By Beverly Arviso, CPA, CPCM, CFCM

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Beverly Arviso
Beverly Arviso, CPA, CPCM, CFCM is the President of Arviso, Inc. She is a frequent lecturer and author on topics pertinent to government contractors. She can be reached at (757) 373-956 or via email at beverly@arvisoinc.com.

Receiving a cost reimbursement contract, whether as a prime contractor or a subcontractor, seems to be an attractive proposition, but the reality is this contract type exposes your business to a significant amount of risk and audit exposure. Are you ready for the risk?

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Regardless of the size of your company, prior to receiving a cost reimbursement contract, your system must be deemed adequate for determining costs applicable to the contract or order prior to award of a cost reimbursement contract pursuant to FAR 16.301-3. If the pending contract or order is being considered for award by the Department of Defense, the adequacy determination is often performed by the Defense Contract Audit Agency (DCAA) using the Pre-Award Accounting System Survey, SF 1408 (refer to the responsibility determinations in FAR Part 9.106-4), aka an accounting system audit. Non-DoD agencies may choose to use DCAA or make an independent determination on the adequacy of the accounting system prior to award. The following risk areas should be reviewed to determine if your business is ready to receive a cost reimbursement contract.

The contract or subcontract will likely include the clause at 52.216-7, Allowable Cost and Payment. This clause is laden with risk exposure as it requires, at a minimum, the following:

  • The submission of an incurred cost submission annually within 6 months after your fiscal year-end. DCAA provides an example of an incurred cost electronically (ICE) model, which can be downloaded at www.dcaa.mil. Additional instructions on the preparation and submission of this ICE can also be found at DCAA’s website in the Information for Contractors pamphlet.
  • Prompt payment of your subcontractors or vendors, in accordance with the terms and conditions of a subcontract or invoice, and ordinarily within 30 days of the submission of the Contractor’s payment request to the government. To the extent payment to subcontractors or vendors is not paid within the terms of the agreement, the costs may be deemed unallowable for reimbursement of costs. This important, but often overlooked, requirement is part of the auditor’s test during the adequacy determination.
  • Description of your accounting system procedures for identifying and excluding unallowable costs from the costs claimed and billed (technically not “required”, but may be needed during the audit process)
  • A contract briefing system, which generally includes a synopsis of all pertinent contract provisions, such as contract type, contract amount, product or service to be provided, contract performance period, rate ceilings, advance approval requirements, pre-contract cost allowability limitations, and billing limitations. (While a contract brief is not technically “required”, it may be needed and may serve as a beneficial business tool during the audit process.)
  • The development of billing rates that represent the anticipated final rates and are used to prepare interim billing vouchers on cost reimbursement invoices throughout the year. The billing rates may be prospectively or retroactively revised by mutual agreement, at either party’s request, to prevent substantial overpayment or underpayment (FAR 42.704).
  • The certification of final indirect costs, which can expose the contractor to penalties and interest to the extent unallowable costs are claimed as part of the incurred cost submission (FAR 42.703-2 and 42.709).
  • The cost principles at FAR Part 31 will apply to your entire business segment or entity depending on your business structure. This exposes ALL costs in your business, including commercial and/or non-government transactions, to scrutiny in an audit. FAR Part 31 requires an in-depth understanding of and segregation of direct costs, indirect costs, and unallowable costs.
  • Indirect rates need to be readily prepared from the system and reconcile back to your general ledger at least monthly.
  • A proper timekeeping system that tracks labor on a job cost basis needs to be in place. This will form the basis of the labor distribution report, which should be reconciled to payroll records, job cost ledgers, and general ledgers at least monthly.
  • Job cost ledgers should be maintained and reconciled to your general ledger at least monthly.
  • Subcontractors beware that the prime may flow down the requirements of FAR 52.216-7, Allowable Cost and Payment, or other clauses citing the cost principles at FAR Part 31 into your subcontract. If incorporated into your subcontract, these clauses may subject your business to the same level of audit scrutiny as the prime and as detailed herein.
  • Contract expenditures must be monitored and tracked to ensure proper reporting and written notification to the contracting officer when you anticipate reaching 75% of the estimated costs as specified in the schedule in the next 60 days per the Limitation of Cost and/or Limitation of Funds clause (FAR 52.232-20 and FAR 52.232-22, respectively). This clause is often a flow-down clause in subcontract agreements, so subcontractors need to be able to monitor and track funding expenditures as well at the job cost level.
  • If incorporated into the contract or subcontract, FAR 52.216-8, Fixed Fee, requires the contractor to withhold up to 15% of the fixed fee when 85% of the fixed fee is reached. The billing system needs a mechanism for tracking and monitoring the required fee withhold thresholds.
  • When indirect costs are claimed on the material portion of a T&M contract, the contractor and/or subcontractor is also exposed to the Allowable Cost and Payment clause and the cost principles at FAR Part 31. Diligence is required as you review and sign all contract and subcontract agreements to ensure a thorough understanding of the compliance requirements of the contract.
  • Margins on cost reimbursement contracts are often surprisingly smaller than anticipated. This is a common misconception for a company that is familiar with a Time-and-Material (T&M) environment where invoices are prepared at an agreed upon fixed billing rate times the number of hours worked. In a cost reimbursement contract, the cost for labor invoiced is limited to the actual amount of the labor posted to the job and cannot exceed the amount paid to the employee per the employee’s pay stub (prior to the application of indirect rates and fixed fee). While the government will reimburse you for all your allowable, allocable, and reasonable costs, you are not permitted to invoice more than your actual costs incurred and your job cost accounting system needs to be able to track and monitor these costs accordingly.

Contract or subcontract will likely include the clause at 52.216-7, Allowable Cost and Payment. This clause is laden with risk exposure as it requires, at a minimum, the following:

  • The submission of an incurred cost submission annually within 6 months after your fiscal year-end. DCAA provides an example of an incurred cost electronically (ICE) model, which can be downloaded at HYPERLINK “http://www.dcaa.mil” www.dcaa.mil. Additional instructions on the preparation and submission of this ICE can also be found at DCAA’s website in the Information for Contractors pamphlet.
  • Prompt payment of your subcontractors or vendors, in accordance with the terms and conditions of a subcontract or invoice, and ordinarily within 30 days of the submission of the Contractor’s payment request to the government. To the extent payment to subcontractors or vendors is not paid within the terms of the agreement, the costs may be deemed unallowable for reimbursement of costs. This important, but often overlooked, requirement is part of the auditor’s test during the adequacy determination.
  • Description of your accounting system procedures for identifying and excluding unallowable costs from the costs claimed and billed (technically not “required”, but may be needed during the audit process)
  • A contract briefing system, which generally includes a synopsis of all pertinent contract provisions, such as contract type, contract amount, product or service to be provided, contract performance period, rate ceilings, advance approval requirements, pre-contract cost allowability limitations, and billing limitations. (While a contract brief is not technically “required”, it may be needed and may serve as a beneficial business tool during the audit process.)
  • The development of billing rates that represent the anticipated final rates and are used to prepare interim billing vouchers on cost reimbursement invoices throughout the year. The billing rates may be prospectively or retroactively revised by mutual agreement, at either party’s request, to prevent substantial overpayment or underpayment (FAR 42.704).
  • The certification of final indirect costs, which can expose the contractor to penalties and interest to the extent unallowable costs are claimed as part of the incurred cost submission (FAR 42.703-2 and 42.709).
  • The cost principles at FAR Part 31 will apply to your entire business segment or entity depending on your business structure. This exposes ALL costs in your business, including commercial and/or non-government transactions, to scrutiny in an audit. FAR Part 31 requires an in-depth understanding of and segregation of direct costs, indirect costs, and unallowable costs.
  • Indirect rates need to be readily prepared from the system and reconcile back to your general ledger at least monthly.
  • A proper timekeeping system that tracks labor on a job cost basis needs to be in place. This will form the basis of the labor distribution report, which should be reconciled to payroll records, job cost ledgers, and general ledgers at least monthly.
  • Job cost ledgers should be maintained and reconciled to your general ledger at least monthly.
  • Subcontractors beware that the prime may flow down the requirements of FAR 52.216-7, Allowable Cost and Payment, or other clauses citing the cost principles at FAR Part 31 into your subcontract. If incorporated into your subcontract, these clauses may subject your business to the same level of audit scrutiny as the prime and as detailed herein.
  • Contract expenditures must be monitored and tracked to ensure proper reporting and written notification to the contracting officer when you anticipate reaching 75% of the estimated costs as specified in the schedule in the next 60 days per the Limitation of Cost and/or Limitation of Funds clause (FAR 52.232-20 and FAR 52.232-22, respectively). This clause is often a flow-down clause in subcontract agreements, so subcontractors need to be able to monitor and track funding expenditures as well at the job cost level.
  • If incorporated into the contract or subcontract, FAR 52.216-8, Fixed Fee, requires the contractor to withhold up to 15% of the fixed fee when 85% of the fixed fee is reached. The billing system needs a mechanism for tracking and monitoring the required fee withhold thresholds.
  • When indirect costs are claimed on the material portion of a T&M contract, the contractor and/or subcontractor is also exposed to the Allowable Cost and Payment clause and the cost principles at FAR Part 31. Diligence is required as you review and sign all contract and subcontract agreements to ensure a thorough understanding of the compliance requirements of the contract.
  • Margins on cost reimbursement contracts are often surprisingly smaller than anticipated. This is a common misconception for a company that is familiar with a Time-and-Material (T&M) environment where invoices are prepared at an agreed upon fixed billing rate times the number of hours worked. In a cost reimbursement contract, the cost for labor invoiced is limited to the actual amount of the labor posted to the job and cannot exceed the amount paid to the employee per the employee’s pay stub (prior to the application of indirect rates and fixed

Cost reimbursement contracts require careful planning and preparation to ensure your business processes and system are capable of performing in such a manner as to reduce the audit risk to your business. Prior to pursuing a cost reimbursement contract or subcontract, you should take the necessary steps to prepare your business for the risks and additional audit burden to which your business will be exposed. Are you ready?

Beverly Arviso, CPA, CPCM, CFCM is the President of Arviso, Inc. She is a frequent lecturer and author on topics pertinent to government contractors. She can be reached at (757) 373-956 or via email at beverlllarvisoinc.com.