Accounting for Subcontract Labor

(Editor’s Note. Though we have addressed alternative accounting treatments of purchases labor in a prior issue of the GCA DIGEST (First Quarter, 2004), a specific issue has surfaced with one of our clients that we thought would be of interest here. It illustrates how subcontract labor can be treated on contracts other than as an ODC where there may be significant limitation on how much add-ons can be made.)

Our client’s practices of treating subcontract labor, who we will refer to as “Contractor,” utilized mostly subcontract labor on its commercial work but used primarily employee labor on its large cost type contract with the federal government. Contractor’s indirect rate structure was overhead applied on a direct employee labor cost base and G&A applied on a total cost input base where it applied its full overhead, G&A and profit rate on employees for the government contract while in the unusual case of using subcontract labor, it applied only G&A with no profit. The auditors made a determination that the skill categories of labor for the subcontract and employee labor were essentially the same and reasoned that the allocation of overhead, G&A and profit on the employee labor used on its government contract represented an inequitable allocation of such costs to only government work where no such allocations except G&A were applied to the subcontract labor for commercial work. Contractor agreed to change its accounting practice and contacted us for advice.

Though we considered preparing a response challenging the auditor’s recommendation to change the accounting our client decided to simply change the practice. One option our client put forward was to compute average rates for different labor categories where for pricing and billing purposes, the average rate for each category would be billed and the overhead base would consist of all employee and subcontract labor costs. The auditor interestingly resisted this approach, asserting that adding the total burden to an already higher subcontract hourly rate would result in too high of a cost for subcontract labor in spite of lower overall indirect rates (because of the higher base created by including subcontract labor). I say “interestingly” because the proposal would have tended to lower the costs on government work and raise it on commercial effort.

The next option we put forward was to calculate an average employee rate for each labor category, take the hourly rate for each subcontractor and break that hourly rate into two components – one for direct labor consisting of the average employee labor rate for the relevant skill category and the remaining amount would be apportioned to the overhead pool. This was justified by saying the invoice is comparable to a direct charge plus an overhead charge, like Contractors’ employees. We considered two other ways of making the breakdown: (1) identifying the breakdown on the subcontracts’ invoices or (2) prorating the hourly rate on the same ratio as the contractor’s direct versus indirect cost ratio. However, for various reasons Contractor rejected the two alternatives.

Once the desired method was decided upon, we pointed out in an opinion paper that both case law and DCAA guidelines allowed for the selected method (the auditor was not from DCAA but respected their guidance). We pointed out that one seminal case, Software Research Associates (ASBCA 88-3 BCA) approved the selected approach (it even approved the two other alternatives that were rejected.) We also pointed out that DCAA’s Contract Audit Manual, Chapter 7-2102 approved of the treatment of purchased labor as either a direct cost such as an ODC or as a direct labor cost where the excess over employee labor could be charged to overhead as long as a “causal and beneficial relationship” could be shown. In examining the DCAA guidelines we were also struck by another acceptable approach our client had not considered earlier. That is, the creation of a separate overhead rate calculation for subcontract labor where the pool would consist of similar costs in the employee labor pool but exclude fringe benefits and taxes not applicable to subcontractors.

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