to the same contract if issued directly to the contractor's operating segment, the cost allocation practices may be inequitable and/or CAS noncompliant.
The DCAA CAM has several pages discussing cost allocation issues associated with SBUs. If you think you want to try to set up an SBU, you would be well advised to review the discussion.
To sum up, when you establish your organization structure you will identify your segments and the home offices to which they report. Segmentation is an important decision, with implications for mitigating risk of noncompliance as well as implications on the amount of administrative work you will be incurring. Not all segments are created equal: in some circumstances you can establish special cost allocation practices and use the DCAA CAM to justify why they are compliant.
If you’ve come this far, you’ve done most of the work. You’ve created a logical organization structure and made some key decisions about how your cost allocations are going to work. The rest of the job includes choosing logical indirect cost pools and appropriate allocation bases. But the standard pool and base methodology may not be appropriate in all circumstances. There may be some outlier-type segments, business units, and/or contracts that are so different from everything else that they require special handling.
Accordingly, the next installment of this series will discuss the little understood phenomenon of “special allocations.”
|
