Purchased Labor - Accounting Options To Consider

Headline: Purchased Labor - Options To Consider  

QUESTION:  Can we charge labor as direct when we do not direct hire; e.g. we subcontract out the work?  And how should we handle this in our internal accounting system and indirect rates? 

RESPONSE: You are asking a lot in your question.  Lets look and see what the FAR and the DCAA have to say about this as I will share my thoughts on the issue.  Remember, any opinions and recommendations are based on experience, training, and judgment, and do not necessarily reflect the only outcome, nor an exact expectation of government conclusions.  In areas that are often gray, two or more individuals can come to different interpretations and conclusions.  Thats just the way it is.  You must be prepared to support your interpretation and conclusion.

Now the easiest answer is to consider the non-direct hires as a separate Direct Cost line item.  Yes, it is still a direct cost but you could call it Subcontract Labor, Consultant Labor or Purchased Labor.  Whichever you decide could be listed under your Main Grouping called Direct Costs.  So you could have Direct Labor, Subcontract Labor, Direct Materials, Direct Travel, ODCs, etc.

Then, according to how you develop your Indirect Rates (your policy) you typically would not include this non-direct hire labor in your Overhead Base, but you would include it in your G&A base.  Even in this scenario, you should be accumulating the hours and labor dollars for purchased, subcontract, or consultant direct labor.Again, this may be the easiest way.

But as is often the case, requirements of Primes and/or Customers require a little more detailed look at other options.  So lets look a little deeper.

The indirect costs talked about below refer to Fringe Benefits and Overhead.  They DO NOT talk about G&A or Fee!    I prefer to identify indirect costs as they most likely are incurred.  Supporting Direct Staff, they go to Overhead and supporting the company as a whole, they go to G&A.  Typically it balances out and minimizes the stress and administrative hassles of getting too detailed.

I'm a simple guy in a complex world.   

 Lets see what the Auditors have to say  

July 2006 7-2102  

DCAA Contract Audit Manual 7-2102 Purchased Labor  Personnel Procured From Outside Sources  
Some contractors have adopted the practice of obtaining engineers, technical writers, technicians, craftsmen, and other personnel by subcontract (commonly called "Purchased Labor") rather than by direct hire. Such practice, if for any reason other than to meet temporary or emergency requirements, should be carefully studied to determine whether any additional costs resulting there from are reasonable, necessary, and properly allocable to government contracts.

What the Auditors do and are looking for:

I) 7-2102.1 Audit Considerations   a. Contractors accounting treatment of purchased labor varies depending on the circumstances under which purchased labor costs are incurred. For example, some contractors classify purchased labor as direct labor costs when the work is performed in the contractors facilities and under their supervision and otherwise meets the FAR definition of direct costs. These contractors cost such effort using the average labor rate incurred by their own employees for comparable work. Differences between the amounts derived and purchased labor prices are treated as overhead costs and are allocated accordingly.  Other contractors classify purchased labor as subcontract costs. The accounting treatment used should be evaluated on a case-by-case basis as discussed in 7- 2102.2.

b. Purchased labor most likely causes no fringe benefits and other employee related costs to be incurred by the contractor. Such costs are generally paid by the entity providing personnel performing the effort.

c. A fundamental requirement of CAS 418 is that pooled costs shall be allocated to cost objectives in a reasonable proportion to the causal or beneficial relationship of the pooled costs to cost objectives. Purchased labor must share in an allocation of indirect expenses where there is a causal or beneficial relationship, and the allocation method must be consistent with the contractor's disclosed accounting practices. In accordance with CAS 418, a separate allocation base for purchased labor may be necessary to allocate significant overhead costs to purchased labor such as supervision and occupancy costs, or to eliminate other costs not benefiting purchased labor such as fringe benefits costs. 

d. Where the effort of purchased labor is performed in-house using the contractor's supervision and facilities, overhead exclusive of fringe benefits and other employee related costs, if material in amount, should be allocated to purchased labor. Conversely, where the effort of purchased labor is performed offsite under the supervision and control of an entity other than the contractor, none of the contractor's labor overhead costs may be allocable to purchased labor.

II) 7-2102.2 Audit Procedures   The accounting treatment for purchased labor must be evaluated on a case-by-case basis with consideration given to the materiality of costs involved and the overall effect of the accounting treatment on final cost objectives. Acceptance or rejection of the contractor's treatment of purchased labor must be based upon (1) the causal and beneficial relationship of indirect expenses and purchased labor, and (2) the nature of the employer/consultant relationship using the Internal Revenue Services arms-length tests. In making this assessment, the auditor should:

a. Review the contractor's policy, with emphasis on the criteria used in determining whether personnel should be obtained from outside sources instead of by direct hire.

b. Analyze the purchased labor during the current or most recently completed fiscal year, whichever provides sufficient information, too:   (1) Determine the number of purchased labor personnel and the duration of their engagement.   (2) Compare the number of employees on the contractor's payroll (in each classification of purchased labor involved) with the number of equivalent personnel obtained from outside sources.   (3) Compare the cost per staff-year with the contractor's comparable personnel.   (4) Evaluate the contractor's reasons for resorting to the practice. This is particularly important where the engagement extends beyond one year.   (5) Determine whether the contractor's practices are equitable with respect to the utilization of purchased labor on government contracts as compared to commercial work, and on fixed-price contracts as compared to cost-type contracts; and whether the accounting treatments of the costs of such personnel and contractor personnel performing the same kind of work, including allocation of related overhead expenses, are equitable.

c. Coordinate with government production specialists, project engineers, purchase methods analysts, and others on matters such as the effectiveness of performance, staffing requirements, equivalent job classifications, and the award and pricing of the agreements.

d. Examine prior years' records to determine if the practice shows an increasing or decreasing trend.

So what do I think? 

Well, it would depend on how often I used purchased labor and the percentage of purchased labor to employees.

The description under ( Id. ) above is the way I generally look at it.  Review ( Id. ) several times and it should begin to sink in.

In the information above it clearly shows that materiality is important.  If my purchased labor worked on my site (and therefore on my dime), and I incurred significant supervision, occupancy and other related overhead support costs, then I would consider setting up a separate overhead pool for purchased direct labor versus employee direct labor.

The Base for this Overhead Pool, lets call it (PDL), would be of course, Purchased Direct Labor Costs.  The Base for my normal Overhead Pool, lets call it (EDL), would remain Employee Direct Labor Costs.

The types of indirect costs that impact this new Overhead Pool (PDL) include many of the same costs as in my normal overhead pool (EDL), except for fringe benefits and payroll taxes.

So in order to segregate the various overhead line item costs into the Two Overhead Pools I would develop the ratio of Employee Direct Labor and Purchased Direct Labor Costs to the Combined Direct Labor costs.  The percentage ratio derived is what I would use to allocate all overhead costs (excluding Fringe Benefits and Payroll Taxes) into the Two Separate Overhead Pools.

Question for you: The Fringe Benefits and Payroll Taxes would go in which of the Two Overhead Pools, EDL or PDL?  Yes, thats right!  In the Employee Direct Labor Overhead Pool.  Why?  Because these types of costs are typically paid by the agency providing the purchased labor.  Youre so bright.

Let me give you an example: 

Purchased Direct Labor (PDL) is $250,000 and Employee Direct Labor (EDL) is $450,000.  The total is $700,000.   The ratio to allocate our Total Overhead Pool costs into our Two Separate Overhead Pools would be 35.71% for PDL ($250,000/$700,000) and 64.29% for EDL ($450,000/$700,000).

Now let's look at a total Overhead Pool costs of $375,000 that Includes Fringe Benefits and Payroll Taxes for Direct Labor.  If we used only One Overhead Pool our Overhead Rate would be 53.57% ($375,000/$700,000).

This would overstate overhead costs we charged to Purchased Direct Labor and understate overhead costs we charged for Employee Direct Labor.  So to address this we apply the above allocation percentages as follows:  

As always lets see if our checks and balances prove accurate.  We want to determine if our Two Overhead Rates, when applied to the bases we will charge our customers, shows we are recouping all of our Overhead costs.   For Overhead Pool 1 we charge the customer 65.72% on $450,000 of Employee Direct Labor (EDL) or $295,740.   For Overhead Pool 2 we charge the customer 31.71% on $250,000 of Purchased Direct Labor (PDL) or $79,275.   So our Total Overhead Recouped equals $375,015 ($295,740 + $79,275).  The difference of $15 is immaterial and is due to rounding.   We recouped, or will recoup if using this for proposals, all of our overhead.  And we are fairly identifying indirect costs based on benefits received.   Now if the purchased direct labor is immaterial and does not happen often, then I would most likely just roll the purchased direct labor costs or hours, depending which one you use as your base, into the direct labor overall base for my one Overhead Pool (The basic one pool as shown under the column Combined above.)   I would document and describe this in my cost accounting policies and clearly state that if the costs become significant, we will implement a more detailed allocation methodology similar to the one above.  I would also state that we monitor the materiality on a periodic basis.   Got a follow up question?  Contact us or discuss with your colleagues in the Forum Section of our community.  Ask and find out how others have handled this and possible alternatives.  Provide your own thoughts and experiences.   And thats all for this one!   Paul