The Missing $15 Million Incentive Fee Payment
It’s not much as Federal funds are measured, but still. $15 million is not exactly chump change. And according to the Department of Energy’s Inspector General, that amount apparently got lost in the mail.
The Department of Energy (DOE) is in the process of spending about $12 Billion of taxpayer funds at its Hanford, Washington, site. That $12 Billion is funding the Waste Treatment and Immobilization Plant (WTP), which is a “key element” in DOE’s efforts to remediate the site’s high-level nuclear waste. (Hanford is where plutonium was processed during the Manhattan Project and Cold War. It’s polluted as hell.)
Bechtel National Inc. is the prime contractor managing the WTP program. As part of the WTP activities, Bechtel is building “black cell” waste processing rooms. “Black cells” are sealed compartments that will contain the actual WTP processing vessels and equipment. The black cells are sealed and heavily shielded to protect plant workers “from the intense radiation that will occur during WTP operations.” Since there is no “engineered access” to the black cells, there is no practical means of performing maintenance or repair. It’s kind of like a satellite in space, if you will. If anything inside the black cell fails, then that’s it. Consequently, it is critically important that everything going inside the black cells be of the highest quality and (as is the case with spacecraft) be completely traceable in terms of quality assurance. As the DOE IG wrote—
The importance of black cells and hard-to-reach components cannot be over stated. Premature failure of these components could potentially impact safety, contaminate large portions of a multi-billion dollar facility and interrupt waste processing for an unknown period of time.
The DOE IG received allegations that not everything in the WTP black cells met quality assurance standards, and investigated. The IG substantiated the allegations, finding that the contractor could not document that it met quality assurance and/or contract requirements. Interestingly, the audit focused on vessels that were “received and installed prior to mid-2005,” because Bechtel hasn’t acquired any similar vessels in the seven years since then. Why it took seven years for the IG to get around to looking at Bechtel’s quality assurance documentation remains a mystery.
But the more interesting finding—or, at least, the one that’s getting the most play in the press—is the finding that DOE cannot account for at least $15 million in incentive fees that it had demanded Bechtel repay as a penalty for failing to meet QA requirements. The IG reported—
Bechtel was paid $30 million in incentive fee for the delivery and installation of vessels into WTP facilities. When the Department learned that one of the vessels was nonconforming, it instructed Bechtel to return $15 million in performance fee. However, neither the Department's Office of River Protection nor Bechtel could provide evidence that the fee was returned to the Department.
In the body of the audit report, the DOE IG provided some more detail surrounding the missing $15 million. It reported—
The Department did not take aggressive action to retrieve the $15 million fee payment. … the Department requested Bechtel return the $15 million fee payment by February 20, 2004. If not returned by that date, the letter stated that the Department would offset the amount against the next cost invoice submitted by Bechtel. In its response … Bechtel asserted that it didn't completely agree with many of the assertions of the Department; but concluded that a point-by-point response would not bring closure to the issue. As an alternative, Bechtel expressed its desire to discuss the issue with the Department to find a mutually acceptable resolution. Bechtel then submitted a letter to close out open issues on the vessel dated July 12, 2004. We requested the evidence of the resolution; however, there were no records of the meeting or indications that Bechtel repaid the fee. Department officials confirmed there was no documentation indicating that the fee had been repaid or offset against any subsequent invoices.
The DOE IG also identified another $15 Million incentive fee payment for “nonconforming” vessels. But the IG noted that the Department of Energy was unable to recover that second payment, because “at the time we determined the vessel was nonconforming, a different fee criteria applied which denied the Department the ability to recover fee for a nonconforming vessel after it had been installed.” Oops!
We are not going to get into a discussion of patent vs. latent defects here. But we will note for the record that more than six years has passed since the DOE demanded that Bechtel repay the $15 million. Accordingly, we have to smile a bit at the IG recommendation that the DOE management team “Determine whether the $15 million performance fee payment for a nonconforming vessel was returned to the Department and, if not, take necessary action to recoup the fee from Bechtel.”
Perhaps the DOE IG might want to read one or two of our articles on the Contract Disputes Act’s Statute of Limitations?
The Allowability of IR&D for Defense Contractors
Defense contractors spend considerable amounts on “independent” research and development (IR&D or IRAD) efforts. They need to, if they are going to compete for next generation-type defense programs. As our readers likely know, defense contractors’ IR&D expenditures are largely (if not entirely) reimbursed by the U.S. Federal government through payment of indirect costs allocated to direct contract costs—generally in the General & Administrative (G&A) expense rate.
Accounting for IR&D costs can be tricky, as we discussed in this article that covered the Appellate decision in the matter of ATK Thiokol, which so far is the leading precedent regarding how to account (and allocate) IR&D expenses. As we commented in the ATK article—
The Court had to interpret the FAR 31.205-18 cost principle, CAS 402, and CAS 420 in arriving at its decision. The parties’ contentions turned on the meaning of the phrase ‘required in the performance of a contract.’ Allowable IR&D costs are those that are not required in the performance of a contract, but the issue was whether the words meant ‘specifically’ or ‘expressly’ required, or whether they meant ‘implicitly’ required.
As you can see, properly accounting for IR&D costs involves inter-leaving the FAR Cost Principles and at least one (and likely more than one) Cost Accounting Standard. It’s not easy, especially for defense contractors, who also need to look the supplemental Cost Principles in the DFARS.
Another emerging challenge for defense contractors has been the Pentagon’s heightened sensitivity to its reimbursement of contractors’ IR&D expenditures. Like most everything involving Federal funds these days, DOD has been looking at how it can maximize the bang it receives for contractors’ IR&D bucks. We first mentioned the issue in July, 2010, right here, where we wrote that two of Dr. Carter’s “Better Buying Power Initiative” objectives were:
A few months later, Dr. Carter clarified what he meant by the phrase, “encourage effective use of IRAD.” He wrote that the goal was to increase the Pentagon’s focus on contractor IR&D expenditures, so as “to improve the return on IRAD investments for industry and government.”
Dr. Carter’s goal was to be implemented through revisions to the DFARS (the Defense Federal Acquisition Regulation Supplement). We wrote about the proposed revisions, and commented on the additional conditions they would create for many defense contractors. The rule was finalized recently so that, for the large defense contractors (i.e., those that have more than $11 million in reimbursed IR&D costs), in order to have their IR&D costs be allowable, they must submit annual reports to the Defense Technical Information Center (DTIC). And the project information (and associated costs) will be reviewed by DOD oversight officials to ensure that they are “of potential interest to DoD.”
And, unsurprisingly, those reviews are creating some challenges for defense contractors.
Reports are beginning to emerge from several large contractors that the reviews are not going as smoothly as one might have hoped.
The first issue is that DOD reviewers seem to be taking a narrow view of what types of IR&D projects might be “of potential interest” to the Pentagon. Contractors have been provided with an April, 2011, letter from then-Secretary of Defense Robert Gates that lists seven “Science and Technology Priorities” for the Defense Department. The worry is that these seven “strategic investment priorities” define and limit the types of R&D projects that the Pentagon wants to pay for, such that any project that cannot be shoehorned into one of the seven priorities will have its costs disallowed by DCAA and/or DCMA.
Issues that have received negative comments from reviewers include—
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Projects that were started but were subsequently abandoned, especially those that were of a higher dollar value or a large percentage of total IR&D expenditures
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“Shoestring” projects that were started but given insufficient budgets, given the project objectives
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Projects clearly outside the current capability and/or expertise of the contractor (i.e., attempts to enter new technology markets)
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Projects that have incomplete, unclear, or insufficient cost data
In addition, contractors being reviewed are expressing concerns (privately and without attribution) regarding the qualifications of the reviewers. They wonder whether the DOD reviewers have sufficient technical expertise to understand the projects they are reviewing, which are—by definition—state of the art or even just beyond state of the art efforts.
As a practical matter, large defense contractors who qualify for IR&D reviews might want to assess where they are against DOD’s expectations. They should be prepared to defend why their efforts (a) fit into the Technology Roadmap, and (b) why the Technology Roadmap ties to the Pentagon’s strategic science and technology priorities.
Looking at the bigger picture, we wonder if naysayers weren’t correct in worrying that the Defense Department’s renewed focus on contractor IR&D expenses wouldn’t tend to stifle innovation and technology development. If the Pentagon’s vision is an implementation of centralized planning and control that will act to channel contractors’ technology development efforts into only approved channels, then we don’t think that’s going to work out in the long run.
Just ask the former Soviet Union how that centralized planning and control thingee worked out for them.
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Budget Issues and Workforce Impacts
If you’ve been reading blog articles on this site for any length of time, you know we’ve been interested in the health of the defense industrial base, and have written several articles discussing how defense contractors are reacting to budgetary pressures stemming from Congress’ inability to pass a budget (as well as from several other factors, including but not limited to Dr. Carter’s “Better Buying Power Initiative” and Shay Assad’s attack on contractors’ indirect expenses and profits). We could post several links to those blog articles, but the site has a search feature, so you can do your own homework on that, if you’re so inclined.
The Aerospace Industry Associations (AIA) has published many upon many articles of its own, issuing dire warnings of the impact of “sequestration” Defense Department funding cuts on the defense industrial base workforce. In fact, the AIA has estimated job losses in the potential aerospace/defense sector at one million heads.
And while the devasting impact of “sequestration” is undeniable, what is less obvious is the immediate impact on the defense contractor workforce from the current budgetary uncertainty and current DOD cost reduction measures (as noted above). We want to discuss one particular story that came to our attention.
In 2005, UK-based BAE Systems acquired United Defense Industries for $4 Billion and created BAE Systems Land & Armaments, which is reportedly the largest land systems defense contractor in the world (or at least it was, until its recent losses of the M-ATV and FMTV bids). As part of its acquisition of United Defense, BAE Systems acquired the legacy manufacturing operations of Bowen McLaughlin York (BMY), which later became the BMY Combat Systems Division of the Harsco Corporation, based in Pennsylvania.
Today, as it has for nearly 75 years, BAE Systems’ York, Pennsylvania, plant manufactures a number of mature ground combat and land defense systems products—including various types of Bradley Fighting Vehicles. Nearly 1,300 employees work on defense products, as perhaps their fathers and grand-fathers did before them. (And women, too! We didn’t forget.) Reportedly, 80 percent of the Army’s fleet of Bradley FVs has passed through the York plant at one time or another.
But times have been tough recently. As noted, a couple of very large “must-win” bids were lost, and (as we’ve reported) the Army seems to have fumbled its Next Generation Ground Combat Vehicle program. With large-scale ground combat operations winding-down in Southwest Asia, and the US Army planning to halt Bradley FV production (perhaps for several years) starting in 2014, management is looking at a backlog burn-down without much in the way of new orders to replace it.
Which inevitably means workforce reductions.
In early May, 2012, BAE Systems announced that 210 workers at the York, Pennsylvania, plant would be furloughed for about 30 days this summer. That’s about 20 percent of the plant’s workforce. Although management commented that the furlough (which applies to both salaried management and hourly union workers) stemmed from “the normal ebbs and flows of the business,” it was clear that the move was made in response to more than the general business climate.
According to the Reuters article (link above), BAE Systems stated that the root cause of the furlough was “a delay in a Fiscal 2012 contract award for upgrades to the Army’s M2 Bradley Fighting Vehicles.” The delays in awarding the contract led to slips in delivery schedules of long-lead materials from suppliers. No materials, no upgrades. Thus: temporary lay-offs.
But as usual, the story behind the story is more interesting.
According to Inside Defense and Inside the Army (subscription required), the Army put the blame for the contract award delay on BAE Systems itself. Reportedly, the Army has asserted that the delay occurred because “BAE did not submit a compliant bid proposal.” Ms. Heidi Shyu (acting Army Acquisition Executive) wrote in an email to Congress that (reportedly), “BAE omitted the fact that they submitted an inadequate cost proposal … which significantly contributed to the delay in contract award.”
To be very clear, we do not have any insight into BAE Systems’ proposal. We don’t know whether or not it was “adequate.” But we do know this much: The Bradley FV program has been around for thirty years, entering service in 1981. We know that the contract in question is for an award of Fiscal Year funding. Putting all that together, we have to ask how much data the Army actually needed to see in order to determine the BAE Systems’ price was fair and reasonable. They had years and years of actual cost data; what was going to be new information?
Sure, it was a single-source award and likely subject to TINA. But so what? The purpose of TINA is to place the negotiating parties on an equal footing, not to burden the contractor with providing unnecessary and costly information that confirms with the DCMA Contracting Officer and the Buying Command already knew.
What is more likely, we think, is that DCAA used its infamous Cost Proposal Adequacy Checklist, and kicked-back the proposal because it didn’t meet all the check-boxes. Again: so what? If our guess is correct, then the real question is why did the CO think s/he needed field pricing assistance to perform cost analysis on one of the Army’s most mature production programs?
And so, contract award was delayed (for whatever reason) and now more than two hundred people are facing a month without a paycheck.
But that’s not the end of the story. Demonstrating an almost unbelievable naïveté, the Army complained to Congress that (a) BAE Systems did not tell them about the consequences of the delay, and (b) BAE Systems could avoid the furlough if it only “accelerated” material deliveries from suppliers. Yes, that’s what the Inside Defense and Inside the Army stories reported.
BAE told the Army that program supply chains don’t just accelerate themselves—at least, not without a cost impact or two. The story reported that the Army told Congress that BAE Systems told them that—
BAE stated that production schedules are already locked in accounting for the furlough and even if material deliveries could be accelerated, it may be too late to make this change as the program is already in progress. Multiple program activities would require acceleration at this time, not just material lead times and those accelerations are not possible.
Next the Army tied a different approach (according to the article’s reporting of the Army letter). The Army asked BAE Systems to slow down production rates and stretch out the program to avoid the furlough. (“Such a strategy would not require a material delivery acceleration.”) BAE nixed that suggestion as well. BAE told the Army that if it cut its production rate in half (as the Army had requested) then it would still have to furlough half of the 210 employees. BAE Systems told the Army that slowing production would lead to a “more significant impact than [having] all BAE Bradley Production Union employees being furloughed for 30 days.”
We don’t know. The Army comes out of this looking pretty clueless, in our opinion. One would think that the contractor’s workforce management would be left to the contractor, especially if (as the Army asserted) all the problems stemmed from the contractor’s inadequate proposal. The Army’s (over)reaction seems to us to have a bit of guilt associated with it.
We return to our initial question. How does the Army justify requiring a full-up, fully expensive, TINA-compliant proposal for an annual funding request? If you want to pile-on, then let’s ask why this program isn’t being funding with mult-year money, which would permit more robust long-term planning?
Who’s running this show? We aren’t really sure, but one thing is certain. It’s the local workforce that’s paying the price for this apparent mismanagement.
DCAA Implements New Accounting System Review Program and Says Goodbye to Flash Reports
On April 24, 2012, DCAA issued audit guidance via MRD 12-PAS-012(R), concerning performing reviews of contractors’ accounting systems pursuant to the new DFARS adequacy criteria and business system administration rules. You know, the stuff that we’ve incessantly blogged about here? Yeah, that stuff.
And yet, here we are, blogging about that stuff once again.
We suspected that the easiest way forward for DCAA was to mash several of its previous ICAPS audit programs into one, and call it the “accounting system” audit program. And that’s indeed what happened. It’s the logical move, since that’s essentially with the DAR Council did in establishing the 18 system adequacy criteria in its new DFARS contract clause regarding contractors’ accounting systems.
So the formerly separate ICAPS audits of Billing and Control Environment are now considered to be subsidiary assignments under the “controlling assignment” given Activity Code 11070. Other former ICAPS audits such as Labor Accounting and ODC Accounting are being completely incorporated into the Accounting System Audit procedures. In addition, some other formerly separate ICAPS-type audits (e.g., Timekeeping, purchase existence/consumption) will now be performed separately but “referenced and incorporated” into the controlling Accounting System Audit assignment, as will CAS compliance reviews.
Importantly, the new DCAA accounting system audit program asserted that, in order to comply with GAGAS, auditors cannot use the definition of “significant deficiency” found in the new DFARS rules. Instead of the definition mandated by regulation, DCAA auditors will use the following—
A deficiency, or combination of deficiencies, in internal control over compliance such that there is a reasonable possibility that a material noncompliance with a compliance requirement (e.g., applicable Government contract laws and regulations) will not be prevented, or detected and corrected on a timely basis.
Given that much of the controversy surrounding adoption of the business system administration rules concerned DCAA’s approach to the term “significant deficiency,” and the lack of clarity regarding application of the concept of materiality to the word “significant,” we think that contractors should be concerned with DCAA’s definitional flexibility. Very concerned.
The audit guidance devoted substantial verbiage to addressing materiality, perhaps in a proactive attempt to head-off contractors’ criticism of the audit procedures. Here is a snippet of that verbiage (emphasis in original)—
In evaluating whether a noncompliance is severe enough to be considered a material noncompliance and a significant deficiency/material weakness, the auditor should consider the likelihood that the identified noncompliance with the DFARS criteria will result in noncompliance with other applicable Government contract laws and regulations (e.g., with FAR Subpart 31.2, CAS, or applicable requirements in FAR Part 15) and the magnitude of those potential other noncompliances. If there is a reasonable possibility that the identified noncompliance with the DFARS criteria will result in a material noncompliance with other applicable Government contract laws and regulations, either individually or in combination, it is a significant deficiency/material weakness. Some of the specific factors that auditors should consider include:
- The nature and frequency of the noncompliance with the DFARS criteria identified with appropriate consideration of sampling risk (i.e., the risk that the conclusion based on the sample is different than it would be had the entire population been tested).
- Whether the noncompliance with the DFARS criteria is material considering the nature of the compliance requirements.
- The root cause of the noncompliance. (Understanding why the noncompliance occurred will help to determine if it is systemic and significant.)
- The effect of compensating controls.
- The possible future consequences of the noncompliance with the DFARS criteria.
- Qualitative considerations, including the needs and expectations of the report’s users. For Government contract cost issues, qualitative considerations also include serving the public interest and honoring the public trust.
Astute readers will notice that DCAA’s “specific factors that auditors should consider” are not especially helpful. We like the bit about taking into account the effect of compensating controls; however, we don’t care at all for the bit about taking into account “qualitative considerations.” We don’t think all the verbiage in the guidance regarding materiality really reduced industry’s concerns. We predict problems lie ahead in that area.
We also predict future challenges associated with this piece of audit guidance—
In addition, it is not necessary to demonstrate an actual monetary impact to the Government (e.g., unallowable or unallocable costs, or that the price the Government negotiated for a contract was unreasonable) to report a significant deficiency/material weakness. There only needs to be a reasonable possibility that the noncompliance with the DFARS criteria will result in a material noncompliance with other applicable Government contract laws and regulations, thus materially affecting the reliability of the data produced by the system. … If the audit team determines that a noncompliance is not a significant deficiency/material weakness, the team should consider whether prudent officials, having knowledge of the same facts and circumstances, would likely reach the same conclusion (i.e., that the official would conclude that he/she can rely on the information produced by the contractor’s system in the conduct of his/her duties and responsibilities).
(Emphasis in original.)
So, yeah. Based on the foregoing, you might be thinking that DCAA HQ is telling its auditors that they don’t actually need to find any significant deficiencies in order to report them. Instead, all they need is to demonstrate a “reasonable possibility” that the contractor’s practices might not comply with governmental laws and regulations. And if by chance the auditors conclude that there is no reasonable possibility of that actually happening, then they need to reconsider and think about whether “prudent officials” (e.g., senior policy-makers at Fort Belvoir) would agree with their conclusion.
Could the bar have been set any lower? Could the subtext have been made any clearer? We don’t think so.
Okay, moving on. In case you were wondering about this article’s title and have been waiting impatiently for us to get to the part about the end of the issuance of Flash Reports, well here you go.
The same MRD announced the demise of the poorly thought-out and poorly implemented Flash Reports. Those reports were intended to flag detected/suspected internal control failures, but (in our view) the whole concept was a failure. The problem, as many of us know all too well, was that DCAA never had the bandwidth to follow-up as its audit procedures required. And DCMA never cared about the Flash Reports in the first place; typically, the DCMA ACO wanted a full-scope audit report before taking action. So the Flash Reports themselves, which at first seemed so ominous and scary, lost all urgency after about the tenth one received. It became kind of a joke, really. So we will all be glad to see them disappear.
But The King is Dead/Long Live The King.
DCAA introduced a new type of audit report to replace the Flash Report—the Deficiency Report. Here how DCAA described the new report (emphasis in original)—
GAGAS … require auditors to include in the report deficiencies, or a combination of deficiencies, in internal control that are less severe than material weaknesses (and, hence, also less severe than a significant deficiency as defined by the DFARS), yet important enough to merit the attention of those charged with governance (i.e., responsible contractor management officials). …
Upon completion of the separate Billing Audit and Control Environment Audit sub-assignments, the results will be summarized in a memorandum for record (MFR) to be reported as a part of the … Accounting System Audit. If a significant deficiency/material weakness is identified as a result of those audits, auditors should generally not wait for the completion of the Accounting System Audit to report the deficiency…. Instead, a deficiency report should be issued under the Billing Audit and Control Environment Audit sub-assignment number …
Because of the importance of timely communication of deficiencies, it also may be appropriate in some cases to issue an audit report on a significant deficiency/material weakness identified in an in-process business system audit (e.g., prior to completion of the Billing Audit or Control Environment Audit sub-assignment). In those cases, the auditor will … set up a separate assignment using the new 11070 Deficiency Report subactivity. The new subactivity code also is used to report deficiencies identified in other than business systems audits ... The Deficiency Report Assignment should not be established until there is sufficient evidence that a significant deficiency/material weakness exists and the elements of a finding for the deficiency are fully developed in the originating in-process business system audit….
The Deficiency Report Assignment is an integral part of the originating GAGAS examination engagement (e.g., incurred cost audit), not a separate examination. As a result, it is not necessary to document in the deficiency report assignment many of the procedures generally required to comply with GAGAS for an examination, since the GAGAS procedures would be documented in the originating GAGAS examination engagement. The deficiency report assignment working papers will reference the originating assignment and include the working papers from that assignment that contain support for the noncompliance with the DFARS criteria. …
If the evaluation of the identified noncompliance with the DFARS criteria and the elements of a finding were not fully developed in the originating assignment … the auditor should perform procedures to accomplish that as part of the Deficiency Report Assignment so as not to delay issuance of the report on the originating examination. However, such effort should generally not be extensive since the objective is not to evaluate the contractor’s compliance with all aspects of the applicable DFARS criterion or criteria but only to establish whether the noncompliance identified in the originating audit is a material noncompliance; and, therefore, represents a significant deficiency/material weakness or is less severe than a significant deficiency/material weakness, yet important enough to warrant the attention of responsible contractor officials. In either case, the noncompliance will be reported in the deficiency report.
Whew. Sorry about that, readers. But we felt it best for you to see, first-hand, what DCAA intends for its new Deficiency Reports. As you can tell, there are only subtle differences between the old Flash Reports and the new Deficiency Reports.
So the bottom line is that DCAA is moving forward in implementing the new DFARS Business System administration rules in the manner that many of us feared and warned the DAR Council about. The audit agency is redefining “significant deficiency” in a manner that is contrary to the plain, explicit, definition promulgated by the DAR Council—in essence, revising Federal regulations illegally and without soliciting any public comment.
DCAA has published audit guidance that warns auditors to think—and then think again—before giving contractors’ accounting systems a clean bill of health. Yeah, so much for independence and objectivity.
Finally, DCAA has put a stake in the heart of its ill-advised Flash Report methodology; but, like a Frankenstein monster, the audit agency has resurrected and reconstituted its reporting into new Deficiency Reports.
We are disappointed and disheartened that, once again, DCAA has chosen an adversarial position that actually inhibits timely and accurate audit reports. Disappointed and disheartened, yes. Surprised? No.
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