Linda S. Bruggeman

The Defense Contracting Audit Agency‘s (“DCAA’s”)  focus on squeezing every penny from contracts has reached a new level with two recent memoranda to auditors providing guidance on identifying allegedly “expressly unallowable costs.”  As discussed below, in many respects the guidance seems inconsistent with both the language and intent of the applicable statutes and regulations.

This paper provides: (1) an analysis of the guidance; (2) an analysis of the underlying statutes and regulations; (3) an analysis of the case law – Emerson Electric– on which DCAA erroneously relies; and (4) specific examples of some of the more than 110 expressly unallowable costs identified in the DCAA’s memoranda that are questionable.

Assuming that auditors follow the new guidance, contractors will undoubtedly face an unwarranted increase in penalty recommendations and assertions of noncompliance with CAS 405.  The intent of this white paper is to explain why that should not occur if precedent, logic, and common sense prevail.

What Does the Guidance Say?

On December 18, 2014, DCAA issued a Memorandum for Regional Directors (the “December 18 MRD”) entitled “Audit Alert Distributing a Listing of Cost Principles That Identify Expressly Unallowable Cost” (14-PAC-021(R)).  On January 7, 2015, DCAA issued a second Memorandum for Regional Directors (the “January 7 MRD”) entitled “Audit Alert on Identifying Expressly Unallowable Costs” (14-PAC-022(R)) to “enhance” the earlier guidance.

The December 18 MRD distributes a 32-page “matrix” of Federal Acquisition Regulation (“FAR”) and Department of Defense Federal Acquisition Regulation Supplement (“DFARS”) clauses that are purported to “meet the definition of expressly unallowable costs.”  Even though it specifically states that the list “does not represent the legal position of the Government,” the December 18 MRD includes the following instruction:

If an audit team questions costs based on a cost principle that is on the list, it generally should treat the questioned costs as expressly unallowable and subject to penalties.

The December 18 MRD also states that the matrix is not a “comprehensive” list of expressly unallowable costs, and directs auditors to “perform additional analysis” to determine whether other costs that might be questioned are expressly unallowable “based on the facts and circumstances of that particular situation.”

The January 7 MRD “enhances” DCAA’s earlier guidance for determining whether particular costs are expressly unallowable, including those “based on cost principles that do not state in direct terms that the cost is unallowable.”  Specifically, the January 7 MRD states as follows:

In order for a cost to be expressly unallowable, the Government must show that it was unreasonable under all the circumstances for a person in the contractor’s position to conclude that the costs were allowable.  Thus, a cost principle makes costs expressly unallowable if:

1. It states in direct terms that the costs are unallowable, or leaves little room for differences of opinion as to whether the particular cost meets the allowability criteria; and

2. It identifies the specific cost or type of costs in a way that leaves little room for interpretation.

While certain aspects of this supplementary guidance are helpful – e.g.,one can certainly agree with DCAA that costs alleged to be unallowable merely because they are “unreasonable” do not qualify as “expressly unallowable” – in many other respects these Memoranda for Regional Directors at best are confusing and at worst ignore the distinction between costs that may be unallowable depending upon the circumstances and costs that are “expressly unallowable.”

The DCAA Guidance Is Inconsistent With Statutes and RegulationsAnd Is Overbroad

An “expressly unallowable cost” is defined as

a particular item or type of cost which, under the express provisions of an applicable law, regulation, or contract, is specifically named and stated to be unallowable.

48 C.F.R. 9904.405-30(a)(2).

Both the FAR and Cost Accounting Standard (“CAS”) 405 require that “expressly unallowable” costs be “identified and excluded from any billing, claim, or proposal applicable to a Government contract.”  48 C.F.R. 9904.405-40(a).  In the Preamble to the original promulgation of CAS 405, the CAS Board explained the intended scope as follows:

The [CAS] Board, in its definition of an “expressly unallowable cost,” has used the word “expressly” in the broad dictionary sense—that which is in direct or unmistakable terms.

Cost Accounting Standards Guide (CCH) ¶3992, Preamble to Original Publication, 9-6-73.  Negotiated National Defense Contracts 38 Fed. Reg. 24195, 24196.  The CAS Board also described the requirement as applicable to “costs which are unequivocally made unallowable by the express provisions of an applicable law, regulation or contract.”  Id.

The CAS clause provides for an adjustment in the contract price or cost allowance, plus interest, if the contractor or a subcontractor fails to comply with CAS and the failure causes the Government to pay increased costs.  48 C.F.R. 52.230-2.  Failure to exclude “expressly unallowable” costs as required by CAS 405 may result in adjustments to fixed price contracts as well as disallowance of costs on flexibly priced contracts.

FAR §42.709 and the clause at FAR §52.242-3, Penalties for Unallowable Costs, permit the assessment of penalties against a contractor that includes “expressly unallowable” and certain other unallowable indirect costs in final indirect cost rate proposals or the final statement of costs incurred or estimated to be incurred under a fixed-price incentive contract.  The penalty provisions apply to all contracts over $700,000 except fixed-price contracts without cost incentives and firm fixed price contracts for commercial items.  FAR §42.709(b).

The statutory authority for assessment of penalties for unallowable costs is at 10 U.S.C. 2324 for Department of Defense contracts and 41 U.S.C. 256 for civilian agency contracts.  In pertinent part, the assessment of penalties is permitted when a contractor submits a cost that is “expressly unallowable under a [FAR or FAR Supplement] cost principle . . . that defines the allowability of specific selected costs.”  10 U.S.C. §§2324(a), (b)(1); 41 U.S.C. §§256(a), (b)(1).

As originally enacted in 1985 for DOD contracts, the statute applied to costs that were unallowable based on “clear and convincing evidence.”  P.L. No. 99-145, Sec. 911(a), 99 Stat. 682.  Incorporation of the “clear and convincing evidence” standard as opposed to the “preponderance of the evidence” standard generally applied in civil cases, including litigation involving allowable cost issues, clearly indicates that Congress did not intend for punitive measures to be taken in every routine cost disallowance case.  Rather, throughout the legislative history of that statute there is ample evidence of Congressional concern about the submission in Government contractor indirect rate proposals of such costs as golf outings and other entertainment, expenses for promotional items, and a variety of activities related solely to the contractor’s commercial business.  See, e.g., H.R. Rep. No. 99-169, 99th Cong., 1st Sess. (June 11, 1985) at 8-10; 131 Cong. Rec. H4802-07 (daily ed. June 25, 1985) (statements of Reps. Nichols, Bryant, and Sikorski).

Congressional intent that penalties be imposed only for the submission of those costs that are indisputably unallowable was emphasized in the enactment of amendments to 10 U.S.C. § 2324 that were intended to “clarify that a contractor will be charged a penalty only if the cost has been expressly disallowed by regulation . . . .”  See H. R. Rep. No. 102-966, 102d Cong., 2d Sess., at 728 (Oct. 1, 1992) (emphasis added).  The accompanying Senate Report includes the following explanation:

INDIRECT COSTS UNDER DEFENSE CONTRACTS

Current law, 10 U.S.C. 2324, requires a contractor who submits a proposal for settlement of costs to pay a penalty if the submission contains unallowable costs. This serves as an important deterrent to fraudulent or negligent submissions. As presently worded, however, the statute requires penalties to be assessed even when there are reasonable differences of opinion on the issue of allowability or when unallowable costs were included inadvertently in a submission. The committee recommends a provision which would revise current law. Under the revision, penalties would be applied if the submission contains indirect costs that are expressly unallowable under the Federal Acquisition Regulation or the Defense Federal Acquisition Regulation Supplement.

S. Rep. No. 102-352, at 237 (1992).

The expansion of “expressly unallowable” costs in the DCAA guidance is inconsistent with this statutory and regulatory precedent.

The DCAA’s Reliance On Emerson Electric Is Misguided

The new DCAA guidance relies heavily on Emerson Electric Co., ASBCA No. 30090, 87-1 BCA ¶ 19,478, as legal authority for classifying many of the costs in its matrix as expressly unallowable, specifically 21 of the 110 matrix items.  See Matrix Items 3, 17, 31, 43, 47, 58-60, 71, 75-78, 81-83, 85, 94-95, 97, 107.  While DCAA’s guidance accurately quotes Emerson Electric with respect to the meaning of “expressly unallowable” costs, Emerson Electricdoes not support the DCAA basic premise – that costs can be expressly unallowable depending on the circumstances.  Emerson Electricdid not involve costs that could be unallowable depending upon the circumstances or involve the assessment of penalties for including costs determined unallowable based on variable circumstances.  There was no argument in Emerson Electricthat the costs at issue did not constitute foreign selling costs.  Rather, the analysis in Emerson Electric focused on whether the drafters’ prohibition on the allocation of the costs at issue meant that the costs were unallowable.

At issue in Emerson Electric was the allowability of certain foreign military selling costs charged indirectly to domestic Government contracts and the related issue of whether the contractor's accounting for those costs violated CAS 405.  The determination of unallowability was based on a provision in the Defense Acquisition Regulation (“DAR”) that stated that “[s]elling costs are allowable to the extent they are reasonable and are allocable to Government business. . . . Selling costs incurred in connection with potential and actual Foreign Military Sales as defined by the Arms Export Control Act, or foreign sales of military products shall not be allocable to U.S. Government contracts for U.S. Government requirements.”  DAR 15-205.37 (emphasis added).  The contractor argued that the literal language of the regulation did not state that the costs were “unallowable” and that therefore the provisions of CAS 405 did not apply.  The Armed Services Board of Contract Appeals (the “Board”) disagreed, concluding that it was “clear beyond cavil” that the meaning of the phrase “shall not be allocable to,” when read with the rest of the paragraph, made foreign military selling costs expressly unallowable on domestic Government contracts.  Emerson Electric, 87-1 BCA ¶ 19,478 at 33.

In Emerson Electric, the Board made a decision in the context of a particular regulation, that a cost that was not “allocable” was effectively “expressly unallowable.”  The Board did not consider whether costs could be unallowable depending upon the circumstances.  Nevertheless, the DCAA guidance is “mis-relying” on Emerson Electric for that proposition 21 times in its matrix.

A Few Examples

A detailed review of every cost on DCAA’s “matrix” is beyond the scope of this paper, but the following examples involving reliance on Emerson Electricand other issues, illustrate some of the critical flaws in the new guidance.

• Excessive Pass-Through Charges (Matrix Item 2 – non-Emerson Electric)

The matrix classifies indirect costs that meet the definition of “excessive pass-through charge” as “expressly unallowable.”  FAR 31.203(i).  That definition is found in the clause entitled Limitations on Pass-Through Charges, which provides in paragraph (a) as follows:

Excessive pass-through charge, with respect to a Contractor or subcontractor that adds no or negligible value to a contract or subcontract, means a charge to the Government by the Contractor or subcontractor that is for indirect costs or profit/fee on work performed by a subcontractor (other than charges for the costs of managing subcontracts and any applicable indirect costs and associated profit/fee based on such costs).

48 C.F.R. 52.215-23, para. (a).  The clause includes the following additional definitions:

Added value means that the Contractor performs subcontract management functions that the Contracting Officer determines are a benefit to the Government (e.g., processing orders of parts or services, maintaining inventory, reducing delivery lead times, managing multiple sources for contract requirements, coordinating deliveries, performing quality assurance functions).

***

No or negligible value means the Contractor or subcontractor cannot demonstrate to the Contracting Officer that its effort added value to the contract or subcontract in accomplishing the work performed under the contract (including task or delivery orders).

Id.

By including this item on the matrix, DCAA appears to be disregarding its own criteria for determining whether a cost is “expressly unallowable”:  whether the work added more than negligible value to the work performed by a subcontractor is manifestly an issue that could be open to interpretation and judgment.  In fact, the clause itself provides for a contractor or subcontractor to “demonstrate to the Contracting Officer that its effort added value.”  As discussed in the Fiber Materials case cited below, the contracting officer has discretion to allow pass-through costs that he or she determines not to be “excessive.”  These are exactly the type of costs that are not“expressly unallowable.”

• Idle Facilities (Matrix Item 52 – non-Emerson Electric)

DCAA’s matrix identifies certain costs of idle facilities as “expressly unallowable,” citing the following provision in the idle facilities/idle capacity cost principle:

(b) The costs of idle facilities are unallowable unless the facilities –

(1) Are necessary to meet fluctuations in workload; or

(2) Were necessary when acquired and are now idle because of changes in requirements, production economies, reorganization, termination, or other causes which could not have been reasonably foreseen. (Costs of idle facilities are allowable for a reasonable period, ordinarily not to exceed 1 year, depending upon the initiative taken to use, lease, or dispose of the idle facilities (but see 31.205-42)).

. . .

(d) Any costs to be paid directly by the Government for idle facilities or idle capacity reserved for defense mobilization production shall be the subject of a separate agreement.

48 C.F.R. 31.205-17(b), (d).

Once again, DCAA appears to have ignored its own strictures on the definition of “expressly unallowable.”  Determining whether idle facilities were “necessary to meet fluctuations in workload,” or whether the facilities are idle “because of changes in requirements, production economies, reorganization, termination, or other causes which could not have been reasonably foreseen” is obviously open to interpretation and “differences of opinion.”  Even if idle facilities costs are ultimately found unallowable in accordance with the cost principle’s criteria, they should not be classified as “expressly unallowable.”

• Airfare (Matrix Item 96 – non-Emerson Electric)

According to DCAA, airfare exceeding “the lowest priced airfare available to the contractor during normal business hours” under the travel cost principle is an expressly unallowable cost.  The travel cost regulation provides, in pertinent part, as follows:

Airfare costs in excess of the lowest priced airfare available to the contractor during normal business hours are unallowable except when such accommodations require circuitous routing, require travel during unreasonable hours, excessively prolong travel, result in increased cost that would offset transportation savings, are not reasonably adequate for the physical or medical needs of the traveler, or are not reasonably available to meet mission requirements. . . .

48 C.F.R. 31.205-46(b).

It is difficult to understand how DCAA could argue that this regulation identifies “expressly unallowable” costs.  To begin with, anyone who has bought airline tickets knows that determining the “lowest priced airfare available” is no simple matter, e.g.,what is available on Monday is not necessarily available on Tuesday.  Furthermore, what is “circuitous routing”?  What would “require travel during unreasonable hours”?  What would “excessively prolong travel”?  What would “result in increased cost that would offset transportation savings”?  What is “not reasonably adequate for the physical or medical needs of the traveler”?  What is “not reasonably available to meet mission requirements”?  Reasonable minds could – and no doubt would – differ on the answers to many if not all of those questions.

The January 7 MRD itself states that a cost is “expressly unallowable” only if “it was unreasonable under all the circumstances for a person in the contractor’s position to conclude that the costs were allowable,” i.e.,if a cost principle “leaves little room for differences of opinion as to whether the particular cost meets the allowability criteria” and “identifies the specific cost or type of costs in a way that leaves little room for interpretation.”  Airfare costs made unallowable under this cost principle do not even arguably meet DCAA’s own definition.

• Contractor-Owned, -Leased, or –Chartered Aircraft (Matrix Item 97 – Emerson Electric)

The DCAA matrix identifies unallowable costs of travel on contractor-owned, -leased, or –chartered aircraft as “expressly unallowable,” citing the following provision in the travel cost principle:

The costs of travel by contractor-owned, -leased, or -chartered aircraft are limited to the allowable airfare described in paragraph (b) of this subsection for the flight destination unless travel by such aircraft is specifically required by contract specification, term, or condition, or a higher amount is approved by the contracting officer. A higher amount may be agreed to when one or more of the circumstances for justifying higher than allowable airfare listed in paragraph (b) of this subsection are applicable, or when an advance agreement under subparagraph (c)(3) of this subsection has been executed. . . .

48 C.F.R. 31.205-46(c)(2).

DCAA adds the following comments:

The costs of travel by contractor-owned, -leased, or chartered aircraft that exceed the allowable airfare described in paragraph (b) of this subsection for the flight destination are expressly unallowable and subject to penalty unless:

• travel by such aircraft is specifically required by contract specification, term, or condition,

• a higher amount is approved by the contracting officer,

• one or more of the circumstances for justifying higher than allowable airfare listed in paragraph (b) of this subsection are applicable, or

• an advance agreement under subparagraph (c)(3) of this subsection has been executed.

Although this cost principle does not use the term “unallowable” or “not allowable,” we determined that the costs are expressly unallowable pursuant to Emerson Electric Co., 87-1 BCA ¶ 19,478.

As discussed above, determining the amount of allowable airfare in accordance with the criteria in paragraph (b) of the travel cost principle leaves a great deal of “room for interpretation” and “differences of opinion,” and thus arguably does not meet DCAA’s own “expressly unallowable” criteria.  In addition, however, the cost principle specifically states that a higher amount could be approved by the contracting officer.  In Fiber Materials, Inc.,ASBCA No. 53616, 07-1 BCA ¶ 33,563, the Board considered the disallowance and penalty assessment on leased aircraft costs included in indirect cost rate proposals.  While it upheld the disallowance of the costs in excess of the applicable standard airfare because the contractor had failed to justify the excess costs, the Board specifically rejected the assessment of a penalty because the contracting officer had the discretion to allow the costs:

In General Dynamics Corp., ASBCA No. 49372, 02-2 BCA ¶ 31,888 at 157,570, rev’d in part on other grounds, Rumsfeld v. General Dynamics Corp., 365 F.3d 1380 (Fed. Cir. 2004), the Board reversed the CO’s assessment of a penalty for the contractor’s inclusion of allegedly expressly unallowable legal costs associated with civil fraud litigation brought by the government. The Board stated that:

The FAR and CAS definitions of “expressly unallowable” point to the need to examine the particular principle involved in light of the surrounding circumstances. Moreover, since Congress adopted the “expressly unallowable” standard to make it clear that a penalty should not be assessed where there were reasonable differences of opinion about the allowability of costs, we think the Government must show that it was unreasonable under all the circumstances for a person in the contractor’s position to conclude that the costs were allowable. The scope of the inquiry will vary with the clarity and complexity of the particular cost principle and the circumstances involved.

The Board noted that, in assessing a penalty, the government bears the burden of proof. Id. at 157,569.

We conclude that, under the circumstances here, the disputed aircraft costs were not “expressly unallowable” under FAR 31.205-46(e)(2). The ACO had discretion under (e)(2), as established, to accept supported costs. We think that appellant’s claim was sufficiently colorable to preclude penalties.

Fiber Materials, Inc., 07-1 BCA ¶ 33,563.

DCAA’s guidance omits any mention of the Fiber Materials case, relying only on Emerson Electric.

• Employee Fringe Benefits (Matrix Item 106 – non-Emerson Electric)

DCAA’s matrix includes employee fringe benefit costs “that are contrary to law, employer-employee agreement, or an established policy of the contractor,” citing the DFARS.  48 C.F.R. 231.205-6(m)(1).  These costs were already unallowable under FAR 31.205-6(m), but DOD issued the rule specifically to make them subject to penalties:

The objective of this final rule is to explicitly state that fringe benefit costs incurred or estimated that are contrary to law, employer-employee agreement, or an established policy of the contractor are unallowable. Although fringe benefit costs that do not meet these criteria are not allowable, the Federal Acquisition Regulation (FAR) does not make them expressly unallowable. Specifying these fringe benefit costs are expressly unallowable in the DFARS makes the penalties at FAR 42.709–1 applicable if a contractor includes such unallowable fringe benefit costs in a final indirect cost rate proposal or in the final statement of costs incurred under a fixed-price incentive contract.

78 Fed. Reg. 73451, 73453 (Dec. 6, 2013).  Promulgation of this regulation was prompted by the DOD’s long-running efforts to impose penalties on contractors for including costs of providing health insurance to ineligible dependents in final indirect cost submissions.  SeeManos, “Penalties for Unallowable Costs,” 8 No. 5 Costs, Pricing & Accounting Rep. ¶ 38 (Sept. 2013).

Two aspects of this explanation deserve mention.  As a threshold matter, whether a particular fringe benefit is “contrary to law, employer-employee agreement, or an established policy” may well be open to interpretation and a matter as to which reasonable minds might disagree.  More critically, however, DOD’s explanation recognizes that costs unallowable because they do not meet criteria in a cost principle are not thereby “expressly unallowable.”  The explanation thus explicitly undercuts DCAA’s reliance on the Emersondecision for categorizing many of the costs on its matrix as “expressly unallowable.”

Conclusion

Perhaps in its zeal to reduce payments to the maximum possible amount, DCAA has issued guidance that recommends the assessment of penalties for submission of costs that fall well short of the “expressly unallowable” standard authorized in the law and regulations.  This guidance, however, is inconsistent with the intent of the statutes and regulations and not supported by the case law upon which DCAA relies.

Linda Bruggeman is a Counsel in the Washington, D.C. office of Miles & Stockbridge.  Linda specializes in government contract cost and cost accounting issues.  She joined Miles & Stockbridge in 2014 after practicing for over two decades at Crowell & Moring LLP.

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation.