Harold M. Hendler, CPA, is the editor of this new department. He is Tax Manager at Prime Motor Inns, Inc., in Fairfield, NJ. Mr. Hendler is a member of the General Committee of Members in Industry of the NYSSCPA He is an author of "Bender's New York Taxes" and has previously written for The CPA Journal. Mr. Hendler has industry experience in banking, leasing, and manufacturing.

Editor Hendler would like to know of subjects of interest to CPAs in industry, Please write to him at: Harold Hendler, rio Managing Editor, The CPA Journal, 200 Park Ave., New York, NY 10166-0010.

ACTIVITY BASED COSTING FOR DEFENSE CONTRACTORS

Activity based costing (ABC) is a system by which overhead costs are allocated directly to products using activity drivers to measure the cost allocable to a particular product. Traditional cost accounting allocates overhead on volume-related bases such as direct labor dollars, direct labor hours, machine hours, or material dollars.

The philosophy behind ABC is that activities consume costs and the knowledge gained by understanding the cost of activities is a tool that can help a business become more competitive.

ABC is not for all businesses, but there are warning signs that an existing cost system is faulty. The AICPA's Industry Committee identified 11 symptoms of a faulty cost svstem in the July 1991 issue of The CPA Letter. These symptoms related to confusion about prices in the marketplace versus product cost, use of volume-related bases to allocate overhead, and high inventory values. In any of these cases, ABC is more relevant to the daily operations of a business than is a traditional income statement, a departmental income statement, or a schedule of rates prepared by a federal government contractor for the Department of Defense.

Given the assumption that ABC is a more accurate measure of the real cost of a product than are traditional cost accounting methods, does it follow that ABC should be the preferred accounting method?

The Time Is Now ! Technological advances both in manufacturing and information processing over the past few years have made the implementation of ABC systems possible and affordable. Computer integrated manufacturing, just-in-time (JIT) inventory techniques, and total quality management programs have enabled companies to bring their product or service to market quicker and at lower cost. "Not only has accounting done nothing to help high tech stax, globally competitive in the new decade; it has often hindered competitiveness. When it comes time to justify the investments required for factory automation, total quality, orJIT, the numbers generated by cost accounting procedures minimize the apparent gains from the new production process and inflate the apparent costs."(1)

Because of advances in information technology, namely more powerful, inexpensive computers and inexpensive modelling software, the time for ABC is here. A survey conducted in November 1990 by the Cost Management Group of the National Association of Accountants (now called the Institute of Management Accountants), found that 11% of U.S. companies were using ABC while 19% were considering ABC implementation. "A significant majority of the companies that have implemented ABC say their experience has increased the quality of cost management information."(2)

It should follow that the company with better cost management is in a position to maximize efficiency and competitiveness.

A Matter of Survival

Given the tighter defense budget, the recession, and the move away from second sourcing, it is a matter of survival for companies to gain a competitive edge. Yet a defense contractor faces ABC implementation obstacles that a commercial enterprise does not. Defense contractors that are required to follow Cost Accounting Standards (CAS) must consider three standards if they wish to adopt ABC.

* CAS 401 requires consistency in estimating, accumulating, and reporting costs;

* CAS 402 requires that costs incurred for the same purpose be allocated consistently; and

* CAS 418 governs the consistency, accumulation, and allocability of direct and indirect costs.

A change to ABC affects these standards and is a change in accounting practice that under Federal Acquisition Regulations (FAR) 52.230-4 requires disclosure to the government and submission of a cost impact proposal. If the costs under ABC resttit in lower costs to the government, then the government will initiate a downward price adjustment. If the costs under ABC result in higher costs to the government, no increase will be allowed for CAS contracts unless the contracting officer determines that it is in the interest of the government to pax, for the increased costs FAR 52.230-3(a)(4).

Figure I illustrates how ABC significantly changes the costs allocated to two contracts. The example, adopted from CFO magazine? compares traditional financial accounting versus ABC reporting, traditional rate computations versus ABC reallocation, and traditional product costing versus ABC product costing. Two contracts to manufacture the same item require identical direct material and direct labor. Contract A has 10 delivery orders and Contract B has 90. A detailed analysis at this company has determined that a significant amount of overhead expense is generated by the activity. of an order being run through the plant. The example shows the transformation of some overhead expense from an indirect expense into an identifiable activity that can be directly attributed to final cost objectives (a direct expense). This is accomplished with cost drivers; in this case, the number of orders is driving costs. Note that the example did not reclassify all indirect cost. The reader should not be misled by the simplicity of the example. Most companies have multiple cost drivers. The costs associated with activities are determined after a detailed and sometimes lengthy evaluation of the processes within a company. This involves data collection, interviews, model building, pilot studies, and lots of planning.

Lose-Lose Situation

Further complicating a contractor's willingness to change to ABC is the Truth in Negotiation Act PL 87-653, 10 U.S.C. 2306(f). Under this law, "If the contractor fails to disclose to the government at the time of price agreement all the significant cost and pricing data used in developing the proposal, or the data submitted were not current, accurate, and complete, the government may reduce the negotiated price to reflect this violation.' q

Not only is the data generated by ABC svstem cost and pricing data, but so is any information gained in the planning stages. The contractor needs to keep appropriate government representatives informed of any cost and pricing data it generates.

A company mav find itself in this type of situation. A contractor determines that ABC will result in an overall reduction of costs to the government. However, because the cost impact study reveals an upward revision to one contract, the ABC is tabled for the time being. The contractor subsequently negotiates a contract under the higher-priced traditional method. Nobody wins, the government pays a higher price, the contractor is exposed to an allegation of defective pricing, and risks losing contracts that might have been won under ABC.

ABC has been around for at least six years, although its appearance in the defense community has been emerging over the last three years. As a result of dialogue with the larger defense contractors on the west coast, the Defense Contract Audit Agency (DCAA) began to research what they call Cost Accounting for Technological Modernization (CATM). The Accounting Policy Division (PAD) has issued three memoranda on the subject. They are:

* 90-PAD-10 issued January 1990 entitled, "Study on Cost Accounting for Technological Modernization." DCAA conducted a survey of eight contractor sights with sales ranging from $305 million to $5 billion. The report recognized that manufacturing operations are changing and that is causing direct costs to decrease and indirect costs to increase. DCAA proposed to train its auditors in this concept.

* 90-PAD-29 issued February 2, 1990 entitled, "Cost Accounting for Technological Modernization, Case Study of an Accounting Change Due to Technological Changes." The contractor was changing its overhead base from direct labor dollars to machine hours. This report pointed out that the length of time required to make an accounting change was longer than anticipated, cooperation between the government and the contractor is essential for project success, the need for technical assistance by both the contractor and the government and the need for guidance addressing CATM issues.

* 91-PAD-14 issued January 22, 1991 entitled, "Audit Guidance on Issues Related to Advanced Cost Management Systems (ACMS)." This memorandum is a compilation of questions that had arisen in the field. It describes ACMS and explains the DCAA audit role and responsibilities in a contractor's ACMS, cost impact proposal and pilot study. The auditor's responsibility for CAS 402 and ACMS is to verify that the system complies with the contractor's Disclosure Statement. "It is the contractor's responsibility to assure that costs are charged properly." The memorandum reiterated that audits of ACMS should be conducted within existing regulatory framework. There may be more cost pools to audit and other issues may arise, but a waiver from CAS is not appropriate.

The Defense Contract Audit Agency Position

Putting the various policy statements into perspective, DCAA's view can be summarized as follows:

* Activity based costing is an acceptable method of accounting for government contracts. It is an accounting change and requires a disclosure statement change in accordance with regulations.

* Early communication from a contractor is advised. DCAA should be involved throughout the process.

* There may be cases where DCAA will encourage, but not advocate, a change from a traditional cost accounting system to ACMS by pointing out accounting weaknesses that require attention. This is where there are inequities in the relationship between an expense pool and its allocation base.

* Local level DCAA are or will be capable of conducting ACMS reviews. The issues that arise should be dealt with in terms of existing regulations.

* Contractors must provide current, accurate, and complete information to the government. Any data related to ACMS could be considered cost and pricing data.

Industry and DCAA have been cooperating in the field of ACMS, yet the specter of defective pricing and uncertain rate and/or contract adjustments have prevented most defense contractors from full adoption of ABC.

Serious Consideration to ABC

An informal survey of several contractors was made to see what they were doing in the area of ABC. A few contractors had performed detailed analyses of the processes in their systems for the purposes of cost containment but had not prepared cost impact proposals on any contracts.

One contractor with commercial and militarv divisions was considering ABC in the commercial division's long range plans but was not considering ABC in the military division due to the complexity of the regulations.

Another contractor has completed a conceptual design of an ABC system for a single product line and has committed to a pilot study. The product line is exempt from cost and pricing data because it has a commercial item exclusion, and accordingly, no cost impact proposal was prepared. This contractor brought the government into the process in the conceptual phase and believed that it was a good move. The contractor did comment that the government brought its legal and financial teams as well as DCAA to review the proposal.

Finally, one contractor perceived a need for ABC at a plant but has decided not to go forward with ABC. This contractor had informally contacted the branch in which the plant was located and was surprised to find the local DCAA conversant about ABC.

Trickle-Down Implementation Is Likely

The future of ABC in the defense industry is being worked out in the trenches at the large defense contractors. Eventually, it will trickle down into the mid-size contractors and may be adopted at some smaller ones. If the government moves to more commercial purchases as they did during the Gulf War by purchasing personal computers from Compu-Add, the government will pay competitive prices for many more items. Then contractors will have no choice but to adopt cost accounting methods that mirror the shop floor.

1 Wise, Ray, "Why Aren't Quality. Programs Boosting Industry Profits?" Electronic Business, March 5, 1990.

2 Cost Management Update, Cost Management Group of the National Association of Accountants, January 1991.

3 Flentov, Peter and Shuman, Eric L., "Putting ABC through Its Paces," CFO, April 1991.

4 Audits of Federal Government Contractors, AICPA, 1990.