In our experience, some government contractors occasionally remove (i.e., deduct) allowable indirect costs prior to calculating proposed indirect cost rates. They may do this for any number of reasons, the most common of which are to achieve cost competitiveness and to minimize final rate true-ups. Obviously, by not claiming these costs, the contractor’s profit erodes. While we believe most taxpayers would view this situation favorably, we often hear that the government isn’t satisfied. It’s a good thing, and they want more of it.
Government’s auditors often posit that voluntarily indirect cost reductions must be included in one or more allocation bases and, thus, grossed-up with their share of indirect costs. For example, when a contractor voluntarily removes $100,000 of allowable costs from its overhead pool, these costs would have otherwise been an element of the G&A base. Assuming the contractor’s G&A rate is 10 percent, the government asserts that the voluntary reduction should instead be $110,000 (because G&A base costs absorb their share of G&A pool costs). In sum: another good deed that doesn’t escape punishment.
To be fair, the government’s cost accounting rules indeed require contractors to include both allowable and unallowable costs in allocation bases, such that they all bear their fair share of indirect costs. So the government’s point has some luster. But beyond the surface-level appeal, it seems inherently wrong to apply this rule to voluntary reductions of allowable indirect costs. A thoughtful analysis of economic substance suggests that a voluntary reduction is more akin to a “credit” (from the contractor’s profits), which negates or offsets a cost as if it was never incurred. To us, this approach feels more balanced and reasonable than the government’s demand for a bigger discount.
Wherever this issue arises, we encourage contracting officers to use business judgement to achieve fairness and equity, and avoid interpreting rules in a way that advantages the government and disadvantages contractors. To the extent contractors remove otherwise allowable indirect costs from cost pools (for whatever reason), we recommend referring to the adjustment as a “voluntary reduction” in their indirect cost rate proposals. Too often we see contractors use the term “voluntary disallowance,” which invites auditors to assume that the underlying costs may be unallowable and should be included in allocation bases.
On a final note, and to be clear, “voluntary reductions” relate to otherwise allowable indirect costs and are made at the contractor’s sole discretion. Conversely, certain types of government contracts obligate contractors to exclude unallowable costs (including any indirect costs allocable to them) from proposals and billings. Failure to do so could result in penalties and interest. Contractors should not conflate these two separate and distinct scenarios – one is voluntary, the other is obligatory.