For Government Contractors Thinking They are Not Subject to Cost Accounting Standard 407 - Think Again
Cost Accounting Standard (CAS) 407 is the regulation contractors must be aware of when utilizing standard costing on government contracts. But CAS 407 also poses challenges for contractors not subject to the regulation, because the government still relies on the criteria for acceptability of standard costing practices described within CAS 407 to evaluate all contractors. Therefore, whether a contractor is subject to CAS 407 or not, it is prudent to follow the standard costing practices outlined in the regulation.
Below is a dialogue about the regulations pertinent to the use of standard costing on government contracts and identification of areas for consideration in designing a standard costing system juxtaposed with CAS 407 that will be considered acceptable to the government.
FUNDAMENTAL REQUIREMENTS OF CAS 407
One of the fundamental requirements of CAS 407 per language in the regulation is that variances generated due to the use of standard labor and/or material rates must be accounted for at the production unit. A production unit is defined as a grouping of activities which either use homogeneous inputs or yield homogeneous outputs. Since this section of the standard is so critical, it’s important to look at what these terms mean and where the risks lie with regards to compliance with the requirement.
Homogeneous Outputs: This term refers to situations where identical products are produced by a cost center. If that is the case, then compliance with CAS 407 becomes simple, because any costs accumulated in that cost center may be treated as incurred by the production unit (the one homogeneous product), and any variances can be distributed to that production unit easily. In many cases this is not possible because a variety of different products are often manufactured by a cost center, thus negating the contractor’s ability to state that homogeneous outputs exist.
A simple example to illustrate the requirements relative to homogeneous outputs is a department that exists to produce an electronic circuit board for use in a government weapons system. If the department always produces the same circuit board, with the same contractual requirements, then the department is said to have met the homogeneous output requirement because the same exact circuit board is being produced for all contracts. However, suppose a government customer requires additional testing of the circuit board beyond that required for other units produced by the department. Now, even though the product looks identical, there are differences in specifications that require different levels of quality control testing, which results in a different cost to produce the units. In this circumstance, the department no longer yields homogeneous outputs. Therefore, the quality control function may need to be separated from the other departmental costs and separate standard costing methods developed to comply with CAS 407.
Homogeneous Inputs: This term refers to those situations where a contractor cannot claim that homogeneous outputs exist. The contractor must then make a more difficult argument that homogeneous inputs exist.
Below are specific discussions and examples related to labor and material standards when claiming homogenous inputs:
- Labor Rate Standards: If a contractor wishes to make the argument that a category of direct labor for which a CAS 407 compliant standard rate is calculated, the functions performed within the category must not be “materially disparate” and the employees involved must be “interchangeable” with respect to the functions performed. Compliance with this requirement may be difficult to substantiate. To prove the employees are interchangeable, the contractor would need to perform time studies and produce other substantiating documentation. The argument would fail if there are different technical requirements for different products, and the auditor can show that a different labor mix within the category would be needed. The employees would then not be considered interchangeable and the contractor could be found to be noncompliant with CAS 407. For example, assume a fabrication department utilizes welders to fabricate a variety of different assemblies on different government contracts. If the welders all are interchangeable on any of the products produced, and this can be proved through documentation such as welding specifications that are the same for all products (type of weld, quality standard, etc.), then the welders may be combined into one labor rate standard. However, if one product requires more senior welders to meet product specifications, then the welders would not be interchangeable and one standard rate could not be developed for welders. Multiple different categories may be necessary.
- Labor-Time Standards: Contractors develop labor time standards for categories of direct labor using time studies and other documentation that is updated as conditions change. The same concerns related to whether the labor rate is not materially disparate and is interchangeable apply equally to labor time standards.
- Material-Price Standards: Contractors using material price standards must be able to substantiate that the material category is not materially disparate (i.e. that the materials can be used interchangeably for the production unit for which the price standard has been developed), much like labor-rate standards.
- Material Quantity Standards: Material quantity standards may be very helpful in eliminating the need to track material quantities used to specific production units. As with labor time standards, studies must be performed to determine the standard quantity needed of a material for a given production unit.
Another one of the fundamental requirements is that contractor practices with respect to setting and revising standards, use of standard costs, and disposition of variances must be stated in writing and consistently followed. Quite a few contractors have been found non-compliant with CAS 407 just because they did not have a policy that included these elements and was up to date.
VARIANCE DISPOSITION REQUIREMENTS
One of the most important areas for consideration when developing a compliant standard costing system is how to dispose of variances. Specific required accounting treatment is dependent upon the materiality of the variances as follows:
- Significant variances shall be allocated to cost objectives (including in process inventory) in a method that follows how the standard costs were applied. Required treatment depends on whether the contractor is claiming homogenous input or homogeneous outputs as covered above:
- Homogeneous Outputs: If claiming that homogenous outputs exist, simply apply the variance evenly to the units of output for the period.
- Homogeneous Inputs: If claiming homogenous inputs, the variance will be disposed of based on the standard costs applied. For example, if a standard rate was applied for a category, the variance will also be applied in the same proportion as the standard costs were applied to cost objectives.
- Immaterial variances may be included in appropriate indirect cost pools for allocation to applicable cost objectives.
Variances must be disposed of at least annually.
AREAS OF RISK RELATED TO VARIANCE DISPOSITION
Many contractors are found noncompliant with CAS 407, because of the method they used to distribute variances to cost objectives. Risk areas include:
- Frequency of variance distribution: Contractors may believe that because CAS 407 indicates that variances must be disposed of at least annually that they will be in the clear if they dispose of variances annually. However, there are circumstances where this could still lead to a CAS 407 noncompliance. If the variances are significant, the standard requires that all cost objectives receive an equitable share of the variance. If done annually, after the period of performance ends, it may not be possible to recover the costs under those contracts. Contractors should utilize a shorter period for variance disposition to ensure all cost objectives receive an equitable share of the variance, so that the costs are recoverable.
- Recovery of variance through indirect rates: It can be unclear to contractors when a variance is material in amount, and therefore not recoverable through inclusion in indirect rates. The indirect rate structure may also not be aligned with the method used to determine production units. This may result in situations where government auditors take exception to variance distribution through indirect rates or take exception to the structure of the indirect rates for purposes of equitably disposing of the variances.
WHAT Does COHNREZNICk Think?
While CAS 407 has been around for a long time, contractors still find compliance in this area to be a challenge for several reasons. The standard itself is somewhat complex and requires a full understanding of acceptable approaches to achieve compliance. Relying on commercial practices for standard cost accounting is not a safe harbor. Instead, contractors using standard costing on government contracts should become very familiar with the detailed requirements of CAS 407 and should assume that whether the contractor is subject to CAS 407 or not, government auditors will use CAS 407 as the standard by which they judge the equitability of standard costing practices utilized.
To learn more about Government standard cost issues, please contact:
Jeffrey Witt, CPA
Senior Manager, Government Contracting Industry Practice