Contractor Accounting National Business Institute Richard E. McDermott, Ph.D. Defense Contractors Construction Contractors General Contractors

Contractor Contractor AccountingAccounting

National Business National Business InstituteInstitute

Richard E. McDermott, Richard E. McDermott, Ph.D.Ph.D.

Defense Contractors

Construction Contractors

General Contractors

Defense Contractor Defense Contractor AccountingAccounting

To give students an introductory To give students an introductory vocabulary in defense contracting vocabulary in defense contracting and accounting.and accounting.

To help students understand the To help students understand the unique problems faced by the unique problems faced by the Department of Defense in the Department of Defense in the procurement of sophisticated procurement of sophisticated weapons systems weapons systems and the role that and the role that the contractor’s accountant plays in the contractor’s accountant plays in this processthis process..

Session Objectives--DefenseSession Objectives--Defense

Session Objectives--Session Objectives--DefenseDefense To show students how to bid To show students how to bid

government defense contracts.government defense contracts. To give students the steps in To give students the steps in

the establishment of a defense the establishment of a defense contractor cost accounting contractor cost accounting system.system.

First Step in First Step in Procurement ProcessProcurement Process Preparation of Preparation of functional functional

specification--specification--narrative narrative description of the proposed description of the proposed system.system.

Preparation of Preparation of detailed designdetailed design----technical drawings.technical drawings.– The more time you spend on these The more time you spend on these

steps the less time you will spend steps the less time you will spend later.later.

Pricing ConsiderationsPricing Considerations

Two general types of pricing--Two general types of pricing--prospectiveprospective (i.e. fixed price) (i.e. fixed price) and and retroactiveretroactive (i.e. cost (i.e. cost reimbursement).reimbursement).– Fixed price contracts put contractor at Fixed price contracts put contractor at

risk.risk.– Cost reimbursement put the customer at Cost reimbursement put the customer at

risk.risk. There are multiple variations of There are multiple variations of

these two contract forms.these two contract forms.

Choose Choose fixed price fixed price contract when:contract when:

There is a market price for the There is a market price for the contract or service (i.e. “off-contract or service (i.e. “off-the-shelf” items).the-shelf” items).

It is relatively It is relatively easy to estimate easy to estimate prospectively theprospectively thecost of acost of aproduct or service.product or service.

Choose Choose cost cost reimbursement reimbursement when:when:

It is impossible to estimate the amount It is impossible to estimate the amount of work it will take to complete the of work it will take to complete the project.project.

Technology beyond “state-of-the-art” is Technology beyond “state-of-the-art” is required.required.

The project is a research and The project is a research and development effort and involves the development effort and involves the development of new technology or development of new technology or knowledge.knowledge.

There are immeasurable contingencies.There are immeasurable contingencies.

Contract Pricing Contract Pricing ArrangementsArrangements

Contract Pricing Contract Pricing Arrangements:Arrangements: Firm Fixed PriceFirm Fixed Price Fixed Price Incentive--Firm TargetFixed Price Incentive--Firm Target Fixed Price Incentive--Successive Fixed Price Incentive--Successive

TargetsTargets Fixed Price with RedeterminationFixed Price with Redetermination Fixed Price with Economic Price Fixed Price with Economic Price

AdjustmentAdjustment

Contract Pricing Contract Pricing Arrangements:Arrangements:

Cost Plus Incentive FeeCost Plus Incentive Fee Cost Fixed FeeCost Fixed Fee Cost ContractCost Contract Cost SharingCost Sharing Time and materialsTime and materials Labor Hour contractLabor Hour contract

Firm Fixed Price (FFP)Firm Fixed Price (FFP)

Refers to a family of pricing Refers to a family of pricing arrangements whose arrangements whose common discipline is a common discipline is a ceiling beyond which the ceiling beyond which the Government bears no Government bears no financial responsibility.financial responsibility.

FP Incentive--Firm FP Incentive--Firm TargetTarget

The ingredients of this type The ingredients of this type of contract are:of contract are:– Target costTarget cost– Target profitTarget profit– Target priceTarget price– Price ceilingPrice ceiling– Share arrangement Share arrangement

FP Incentive--Firm FP Incentive--Firm TargetTarget

Target Cost $10,000,000 Target Profit $850,000 Target Price $10,850,000 Price Ceiling $12,833,333 Sharing Arrangement 70/30

Costs above $10,000,000 are subject to sharing arrangement. If total costs hit $12,833,333 that becomes the final contract price.

FP Incentive Successive FP Incentive Successive TargetsTargets Long lead-times make Long lead-times make

make it necessary when make it necessary when acquiring a new system to acquiring a new system to contract for a follow-on-contract for a follow-on-quantity before designquantity before designor production stabilityor production stabilityhas been achieved. has been achieved.

FP Incentive Successive FP Incentive Successive TargetsTargets This arrangement is designed for This arrangement is designed for

situations involving the procurement situations involving the procurement of first or second production of first or second production quantity of a newly developed item.quantity of a newly developed item.

There is price uncertainty that There is price uncertainty that precludes finalizing the contract precludes finalizing the contract now. The uncertainty will be now. The uncertainty will be resolved before the contract if resolved before the contract if “firmed up.”“firmed up.”

FP Incentive Successive FP Incentive Successive TargetsTargets

Negotiate initial target cost. When Negotiate initial target cost. When the contract is “firmed up” if the the contract is “firmed up” if the target cost is decreased, the target cost is decreased, the difference between the final fixed difference between the final fixed price and the target cost is split price and the target cost is split between the government and the between the government and the contractor (contractor receives contractor (contractor receives split in addition to the split in addition to the contract price).contract price).

FP Incentive Successive FP Incentive Successive TargetsTargets If the target price is If the target price is

increased at the time of increased at the time of “firm-up” then the “firm-up” then the contractor has a percentage contractor has a percentage of the increaseof the increasededucted from deducted from his ceiling on his ceiling on profits.profits.

Fixed Price with Fixed Price with RedeterminationRedetermination

The government and The government and contractor agree in advance contractor agree in advance to have two fixed price to have two fixed price contracts--one negotiated contracts--one negotiated now and one to be now and one to be negotiated negotiated later.later.

FP with Economic Price FP with Economic Price Adj.Adj.

Designed to Designed to cope with cope with economic economic uncertainties uncertainties that threaten that threaten long-run, fixed long-run, fixed price typeprice typecontracts. contracts.

FP with Economic Price FP with Economic Price AdjAdj..

These contracts provide for These contracts provide for contract increases or contract increases or decreases to protect the decreases to protect the Government and contractor Government and contractor from from the effect of economic the effect of economic changes.changes.

Cost Plus Incentive FeeCost Plus Incentive Fee

Injects an incentive sharing Injects an incentive sharing formula into what would formula into what would otherwise be a cost-otherwise be a cost-reimbursement with a 100/0 reimbursement with a 100/0 share.share.


Three characteristics differentiate Three characteristics differentiate this contract from this contract from Fixed Price Fixed Price Incentive Fee Incentive Fee or or Fixed Price Fixed Price Incentive Target Incentive Target contracts:contracts:– There is no ceiling price.There is no ceiling price.– Total reimbursable costs are the final Total reimbursable costs are the final

contract costs.contract costs.– The maximum fee of the contractor is The maximum fee of the contractor is

subject to limitations.subject to limitations.


MAX

MIN

SHARE LINEPROFIT

$25,000

$20,000

$15,000

$10,000

$5,000 CONTRACT COSTS (000s)

$300 $400 $500 $600 $700

Other Contract Types

Cost plus fixed feeCost plus fixed fee--self --self explanatory.explanatory.

Cost contractCost contract--no profit is paid. --no profit is paid. Used for research contracts.Used for research contracts.

Cost sharingCost sharing--government --government reimburses contractor a reimburses contractor a predetermined percentage of predetermined percentage of costs. Used for research costs. Used for research contracts.contracts.

Other Contract TypesOther Contract Types

Time and materialsTime and materials--this --this arrangement is used to buy labor arrangement is used to buy labor loaded with indirect costs and loaded with indirect costs and profit, and materials which are profit, and materials which are loaded with indirect costs but no loaded with indirect costs but no profit.profit.

Labor hour contractLabor hour contract--same as --same as above except materials are not above except materials are not purchased under the contract.purchased under the contract.

Specific guidelines for . Specific guidelines for . . .. .

Defense Defense ContractorsContractors

Construction Construction ContractorsContractors

General General ContractorsContractors

Contract PhasesContract Phases

Preparing to bidPreparing to bid BiddingBidding Tracking costs Tracking costs Reporting costsReporting costs Managing Managing

contractscontracts Final analysisFinal analysis

Preparing to Bid Preparing to Bid ContractsContracts

Decide . . .Decide . . .

The number and kind of cost The number and kind of cost pools you will use.pools you will use.

The types of rates you will use The types of rates you will use to distribute indirect costs to to distribute indirect costs to contracts.contracts.

The rate base or denominator The rate base or denominator activity to be used in activity to be used in calculating the rate.calculating the rate.

Typical Rates:Typical Rates:

Overhead rates Overhead rates (factory or on-site (factory or on-site OH).OH).

Materials handling rates Materials handling rates (purchasing & materials handling (purchasing & materials handling costs.costs.

General and Administrative General and Administrative (G&A) (G&A) rates (non overhead administrative rates (non overhead administrative costs).costs).

Other.Other.Rate = Estimated Indirect Cost Pool Denominator Activity

Typical Denominator Typical Denominator Activities:Activities:

Direct or loaded labor dollarsDirect or loaded labor dollars Number of Purchase OrdersNumber of Purchase Orders Total contract costsTotal contract costs Total direct costsTotal direct costs Machine hoursMachine hours Material costsMaterial costs Labor hoursLabor hours

Forward Pricing Rates:Forward Pricing Rates:

Contractor forecasts rates based on Contractor forecasts rates based on historical and estimated indirect costs historical and estimated indirect costs and projected denominator volume.and projected denominator volume.

Defense Contract Audit Agency Defense Contract Audit Agency (DCAA) (DCAA) audits proposed rates and makes a audits proposed rates and makes a recommendation to the Government.recommendation to the Government.

Once rates are accepted they are Once rates are accepted they are typically used to bid all contracts for typically used to bid all contracts for the fiscal year.the fiscal year.

Preparing to BidPreparing to Bid

Once you have decided on the rates Once you have decided on the rates you will use, prepare estimates of you will use, prepare estimates of indirect costs pools for the year.indirect costs pools for the year.

Then prepare estimates of company Then prepare estimates of company direct contract costs for the coming direct contract costs for the coming year (direct labor, direct materials, year (direct labor, direct materials, travel, etc.) and any other travel, etc.) and any other denominator activity to be used in denominator activity to be used in calculating rates.calculating rates.

Preparing to BidPreparing to Bid

Calculate rates. Calculate rates. – Negotiate calculated rates with Negotiate calculated rates with

Government if you are a defense Government if you are a defense contractor.contractor.

Prepare a pro-forma financial Prepare a pro-forma financial statement based on statement based on projected direct and indirect projected direct and indirect costs.costs.

Problem 1Problem 1

TriStar is a defense contractorTriStar is a defense contractor It has three indirect cost ratesIt has three indirect cost rates

– Overhead rate – base is direct labor Overhead rate – base is direct labor dollarsdollars

– Materials handling rate – base is Materials handling rate – base is direct material dollarsdirect material dollars

– General and administrative rate (G&A) General and administrative rate (G&A) – base is total costs excluding G&A– base is total costs excluding G&A

Problem 1Problem 1

At the beginning of the year the At the beginning of the year the controller makes the following controller makes the following estimatesestimates– Overhead expense $2 millionOverhead expense $2 million– Direct labor dollars $8 millionDirect labor dollars $8 million– Material handling expense $1 millionMaterial handling expense $1 million– Direct materials expense $10 millionDirect materials expense $10 million– General and administrative expense General and administrative expense

$4,200,000$4,200,000

Problem 1Problem 1

The United States Air Force comes to The United States Air Force comes to TriStar with a fixed-price contract.TriStar with a fixed-price contract.

Estimated direct costs to complete the Estimated direct costs to complete the contract are:contract are:– Direct labor dollars $520,000Direct labor dollars $520,000– Direct material costs $1,020,000Direct material costs $1,020,000

The company has decided it wants to The company has decided it wants to earn a profit of 10% of total costsearn a profit of 10% of total costs

What should the company bid?What should the company bid?

Step One: Calculate RatesStep One: Calculate Rates

Overhead rate: Overhead rate: – $2,000,000/$8,000,000 = 25%$2,000,000/$8,000,000 = 25%

Materials handling rate: Materials handling rate: – $1,000,000/$10,000,000 = 10%$1,000,000/$10,000,000 = 10%

G&A rate:G&A rate:– $4,200,000/$21,000,000 = 20%$4,200,000/$21,000,000 = 20%

Account Amount

Overhead expense $2,000,000

Direct labor dollars $8,000,000

Materials handling expense $1,000,000

Direct material expense $10,000,000

Total $21,000,000.00

Calculation of G&A base

Step Two: Load Contract with Step Two: Load Contract with Rates and ProfitRates and Profit

Direct Labor Cost $520,000

Overhead Applied ($520,000 x 25%) $130,000

Direct Materials Cost $1,020,000

Materials Handling Rate ($1,020,000 x 10%) $102,000

Subtotal (G&A Base) $1,772,000

G&A Applied ($1,772,000 x 20%) $354,400

Subtotal (Fee Base) $2,126,400

Profit or Fee ($2,126,400 x 10%) $202,640

Contract Bid $2,329,040

Estimating Contract Estimating Contract CostsCosts

Estimation Estimation MethodologiesMethodologies

Round table Round table estimatingestimating

Estimation Estimation by by comparisoncomparison

Detailed Detailed estimatingestimating

Round Table EstimatingRound Table Estimating

Representatives of interested Representatives of interested departments such as departments such as Engineering, Manufacturing, Engineering, Manufacturing, Contracts and Purchasing are Contracts and Purchasing are broughtbroughttogether to estimatetogether to estimatecosts based on marketcosts based on marketconditions.conditions.

Round Table Round Table Estimating:Estimating: The estimate is developed without The estimate is developed without

the benefit of design drawings.the benefit of design drawings. AdvantagesAdvantages of this method include of this method include

speed of application and low cost.speed of application and low cost. DisadvantagesDisadvantages include greater include greater

risk. It should only be used on risk. It should only be used on projects involving existing.projects involving existing.

Estimation by Estimation by ComparisonComparison

Products similar to those Products similar to those requested are selected and requested are selected and compared. Costs are compared. Costs are adjusted to the new task.adjusted to the new task.

Detailed Estimating:Detailed Estimating:

This method is characterized by a This method is characterized by a thorough analysis of all components, thorough analysis of all components, tasks, etc.tasks, etc.– Break each product component into Break each product component into

parts, operations, and cost elements.parts, operations, and cost elements.– Tools used include specifications, Tools used include specifications,

drawings, bill of materials, drawings, bill of materials, production rates, production production rates, production quantities, etc.quantities, etc.


The The most importantmost important step is the step is the preparation of the functional preparation of the functional specification and detailed specification and detailed design. The more complete design. The more complete these these documents are, thedocuments are, theeasier it will be toeasier it will be toprice the price the contract.contract.


It is often to divide the work It is often to divide the work statement into two contracts.statement into two contracts.– A A cost reimbursement contract cost reimbursement contract for for

the preparation of a functional the preparation of a functional specification and detailed design.specification and detailed design.

– A A fixed price contract fixed price contract for the for the manufacture or construction of manufacture or construction of the product from the completed the product from the completed design documents.design documents.

Bidding the ContractBidding the Contract

Bidding a ContractBidding a Contract

Review project’s functional Review project’s functional specification and detailed design.specification and detailed design.

Review bidding requirements & Review bidding requirements & contract conditions.contract conditions.– Bonding and insurance Bonding and insurance

requirementsrequirements– Method and timing of progress Method and timing of progress

paymentspayments


Organize project into Organize project into milestones and tasks for the milestones and tasks for the purpose of tracking and purpose of tracking and managing costs.managing costs.

Prepare a list of work to be Prepare a list of work to be done to complete each task.done to complete each task.

Task

Milestone


Verify that you Verify that you have the have the technical technical resources (in-resources (in-house or house or through through subcontractors) subcontractors) to do the work.to do the work.

Assign direct cost Assign direct cost estimates to each task.estimates to each task.

Determine material quantities Determine material quantities and costs for each task.and costs for each task.

Determine labor hours and Determine labor hours and costs by labor category.costs by labor category.

Estimate travel and equipment Estimate travel and equipment costs.costs.

Get bids from subcontractors.Get bids from subcontractors. Estimate contingency costsEstimate contingency costs


Add up the cost of all tasks Add up the cost of all tasks to determine the estimated to determine the estimated direct costs to complete the direct costs to complete the contract.contract.

Load direct costs using Load direct costs using forward-pricing or forward-pricing or predetermined rates.predetermined rates.


Determine profit mark-up. Determine profit mark-up. Add to contract to determine Add to contract to determine total contract price.total contract price.

Adjust price if necessary for Adjust price if necessary for market factors including market factors including competition.competition.


Perform cash flow analysis to Perform cash flow analysis to determine that you have the determine that you have the working capital to do the job.working capital to do the job.

Tracking Contract CostsTracking Contract Costs

Track Contract Costs Track Contract Costs by:by: TaskTask

– Cost TypeCost Type LaborLabor MaterialMaterial EquipmentEquipment TravelTravel

Use percentage of completion Use percentage of completion or calculate estimated cost to or calculate estimated cost to complete.complete.

Job Costing--Report by Job Costing--Report by Task:Task: Original BudgetOriginal Budget Percent of completion Dollars spentPercent of completion Dollars spent Budget to-date (i.e Budget to-date (i.e “dollars “dollars

earned”earned”)) Spent-to-dateSpent-to-date Estimated cost to completeEstimated cost to complete Estimated over or under-run at Estimated over or under-run at

contract completioncontract completion

Problem 2Problem 2

Consolidated Defense Products has a fixed-Consolidated Defense Products has a fixed-price contractprice contract

Direct labor has been broken into 15 tasksDirect labor has been broken into 15 tasks Task one has a budget of $1,000,000Task one has a budget of $1,000,000 At the end of October $300,000 has been At the end of October $300,000 has been

charged against task onecharged against task one The supervisor estimates that the task is The supervisor estimates that the task is

40% complete40% complete Prepare a management report on task onePrepare a management report on task one

Management ReportManagement Report

Task 1 budget $1,000,000

Spent to-date $300,000

Earned to-date (40% x $1,000,000) $400,000

Overrun (underrun) to-date

(Spent to-date) - (Earned to Date)

($100,000)

Total estimated task cost $300,000/40% $750,000

Estimated total overrun (underrun)direct labor task 1

(Task 1 Budget) - (Total Estimated Costs)

($250,000)

Periodic Revenue Periodic Revenue EarnedEarned Calculation of revenue Calculation of revenue

depends on contract type:depends on contract type:– Fixed price contracts: Percent Fixed price contracts: Percent

of completion is appropriate.of completion is appropriate.– Cost reimbursement--actual Cost reimbursement--actual

costs incurred loaded with costs incurred loaded with forward pricing rates.forward pricing rates.

– Other.Other.

At end of accounting At end of accounting periodperiod Calculate actual overhead rates, Calculate actual overhead rates,

compare to budget.compare to budget. Calculate actual OH rates.Calculate actual OH rates. Prepare income statement, show Prepare income statement, show

variances for direct contract costs variances for direct contract costs by contract, indirect costs cost by contract, indirect costs cost pool.pool.

Incorporate what you have learned Incorporate what you have learned into next year’s rates.into next year’s rates.

The EndThe End

Documents

Contractor Accounting National Business Institute Richard E. McDermott, Ph.D. Defense Contractors Construction Contractors General Contractors