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Navigating the Requirements of Cost-Type Contracts and Sub-Contracts

Navigating the Requirements of Cost-Type Contracts and Sub-Contracts

The award of a Federal Government cost reimbursement contract, as a prime contractor or a subcontractor, can be very good for your business, but this type of contract can also subject your business to a significant amount of risk, oversight, and audit exposure.

In this article we will review the specific Federal Acquisition Regulations (“FAR”) covering cost-type contracts, the types of cost-type contracts, and risks and mitigation strategies to minimize your company’s exposure.

Types of Cost Contracts

FAR Part 16 describes types of contracts that may be used in acquisitions. It prescribes policies and procedures and provides contracting officers with guidance for selecting a contract-type appropriate to the circumstances of the acquisition.

Cost-reimbursement types of contracts provide for the payment of allowable incurred costs, to the extent prescribed in the contract. These contracts establish an estimate of total cost for the purpose of obligating funds and establishing a ceiling that the contractor may not exceed (except at its own risk) without the approval of the contracting officer. Cost reimbursable contracts take the following forms:

  • Cost Contracts – A contract in which the contractor receives no fee. It may be appropriate for research and development work, particularly with non-profit educational institutions or other non-profit organizations.
  • Cost-sharing contracts – A contract in which the contractor receives no fee and is reimbursed only for an agreed-upon portion of its allowable costs. Used when the contractor agrees to absorb a portion of the costs, in the expectation of substantial compensating benefits.
  • Cost-plus-incentive-fee contracts – A contract that provides for an initially negotiated fee to be adjusted later by a formula based on the relationship of total allowable costs to total target costs.
  • Cost-plus-award-fee contracts – A contract that provides for a fee consisting of a base amount (which may be zero) fixed at the inception of the contract and an award amount, based upon a judgmental evaluation by the government, sufficient to provide motivation for excellence in contract performance.
  • Cost-plus-fixed-fee contracts – A contract that provides for payment to the contractor of a negotiated fee that is fixed at the inception of the contract. The fixed fee does not vary with actual cost but may be adjusted as a result of changes in the work to be performed under the contract. This contract type permits contracting for efforts that might otherwise present too great a risk to contractors, but it provides the contractor only a minimum incentive to control costs.
Acceptable Accounting Systems

Per FAR 16.301-3, regardless of the size of your company, prior to receiving a cost-reimbursement contract, your accounting system must be deemed adequate for determining costs applicable to the contract. If the pending contract is being considered for award by the Department of Defense (“DoD”), the Contracting Officer, or Administrative Contracting Officer (“ACO”), is responsible for determining if the contractor has an adequate accounting system. The adequacy determination is often performed by the Defense Contract Audit Agency (“DCAA”) using the Pre-Award Accounting System Survey, SF 1408 (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 accounting system requirement is the same for cost-type subcontracts. The prime contractor should “flow down” the requirement if awarding a subcontract based on cost. Failure to do so may result in the subcontractor’s costs being disallowed in the primes-incurred cost audit.

To mitigate the risk of your accounting system being found inadequate, it is recommended you perform a self-review or have an outside expert perform the review against the criteria outlined in the SF 1408 prior to the award, or ideally, prior to bid submission, allowing time for system modifications.

Allowable Cost and Payment Clause

Nearly all cost reimbursable contracts will contain the clause at 52.216-7, Allowable Cost and Payment, this clause details the invoicing, record keeping, and reporting requirements for cost-type contracts. These requirements present risks and exposures for both first-time and experienced cost-type contract holders. Prime contractors should flow this clause down to subcontractors when awarding cost reimbursable subcontracts. The requirements include the following:

  • Provisional billing rates – 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 and are monitored by the government.
  • Prompt payment of your subcontractors and vendors – Requires payment to subcontractors and 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.
  • Segregation of unallowable costs – Proper identification and segregation of unallowable costs is a key criterion of an adequate accounting system and failure to properly segregate such costs may result in penalties. Contractors need to segregate unallowable costs and maintain proper documentation in order to withstand audit scrutiny. FAR Part 31 cost principles details unallowable costs.
  • Certification of final indirect costs – Each year the contractor must submit an incurred cost claim within six months after their fiscal year. The claim must be certified by an officer of the company and can expose the contractor to penalties and interest to the extent unallowable costs are claimed (FAR 42.703-2 and 42.709). The DCAA provides an example of an incurred cost claim and electronic model (ICE) on their website.
  • Timekeeping and accounting records – The contractor must have a timekeeping and job cost system that collects costs by project and is reconciled to the general ledger, at least monthly. The timekeeping system will form the basis of the labor distribution reports, which should be reconciled to payroll records and job cost ledgers.
  • Cost monitoring and notification – Contract expenditures must be monitored and tracked to ensure 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.

To mitigate the risks associated with the cost and payments clause requirements, contractors should ensure they have a job cost and timekeeping system in place that at a minimum allows for the following:

  • Segregation of direct and indirect costs
  • Segregation of allowable and unallowable costs and exclude unallowable costs from vouchers
  • Make interim accumulation of costs in the books of account, at least monthly and reconciles to the general ledger
  • Time keeping system that permits hours to be accumulated by day and by project numbers/indirect labor accounts.
  • Requires each employee to record and authorize all hours worked, and is capable of tracking employee changes
  • Requires authorization and approval by the employee’s supervisor.

All practices should be documented in formal policies and procedures that address the requirements of cost-reimbursable contracts.

In Summary

Receiving a cost-type reimbursable contract can be great for business. However, as outlined above, such contracts come with significant reporting and monitoring requirements, can be expensive to implement, and are subject to frequent audit by the DCAA. MGO has team members with extensive experience implementing accounting systems and developing policies and procedures that meet the requirements of complying with the regulations around cost-reimbursable contracts. We also have experience reviewing current systems and providing gap analyses to assist in meeting your current compliance requirements. To learn more about how MGO’s dedicated government contractor practice can help, let’s talk.

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