Cost Accounting Standard 414 - Preambles

Preamble A

Preamble to Original Publication, 6-2-76

The following is the preamble to the original publication of Part 414, 41 FR 22244, June 2, 1976.

The Standard on Cost of Money as an Element of the Cost of Facilities Capital being published today is one of a series being promulgated by the Cost Accounting Standards Board (Board) pursuant to section 719 of the Defense Production Act of 1950, as amended (Pub.L.91-379, 50 U.S.C.App. 2168), which provides for the development of Cost Accounting Standards to be used in connection with negotiated national defense contracts.

Performance under negotiated contracts usually requires the use of facilities which represent significant contractor investments. Accounting principles applicable to financial reporting do not provide for any explicit recognition of the cost of capital committed to facilities. The Board has long been interested in identifying, as a contract cost, a part of the contractor’s total cost of capital. The Board distributed three research papers dealing with the cost of capital in connection with negotiated contracts. These mailings were in June 1974, April 1975, and December 1975. The responses received to all three of those research mailings were useful in the development of the proposal published by the Board on March 5, 1976 (41 FR 9562).

The Board supplemented that March 5 Federal Register request for comments by sending copies of the Federal Register material directly to organizations and individuals who were expected to be interested. The Board has received 82 comments on the March 5 proposal. All of these comments have been carefully considered. The Board appreciates the helpful suggestions and criticisms which have been furnished.

The comments below summarize the major issues discussed by respondents and the significant changes which have been made from the March 5 version of the proposed Standard.

A. -- General Comments

(1) Impact on Contract Prices

Commentators who represented contractors and the accounting profession tended to favor the proposal, while those who represented some Government agencies were opposed. Government representatives were joined by some other commentators who expressed the belief that the cost of money as an element of the cost of capital committed to facilities should remain, explicit or otherwise, a consideration in determining contract profit compensation, rather than be treated as an element of cost. The Board’s early research into the broad question of measurement of the costs related to capital commitment included a number of inquiries about the propriety of a change in the basic concepts of contract cost to include this element.

The cost to be measured, even though imputed, is real and is relevant for contract costing. The Board is persuaded that there has not been adequate agreement on techniques for measuring it. A Cost Accounting Standard is, therefore, appropriate.

Some commentators have expressed concern that contract profit levels may be reduced when this new element of contract cost is recognized, and that there will thus be no real financial benefit from the issuance of the Standard. Such comments are based on a misunderstanding of the Board’s mission. The Standard is intended to improve contract cost measurement and understanding by the contracting parties and to provide for greater uniformity by specifying techniques appropriate to types of circumstances actually encountered. Capital as asset commitment varies widely among contracts. The Board has developed a technique that takes explicit account of such differences in capital intensity. The procurement agencies are now considering their pricing policies and the Board expects the agencies in doing this to give appropriate recognition to this Standard.

(2) Exclusion of Working Capital

As the Board pointed out in its publication on March 5, 1976, its staff has investigated the problems related to measurement of the costs related to investments in operating, or working capital. Most commentators, while generally favoring the Board’s proposal as to the cost of facilities capital, urged that the final promulgation include explicit cost recognition based on the contractor’s investment in working capital. The Board is not prepared at this time to make determinations on all the issues related to working capital. The economic impact of contractor investment in facilities is, by itself, important enough to warrant recognition as a contract cost without delay. The Board will seek to resolve the problems related to measurement of the contract cost attributable to the investment in working capital.

(3) Withdrawal of Proposed CAS No 413

A number of commentators expressed regret that the Board has withdrawn its proposed Cost Accounting Standard No. 413 on Adjustment of Historical Depreciation Costs for Inflation, which was published on October 9, 1975. As the Board pointed out in its March 5, 1976 publication inflation has an impact on interest rates. Research shows that over time there is a strong correlation between interest rates and the rate of change of the price level. The interest rates which were available for measuring the cost of capital would unavoidably include some allowance for inflation. Although a number of respondents denied any overlap, the promulgation of both CAS No. 413 and CAS No. 414 as proposed would have resulted in some duplication of coverage.

The accounting profession continues to consider various approaches to the financial reporting problems related to inflation. The Board will continue to observe the various efforts within the profession, and will consider the usefulness for contract costing purposes of each new statement of generally accepted accounting principles related inflation.

Should the Board consider it appropriate at some future time to measure the impact of inflation in some other way for contracts, it will, of course, reconsider the rate as well as the method selected for measurement the cost of money as an element of the cost of facilities capital.

B. -- Content of the Standard

(1) The Renegotiation Board Rate

The Board’s March 5 publication specified the use of the semiannual interest rate established in accordance with Pub.L.92-41 to serve as a cost of money rate for determining the imputed cost of capital committed to facilities. That law requires that the “rate shall be determined by the Secretary of the Treasury, taking into consideration current private commercial rates of interest for new loans maturing in approximately five years.” (section 2, 85 Stat. 97).

Some commentators have pointed out that the interest rate specified under Pub.L.92-41 was, during 1973-1974, less than the actually experienced rate of general inflation, and thus could not have realistically reflected the rate of inflation. The rate includes provision for the expected impacts of future inflation. In the future as in the past, inflationary expectation may indeed be less than the rate of inflation subsequently experienced; but at times it may also be greater.

Obviously the single interest rate specified under Pub.L.92-41 and used as a cost of money rate in this Standard will rarely be the precise borrowing rate of any particular contractor.

(2) Allocation of Facilities

For contract costing purposes, the cost of capital committed to facilities must be related to contracts. The following three subsections deal with the techniques proposed to establish this relationship.

Simplified Procedure: The Standard being promulgated today is based on allocation to negotiated contracts of an appropriate share of the total cost of money which can be identified with the facilities employees in a business unit. This allocation is made by first identifying the total facilities capital associated with each indirect cost pool. The imputed interest cost is then assigned to contracts on the basis of the same measures used to allocate other costs from those indirect cost pools.

Interested parties almost universally accepted this basic approach. A few have expressed concern, however, that the proposed procedure might entail more effort than would be warranted by the improved precision obtained as compared with a much simpler procedure to approximate the desired allocation.

The March 5 proposal included a provision for a simple allocation technique, based on the established procedure for distribution of G&A expenses. This alternative was to be used “only where the contracting parties agree that the results are not likely to differ materially from those which would be produced under the procedure (otherwise described in the proposed Standard).”

Critics of the proposal suggest that the only way the two parties could agree to use the alternative simple procedure would be to recreate the detail of an allocation using the “regular” method as a comparison. But if the “regular” method must thereby be applied in any case, then there would be no reason to pursue the alternative. The Board has confidence in the reasonableness of the contracting parties in finding ways to achieve the purpose of this Standard. Where the total amount of facilities capital is minor in relation to the estimated incurred cost, for example, the parties could be expected to agree in advance to use the simpler alternative procedure. Similarly, if the contractor has a variety of service centers and other indirect cost pools, which are generally used to serve all productive activities, and which do not individually involve significant facility investments, the alternative procedure could be expected to provide significant administrative convenience, and should probably be used. The situation would be different if a relatively significant portion of the total facilities investment were identified with a service center which is obviously not used with the same intensity for all final cost objectives of the contractor; the imputed cost related to such an investment should be assigned on the basis of the use of the facilities rather than on the basis of some overall allocation procedure.

The instructions in the Standard have been modified slightly to clarify the available flexibility. The Board expects that administrative convenience and the likelihood of significant distortion will be considered in decisions about the use of the simplified alternative procedure permitted.

Basic Allocation Technique. Some commentators criticized the complexity of the regular procedure provided in the March 5 publication. The instructions called for the identification of assets to pools “on any reasonable basis that approximates the actual absorption of depreciation and the related costs of such facilities. The basis of allocation of undistributed assets in each business unit between, for example, the engineering overhead pool and the manufacturing overhead pool, should be related to the manner in which the expenses generated by these assets are absorbed in the two overhead rates. The choice of the basis for allocation is up to the contractor within the limits stated above.” Those critics who feel that the instructions require too much detailed analysis in the case of elaborate overhead distribution systems seem not to have understood the intent of the quoted portion. Consolidation and simplification to a limited number of pools and allocation bases is justified in the typical situation where there are many service centers. Minor editorial changes have been made in the instructions, but the Board has not seen the need for any major change in this regard.

Application to Process Cost Systems. The Standard provides a means for allocating the imputed cost to final cost objectives by developing facilities capital cost factors for indirect cost pools. To determine the cost of money applicable to a given final cost objective, these factors must be multiplied by the corresponding allocation base units identified with the final cost objective. A few commentators questioned the technique for applying this procedure for process cost systems.

In a process cost system all the production costs, including overhead costs, are usually accumulated in cost pools associated with “process cost centers” and are then allocated so final cost objectives or products by means of an individual cost center “charging rate.” The procedures outlined in this Standard for developing facilities capital cost of money factor for overhead and G&A expense pool are equally applicable to “process cost centers” in case of a process cost system. However, difficulties may arise in computing the appropriate amount of cost of money applicable to each cost objective or product. The difficulties will emerge where the cost record of individual contracts or other final cost objectives do not, as a matter of course, identify any amount of allocation base units related to these final cost objectives in the various “process cost centers.” In those circumstance it is anticipated that the contracting parties could agree upon one of several possible acceptable courses of action. Thus it should not be difficult to develop an acceptable allocation basis using statistical methods where appropriate. In addition, the “alternative method,” described in instructions to Form CASB-CMF, could be applied in suitable circumstances.

(3) Inclusion in “Cost Input”

A few commentators questioned whether the imputed cost of capital committed to facilities should be included in the cost input typically to be used as the basis for distribution of G&A expense under the terms of Cost Accounting Standard No. 410. This element of contract cost is indeed a part of total cost. The term “cost input” is defined as “the cost, except G&A expenses, which for contract costing purposes is allocable to the production of goods and services during a cost accounting period.” In principle, the cost of capital committed to facilities, other than those facilities identified with the G&A expense pool, should be included in the total cost input base.

The Board believes that as a practical matter the allocation of the cost of money for the cost accounting period (See Col. 5 Form CASB-CMF) would not be materially affected by the inclusion or exclusion of cost of money from “cost input.” The cost of money for the business unit as a whole would not change. However, to the extent that cost input is used as an allocation base some difference in the allocation to individual contracts can be anticipated. As indicated earlier, however, this difference generally should be immaterial.

In view of the amount of cost accounting data that may be affected by the introduction of cost of money as an element of contract cost and the idiosyncrasies (sic) of the systems designed to handle that data, the Board believes that administrative expedience should not be ignored. Therefore, at this time it does not prescribe whether this element of cost should be included in or excluded from the cost input allocation base. Although the imputed cost of capital committed to facilities should be included in the total cost input allocation base whenever practicable, exclusion of this element will be acceptable whenever the contractor chooses such exclusion on the basis of reasonable administrative convenience. The illustration in Appendix B is prepared showing the inclusion of this cost and also, as an alternative, showing the exclusion of this element of cost from the measure used as an allocation base for G&A expenses.

C. -- Administration

(1) Accounting Records

The Board’s March 5 proposal included the acknowledgement that the imputed cost to be recognized has not been treated under the generally accepted accounting principles applicable to external financial reporting. Even so, several commentators felt the need to point out to the Board that the proposal would involve a cost not currently recognized in published corporate financial reports.

The Board has often emphasized that memorandum records, not necessarily a part of the contractor’s formal accounting system, can furnish adequate accounting support for contract purposes, where these purposes differ from those for which the accounting system was developed. The imputed cost to be recognized under this Standard is no exception. The Standard provides the techniques by which this cost will be measured, starting with data already in the accounting records.

(2) Preparation of Estimates

The March 5 proposal included the provisions that “where the cost of money must be determined on a prospective basis the cost of money rate shall be based on the most recent available rate published * * *.” Some commentators urged that the Standard make more clear the relationship of the published rate to the rate to be used in estimates. Some urged that the published rate be required, and others asked for the publication of official forecasts, which should be used for estimates.

Other commentators pointed out that the determination of the cost of money applicable to a proposed contract requires estimation of a number of asset values and allocation rates. They asked that the Board provide clear instructions as to prospective application.

The Board has never undertaken to advise the contracting parties as to techniques for estimating or for agreeing upon specific amounts of estimated costs. In the case of the imputed cost of capital committed to facilities, as for other elements of cost, the clear determination of the procedure by which “actual” cost will later be measured can eliminate confusion as to the nature of the estimate. The parties may, of course, use any techniques which seem appropriate for agreeing on the numeric values to be included in contract cost estimates.

(3) Compliance with Standard No. 401

The Board has earlier promulgated a Standard (4 CFR Part 401) which requires that the practices used in pricing a proposal (estimating) shall be consistent with the cost accounting practices used in accumulating and reporting costs. One of the essential features of that Standard is the requirement that any significant element of cost in the estimate can be compared with the corresponding actual cost. A number of commentators have expressed concern about the applicability of that Standard to an imputed cost.

For the purposes of complying with Standard No. 401 the Board believes that any reasonable estimating technique which establishes the cost of money as a separate amount is acceptable. It is not necessary in estimating to follow precisely the procedures, including Form CASB-CMF, incorporated in the Standard.

D. -- Applicability

(1) Use Rates

Contractors are sometimes compensated for the use of facilities by means of “use rates” authorized under Government procurement policies. These rates may cover various elements of ownership costs, including depreciation. The March 5 publication contained a proposed exemption for situations where such use charges were included in contract costs. A number of commentators criticized that proposed exemption.

The Board does not intend to interfere with the process of establishing “use rates” nor is it prepared to define at this time the factors that should be taken into account when they are formulated. The Board believes that the cost of money is a valid economic cost, and that it is as relevant to a contractor employing a use rate as it is to one using depreciation. Existing schedules of use rates have presumably include appropriate consideration of all elements of the total cost to be considered in developing such rates. The proposed exemption for those covered by use charges is accordingly retained.

(2) Existing Covered Contracts

Many commentators urged revision of 414.70 of the March 5 proposal to delete the exemption of contracts and subcontracts entered into prior to the effective date of the Standard. Such contracts were negotiated under the provisions of Government procurement regulations. In all such regulations, any interest costs incurred by the contractor have been specifically designated as unallowable costs. Furthermore, none of these regulations has recognized any imputed cost capital committed to facilities. The agreement of the parties, embodied in such prior contracts, has necessarily been reached in light of the cost principles existing at the time the contracts were entered into. The Board therefore concludes that this Standard should not be applied to existing contracts and the Board has consequently retained the exemption in 414.70.

E. -- Benefits and Costs

With respect to Cost Accounting Standards, the Board’s primary goal is to issue clearly stated Standards to achieve

(1) an increased degree of uniformity in accounting practices among Government contractors and

(2) consistency in accounting treatment of costs by individual Government contractors. Increased uniformity and consistency are desirable to the extent that they improve understanding a communication.

Contract costs currently do not include any measurement of the cost of money, which is undeniably a cost related to contract performance. The result is that contract cost measurements have made no distinction between contracts with equal amounts of total incurred cost but with vast differences in amounts of facilities investment.

This Standard need have no impact in the aggregate prices paid by the Government but will reflect specific identifiable cost of money as an element of the cost of facilities capital in individual negotiated contracts. Previously, these costs presumably were reflected in nonidentifiable amounts in the profits or fees included in the total contract prices. By reflecting specific costs of money attributable to contractor investments in facilities, this Standard will provide for greater consistency in negotiating total contract prices. The Board understands that procurement agencies expect to take this Standard into account in their current reconsideration of pricing policies. The Standard also will assist the procurement agencies to discriminate more effectively between contracts in which the cost of money is significant and those in which it is not.

The Nation’s mobilization base depends on its facilities. These may be more effectively modernized because of the explicit cost recognition provided by this Standard, which will help to eliminate the existing disincentives which have hampered contractor investments in facilities. Also, to the extent that the Standard results in investment in cost-reducing equipment, the Government will be able to procure goods and services at lower prices.

Some commentators have suggested that the Board’s issuance of Cost Accounting Standard No. 409 caused the need for recognition of this element of cost of facilities capital, and that the Standard being promulgated should be judged in that context. The Board does not agree. The Standard on depreciation was justified by the need for improved criteria with respect to depreciation expense identified with contract performance. Some critics of that Standard argued, in effect, that it should not have been promulgated because, even though it would improve depreciation accounting, there were economic costs not yet being recognized, and that improper depreciation could be justified as an acceptable technique for meeting the economic need. The Board was not and is not persuaded by such reasoning.

The Board has considered the administrative costs related to implementation of this Standard. The most significant potential problems mentioned by commentators were related to features of the proposal which have been modified in response to those comments. The Standard as promulgated today is not expected to involve any significant administrative difficulty, either for contractors or for the Government.

In summary, the Board finds that the benefits of this Standard, which are significant, outweigh the costs, including any inflationary impact.

F. -- Miscellaneous

The Board expects that this Standard will become effective on October 1, 1976.

There is also being published today an amendment to Part 400, Definitions, to incorporate in that part terms defined in 414.30(a) of this Cost Accounting Standard.