Definition. External restructuring costs are the non-routine, nonrecurring costs after a business combination that affect the operations of the business entities that were not previously under common control. Normally these costs are considered to be incurred within three years of the business combination. DFARS 231,205-70(b)(4) defines external restructuring costs as the costs, both direct and indirect, of restructuring activities. Restructuring activities are defined as non-routine, nonrecurring or extraordinary activity to combine facilities, operations or workforce to eliminate redundant capabilities, improve future operations and reduce overall costs. (Editor’s Note. These "external restructuring" costs are a result of a business combination and are distinct from "internal restructuring" costs that also may include similar activities but relate to actions affecting only one business unit rather than one or more business units newly under common control.)

Regulations. The government was ambivalent over a rash of corporate reorganizations in the early to mid nineties. They recognized that lower defense spending required consolidation of defense related industries and this was a good thing if it maintained a strong defense industrial base but they worried that the riches being generated from the reorganization would add costs to government contracts. Such concerns led to the National Defense Authorization Act of 1997 which provided that restructuring costs stemming from business combinations after September 1996 would be allowable only if (1) audited savings for DOD contracts exceeded the costs by a factor of two to one and (2) the business combination had to result in the "preservation of a critical capability." Regulations implementing this legislation are at DFARS 231.205-70.

The DFARS provided dollar thresholds for when the regulations would apply and established several steps before external restructuring costs could be reimbursed. The limitations the regulation puts on cost recovery apply to only those companies where the restructuring costs are $2.5 million or more of costs allocated to DOD contracts. Costs less than $2.5 are considered immaterial and the limitations of recovery do not apply. The $2.5 million amount refers to all restructuring activities associated with a business combination and is not to be applied project by project or business segment by segment. A decision that the threshold is not met cannot be reversed in the future if conditions change (e.g. business mix differs from projected mix).

In accordance with DFARS 231.205-70 the other conditions for allowability include (1) contracts must be properly novated to the appropriate business entity (2) the contractor must submit a proposal for the planned restructuring projects that includes a breakout of costs by year and cost element showing projected costs and savings and an audit conducted to ensure unallowable costs are excluded (though too detailed to recount here, see the Defense Contract Audit Agency Manual, Chapter 7-1903 for details on what must be included in the proposal and Chapter 7-1906 how DCAA will audit it) and (3) the ACO must negotiate an advanced agreement that provides a cost ceiling for allowable restructuring costs. Until these steps are completed, the contractor must segregate the restructuring costs and make sure they are suspended from billings, final cost settlements and overhead rate settlements.

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