*This is Part 1 of a 6-part blog. Each part addresses the fundamental requirements and techniques for application related to the standard, and provides specific examples.
- This Part 1 addresses the overall purpose of the standard, as well as the requirements/techniques for application related to direct costs.
- Part 2 will address the requirements/techniques for application related to indirect cost pools.
- Part 3 will address some of the requirements/techniques for application related to allocation bases.
- Part 4 will address the requirements/techniques for application related to allocation bases not addressed in Part 4 of this blog.
- Part 5 will address special allocations.
- Part 6 will address pre-determined indirect rates.
Background: This standard provides the criteria for the accumulation of indirect costs, including service center and overhead costs, in indirect cost pools. It also includes guidance relating to the selection of allocation measures based on the beneficial or causal relationship between an indirect cost pool and cost objectives. The standard covers the allocation of indirect costs for indirect cost pools other than those covered by CAS 403 (allocation of home office expenses to segments); CAS 410 (allocation of G&A expenses), and CAS 420 (allocation of “Bid & Proposal” and “Independent Research & Development” costs).
- CAS 418.40(a) and CAS 418.50(a)(1) require that a business unit have written policies classifying costs as direct or indirect. The policies must conform to the requirements of CAS 418.
EXAMPLE: A contractor has a written policy stating that direct and indirect costs are classified on a case-by-case basis at the discretion of the Chief Financial Officer. This policy does not comply with CAS 418. The contractor must have objective written policies that describe when a cost is classified as a direct cost and when it is classified as indirect cost.
- CAS 418.50(a)(2) requires that, in accounting for direct costs, the business unit must use actual costs except:
1. CAS 418.50(a)(2)(i) states that standard costs for material and labor may be used as provided for in CAS 407.
EXAMPLE: A contractor uses standard costs for labor and materials. Provided the standard costs comply with CAS 407, use of the standard costs for determining direct labor and material is permitted by CAS 418.
2. In accordance with CAS 418.50(a)(2)(ii), an average cost or pre-established rate for labor may be used provided that:
A. The functions performed are not materially disparate and the employees involved are interchangeable with respect to the functions performed;
EXAMPLE: A contractor has a pre-established rate for machine maintenance. The functions involve repairing the machines. The maintenance department has thirty employees, and all thirty employees can perform maintenance on all of the company machines. Use of a pre-established rate is in conformance with CAS 418.
EXAMPLE: A contractor has a pre-established rate for maintenance work. The maintenance department consists of fifty employees. Twenty of these employees perform maintenance on the companies fabrication machines while the other thirty perform maintenance on the assembly machines. Due to the unique characteristics of the fabrication and assembly machines, only five of the fifty employees are assigned to work on both fabrication and assembly machines. The functions involve the general upkeep of the machines. Use of a pre-established rate does not meet Criteria A because the employees that perform these functions are not interchangeable.
EXAMPLE: A contractor has a pre-established rate for machine work. The maintenance department consists of fifty employees. The maintenance department performs both maintenance and overhaul. Maintenance functions involve minor repairs and upkeep that maintains the workability of the machines. The overhaul function involves machine refurbishment, which requires substantial rework. The overhauls extend the life and/or improve the usefulness of the machines. All of the employees in the maintenance department are capable of performing both maintenance and overhaul work. Use of a pre-established rate does not comply with Criteria A. Although the employees are interchangeable with respect to the functions performed, those functions involved are materially disparate (an overhaul is significantly different from general maintenance).
B. The employees involved all perform their respective functions as an integral team.
EXAMPLE: A group of workers operate in the “Computer Troubleshooting Department”, which is responsible for troubleshooting computer problems with company customers. Some of the workers specialize in software debugging, while others specialize in hardware. Sometimes it is not possible to immediately identify whether the problem involves software or hardware, so two workers are assigned to the problem (one that has expertise in software and one that has expertise in hardware). In other cases, the problem requires an integrated software/hardware solution. The contractor uses a pre-established rate that applies to all troubleshooting performed by this department. This practice is in compliance with Criteria B, since the employees perform their respective functions as an integral team.
C. The employees involved all work in a single production unit yielding homogeneous outputs
EXAMPLE: The contractor proposes to use a pre-established rate of $40 per hour for each of its 40 workers. Some of the workers are painters, others fabricators, and others material inspectors. The end product of this group of workers is the assembly of the core unit for black boxes that are used in aircraft. Each of the core units produced are the same, i.e., they are homogeneous. The contractors practice is in compliance with CAS 418, since the employees all work in a single production unit that yields a homogeneous product.
In accordance with CAS 418.50(a)(2)(ii)(B), when average cost or pre-established rates are used:
A. Any material variances must be disposed at least annually. The timing of the disposition should be consistent from year to year.
EXAMPLE: A contractor uses a pre-established labor rate for its collating department. The contractor has a fiscal year that ends on December 31. The contractor has a policy of disposing of any material variances on June 30 of each year. This practice complies with the requirements of CAS 418. Note that the contractor must dispose of the variance annually and the timing of the disposition must be consistently applied. However, there is no requirement that the variances be disposed of at the end of the fiscal year.
B. Any material variances must be allocated to cost objectives in proportion to the costs previously allocated to these cost objectives.
EXAMPLE: The contractor uses a pre-established direct labor rate of $20 per hour for riveters. During FY 2004, the labor costs of the riveters were allocated to contracts using the pre‑established rate as follows:
|Contract||Hours||Cost (at $20 per hour)|
At the end of the year, the actual average labor rate for the riveters was $25 per hour. This yields a variance of $5 per hour ($25 actual less $20 pre-established). The total variance is therefore $500,000 ($5 variance per hour x 100,000 hours). In accordance with the requirements of CAS 418, the contractor must dispose of the $500,000 variance in proportion to the costs allocated to final cost objectives as follows:
Difference Between Actual and Pre-established Rate ($25 less $20)
Variance Allocated to Each Contract
Therefore, in accordance with CAS 418, the contractor must allocate an additional $100,000 to Contract A, $50,000 to Contract B, $150,000 to Contract C, $125,000 to Contract D, and $75,000 to Contract E.
- In accordance with CAS 418.50(a)(3), Labor or material costs identified specifically with any of the cost objectives listed below must be accounted for as direct labor or direct material costs:
- Final cost objectives;
- Goods produced for stock or product inventory;
- Independent research and development costs;
- Bid and proposal costs;
- Cost centers used to accumulate costs identified with a process cost system (i.e., process cost centers);
- Goods or services produced or acquired for other segments of the contractor and for other cost objectives of a business unit; and
- Self-constructed, fabrication, betterment, improvement, or installation of tangible capital assets.
EXAMPLE: Segment A has a single overhead pool with an allocation base of direct labor dollars. During FY 2014, Segment A incurred $600,000 of overhead costs. The contractor also incurs the following direct labor costs for the year:
|Item||Direct Labor Costs|
|Subcontract for Segment B||$1,000,000|
|Self-Construction of New Facility||$ 500,000|
In accordance with the requirements of CAS 418, the contractor calculates an overhead rate of 10% ($600,000/$6,000,000). Costs are allocated as follows:
|Item||Direct Labor Costs||Overhead Rate||Overhead Cost Allocation|
|Subcontract for Segment B||$1,000,000||
|Self-Construction of New Facility||$ 500,000||
Note that the overhead costs applicable to the IR&D and B&P would be added to IR&D and B&P direct labor costs for allocation in accordance with CAS 420. The $50,000 of overhead costs applicable to construction of the new facility would be accounted for in accordance with CAS 404, 409, and 417.