Total Cost Input (TCI) vs. Value Added (VA)

Background

A contractor should conduct a thorough review of their accounting practices and provide a position paper when a contractor wants to revise its G&A rate calculation using the value-added method rather than the total cost input (TCI) method.

A contractor changed its allocation base to Value Added, and DCAA's rejected Contractor’s change from a TCI to a value added base(total costs excluding material and subcontract expenses) to allocate general and administrative costs. DCAA’s position was the “abrupt” change would “adversely impact the allocation of G&A expense to existing cost reimbursable contracts.” Acknowledging that FAR 31.203 does not specifically require a total cost allocation base be used to allocate G&A expenses, DCAA cites FAR 31.203(c) in defense of its position stating “once an allocation base has been accepted it shall not be fragmented by removing individual elements.”

Response

Distortion of Allocating G&A Expense

A value-added cost base is appropriate when inclusion of material and subcontractor costs would significantly distort the allocation of the G&A expense pool in relation to benefits received.

For example if 72% of the G&A type expense, based on the combined value of direct material/subcontractors and direct labor would be allocated to material and subcontractor costs which would not produce equitable allocations. Unequitable allocations stem from the nature of G&A expenses which is closely associated with managing personnel and manufacturing operations as well as research and development rather than materials and subcontractors.

Fragmenting the Base

As to DCAA’s assertion the change will “fragment the base” a change in the method of allocation is not the same as “fragmentation.” As FAR 31.208(c) suggests, fragmentation refers to the elimination of a portion of the cost input base (e.g. unallowable costs that are normally part of the base should remain in the base).

FAR 31.203(d) provides that the method of allocating indirect costs may require reexamination (i.e. change) when

• (1) substantial differences occur between the cost patterns of work under the contract and the contractor’s other work and
• (2) significant changes occur in the nature of the business, the extent of subcontracting, fixed asset improvement programs, inventories, the volume of sales and production manufacturing processes, the contractor’s products and other circumstances.

In Contractor’s case, in the past 10 years it has changed from a pure engineering firm into both an R&D and manufacturing company and its sales volume has increased from $3 million to $70 million. It is true that Contractor’s G&A expenses should be allocated on a base representing its total activity but considering its operations, total activity is best reflected by direct labor and manufacturing overhead. The inclusion of raw materials and subcontract costs in the base produces a gross distortion in activity because as we have seen above, each dollar of material under the TCI method is considered equivalent to each dollar of labor and overhead. • CAS 410 and the Ford Case

Though Contractor is not CAS covered, the guidance included in CAS 410, Allocating G&A expenses, and associated cases are helpful for illuminating the meaning of total activity. The justification of the use of a value added method in lieu of a TCI method is best illustrated in a classic case, Ford Aerospace and Communications (Aerospace and Communications Corporation Inc. Aeronautic Division, ASBCA 23883). In that case, it was noted the CAS Board in its prefactory comments to CAS 410 stated that “total activity” refers to the production of goods and services during the cost accounting period. It includes material, subcontracts, labor and overhead. In the Ford case, the government maintained that by omitting materials and subcontracts (i.e. using the value-added base) this would result in an inaccurate measure of total activity. The Board rejected this position. Though it noted material and subcontract costs can be “includible in total activity” it is fallacious to conclude “each dollar expended for materials and subcontracts necessarily bears the same relationship to incurrence of G&A expenses as each dollar of labor and overhead.” To the contrary, the total cost of each element comprising total activity “may or may not best represent total activity depending on the circumstances of each business unit. The crucial question is not what activity elements may comprise total activity, but what best represents total activity.”

CAS 410 does not establish a preference for the TCI method. Rather, CAS 410 expressly authorizes three cost input allocation methods (i.e. TCI, value added or a single element representing total activity) and leaves the selection to be based on individual circumstances of the company.

In deciding that a contractor was entitled to use the value-added method, a Board would cite two primary reasons:

1.The material and subcontract content of the contractors contract is disproportionate and G&A expenses pertain more to the contractors in-house activity than to the contractors material and subcontract activity.

2.The G&A expenses provided substantially more benefits to the contractors labor-intensive development contracts than the material intensive production contracts.