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BUS315 Week 4 SolarCal Case Analysis

Cost Classifications and Direct and Indirect Costs

Participants:

Sally- Intern

Dominic- CEO of SolarCal

Luke- Head of Productions

Jake- Head of Accounting/Finance

Melissa- Head of Government Contracting

Dominic: Good morning Sally!

How did everything work out with your job shadowing of Jake?

Sally: Good morning to you too! I had another very productive week working with Jake; he was very knowledgeable in the field of production processes. I also really enjoyed using the tablet he gave me to go through the major components of what his department does. I thought it was very helpful and allowed me to really focus on all of the different concepts he was covering.

Dominic: I’m glad to hear that you and Jake worked well together! Jake is a very valuable resource for us here at SolarCal and I’m happy he provided you with lots of information about some of our day-to-day operations and the industry as a whole.

This week you will be working with Jake again, only this time you will be learning about different cost classifications. I feel that these cost classifications are very important for you to understand because they go hand in hand with our production processes. By learning about these cost classifications you will really get a good foundation for how things work in our company.

Sally: That sounds great! I’m excited to work with Jake again and maybe I will even get to use one of his tablets again!

Dominic: Good morning Jake! I have brought Sally back to you to be a part of the special project you are working on. She needs to first learn about the different cost classifications. Can you get Sally up to speed on this information?

Jake: Sure thing Dominic! I have another presentation put together for Sally to follow along with.

Dominic: That is great! Thank you so much Jake! Sally, enjoy your time with Jake and we will talk later about you accomplishments this week. Take care!

Jake: As Dominic mentioned, we have a special project we are working on and I need to get you up to speed with some key concepts that we will be referencing.

Before we get started, grab a tablet and load the presentation I created for this week.

Sally: I’m all good to go!

Jake: Fantastic! Let’s begin!

Jake: Sally, what can you tell me about cost accounting?

Sally: Cost accounting is a procedure, which enables firms to keep track of the costs that apply to each individual contract or major task they undertake. I recall reading that some forms of cost accounting are used by firms who are reasonably well established.

Jake, how do you think cost accounting is used by these firms?

Jake: That’s a great question! Cost accounting is used by firms in a variety of different ways such as estimating the cost of work before undertaking a project and tracking the costs incurred for doing specific work tasks. Please keep in mind though that under some conditions, the government is vitally interested in the adequacy of a firm’s cost accounting methods.

What do you think happens when the government enters into a contract Sally?

Sally: I recall that when the government enters into a contract where the final price that is paid is dependent on the actual costs incurred, we must be sure that the contractor has an adequate cost accounting system. Is that correct?

Jake: You are very correct! This brings us to our next point, the three major classifications of costs.

The first classifications of costs are reasonable, allowable, and allocable costs. According to federal acquisition regulations, a cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of a competitive business.

From the presentation what can you tell me about the determination of cost reasonableness?

Sally: I believe that the determination of cost reasonableness in specific cases requires skilled judgment and federal regulations that require the contracting officer to consider several questions.

Jake: Excellent! Some of the questions contracting officers may consider include: Is it the type of cost generally recognized as ordinary and necessary in the contractor’s business or in performing the particular contract? Or even, is the cost a significant deviation from established practice?

 

Sally: I can definitely understand why those would be key questions for contracting officers to focus on. There was something I wanted to share with you Jake… something I found interesting in your presentation.

I saw that there are fifty two generally applicable cost principles and noticed that each cost principle defines a particular type of cost and establishes it as an allowable cost, unallowable cost, or allowable cost with restrictions.

Could you explain this concept a little more, I feel like I haven’t quite grasped it yet?

Jake: I will gladly clarify this concept for you. Keep in mind that a cost is allowable if it is expressly identified as allowable in the cost principles. The cost must also meet the relevant tests for the terms of the contract or if it is not addressed in the cost principles, but still meets the requirements of the relevant tests.

Something else to keep in mind is that the decision for determining the allow-ability of a particular cost ultimately rests with the contracting officer. For example, here at SolarCal when we are making cost principle judgments, we try to work very closely with the knowledgeable administrative contracting officer and auditor to gain allow-ability.

Sally: That is very interesting indeed! I do have one more question. What happens if there is a difference of opinion after a contract has been awarded?

Jake: That is a very good question Sally! When there is a difference of opinion after a contract has been awarded, the results can be very disruptive. To try and combat this federal acquisition regulations suggest that contracting officers and contractors reach advance written agreements on how special or unusual costs will be handled when they do arise. Make a note that the agreements must be in writing and signed by the contracting officer and the contractor. It is equally important for both parties to be incorporated into the contract so that both parties are contractually bound.

 

Jake: Let’s now take a look at the second major classification of costs, which are variable, fixed, and semi-variable costs. Sally, what can you tell me about variable costs?

Sally: Well if I recall, variable costs are expenses that go up or down depending on the total volume of work. A couple examples of variable costs that I remember would include the labor and material costs incurred as a direct result of doing work. I do know however that the total labor cost goes up as the output increases; as well as the total cost of material rising as the production volume increases and falls as the volume decreases.

Jake: You hit the nail right on the head, excellent response! Let me tell you a little about fixed costs. Fixed costs remain the same regardless of the amount of production. Building rent would be an example of this where the rent would remain the same whether the company was producing no work or fifty units or even one hundred units.

Sally: I think I have a good understanding of semi-variable costs. Can I explain these costs?

Jake: Sure thing! What do you have for me?

Sally: I’m pretty sure semi-variable costs are costs that are partly fixed and partly variable, but I think this depends on the amount of production being done. I feel that utility costs would serve as a good example. I know that for my utility costs I pay a certain fixed cost just to have my electricity available, and also have to pay even if I don’t turn the lights on.

Jake: Very good Sally! I really liked your example and the connection you made with this concept. We are now going to move on and talk about the final classification of costs.

Jake: We will now discuss the third and final classification of costs. This classification deals with the direct and indirect costs. Please understand that all costs may be classified as either direct or indirect. However, federal acquisition regulations define direct cost as any cost that can be identified specifically with a particular final cost objective. On the flip side, federal acquisition regulations also define indirect cost as any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or an intermediate cost objective.

Go through the presentation and look at the section on direct costs, what do you see?

Sally: I see that direct labor and direct materials are classified as direct costs. It says that the direct labor cost is the expense incurred for people who can be specifically identified with contract work. It also says that direct materials are products that become a part of the finished work or are consumed in doing the work. That is very interesting, what about indirect costs?

Jake: Indirect costs may be divided into two categories. The first are overhead costs which are commonly the only indirect cost category used by small companies that are not engaged in providing widely different services or lines of products. For cases like these, the overhead consists of all the company’s general operating expenses. What do you think larger companies do then Sally?

Sally: I think the larger companies will typically have overhead expenses as well, but these larger companies will instead set up overhead cost pools for each of their operating divisions.

Jake: That is correct Sally, great job! Let’s move on to the second category of indirect costs which are the general and administrative costs. These costs typically involve the headquarters of a company where they may have expenses such as the salaries of the president and other company officers, office equipment, and utilities.

Sally: I read that the government recognizes that companies have direct and indirect costs, and I noticed that their policy is to pay for the reasonable costs of acquiring products and services, plus a reasonable profit. I also recall seeing that the government takes this view as long as the resulting price is itself fair and reasonable. I thought that was interesting.

Jake: Thank you for sharing that with me, I thought that was pretty interesting as well on how the government is involved throughout this process. To expand on your discovery a little more let me talk to you about some other federal regulations.

I first want you to keep in mind that the cost principles currently in place have been fine-tuned over many years through practice, usage, and interpretations of the Board of Contract Appeals and the Federal Courts. Sally, what do you think these federal acquisition regulations state?

Sally: I feel that the federal acquisition regulations would state that cost principles shall be used in pricing negotiated supply, service, experimental, developmental, and research contracts and contract modifications whenever cost analysis is performed. Looking through this presentation a little more closely I believe that the principles must be incorporated by references in contracts with commercial organizations. These references will in turn serve the purpose of determining reimbursable costs in cost reimbursement contracts, costs for termination purposes, and the pricing of changes.

Jake: Very good explanation and quite right you are. Another topic of importance is simplified acquisition procedures. Make a note that simplified acquisition procedures apply to purchases below the small purchase limitation, which is presently one hundred thousand dollars for all agencies. These procedures also do not apply to ordering from Federal Supply Schedules or to delivery orders placed against existing contracts. Is there anything else you would like to share Sally?

Sally: Yes, I read that the small purchase and simplified purchase procedures emphasize simplicity and minimal administrative costs. I think oral solicitations are normally used, but I think very simple written quotations may also be used under certain circumstances.

Jake: I’m glad that you shared your findings with me; you brought up some very important points.

I want to now talk about Cost Accounting Standards as they are something we at SolarCal utilize and are very important to understand. The Cost Accounting Standards are very complex and apply to relatively few contract actions. Keep in mind that the Cost Accounting Standards can be divided into the following categories:

Consistency and Modified Coverage Standards;

Cost Allocation Standards;

Asset Related Standards;

Labor Related Standards;

Material Related Standards; and

The Insurance Standard.

Sally: Thank you for going over that with me. Up until now I had never heard of Cost Accounting Standards, I will definitely take a closer look at these standards as I progress through my internship here at SolarCal.

Jake: It was my pleasure and good thinking on taking a closer look at those standards… they are quite important!

Now I know that we went over quite a bit of information today and I would now like for you to go through some interactive training materials to help build upon some key concepts from today’s lesson.

Jake: Semi-variable costs are costs that are partly fixed and partly variable, depending on the amount of production being done. An example of this would be utility costs. With utility costs, users pay for a certain fixed cost on top of a base charge.

Jake: Direct costs are defined by the federal acquisition as any cost that can be identified specifically with a particular final cost objective. Direct labor and direct materials are also classified as direct costs.

Jake: Indirect costs are defined by the federal acquisition regulations as any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or an intermediate cost objective.

Jake: Simplified Acquisition Procedures apply to purchases below the small purchase limitation, which is presently one hundred thousand dollars for all agencies. These procedures however do not apply to ordering from Federal Supply Schedules or delivery orders placed against existing contracts.

Jake: Fixed costs are the costs that remain the same regardless of the amount of production. Building rent would be an example of this, where the rent remains the same regardless of whether the company produces work in any context.

Jake: Great job on the training materials, I really hoped they helped solidify all of the concepts we discussed today.

Let’s now summarize what we discussed during our time together:

First, we defined cost accounting, which is a procedure which enables firms to keep track of the costs that apply to each individual contract or major task they undertake. Do you remember the first set of the three major classifications of costs?

Sally: I recall that the first three major classifications of costs included reasonable, allowable and allocable costs. I learned that a cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of a competitive business. I then recall that a cost is allowable if it is expressly identified as allowable in the cost principles and meets the relevant tests for the terms of the contract or if it is not addressed in the cost principles, but instead meets the requirements of the relevant tests.

Jake: Excellent job Sally! We then identified the second major classifications of costs as including variable, fixed, and semi-variable costs. We saw that variable costs are expenses that go up or down depending on the total volume of work. While fixed costs remain the same regardless of the amount of production. We also saw that semi-variable costs are costs that are partly fixed and partly variable, depending on the amount of production being done.

Sally: I’ll take the last classification of costs, this section really interested me. This classification dealt with direct and indirect costs. I learned that any cost that can be identified specifically with a particular final cost objective, is an indirect cost. I also remembered that any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or an intermediate cost objective, is referred to as an indirect cost.

Jake: Great job, Sally I can see you were really active during our discussion of that topic. I also told you to make a note about the government’s view of direct and indirect costs. We saw that it is the government's policy to pay for the reasonable costs of acquiring products and services, plus a reasonable profit.

Sally: I definitely took some notes when you were going over the government’s view with those costs. You finished up the lesson by talking about Cost Accounting Standards; I thought this was very interesting. Could you go over this concept one more time?

Jake: I would be delighted! We went first went over how cost principles have been fine-tuned over many years and are utilized whenever cost analysis is performed. We also discovered that Cost Accounting Standards are complex and apply to relatively few contract actions.

Sally: I think I got it now! Thanks again for the review Jake! You were again very helpful this week and I feel that the more I’m with you the more I am learning.

I really think I’m beginning to get a better feel for not only what your department does here at SolarCal but also how the industry functions in the production phases of products.

Jake: It has been my pleasure working with you again and I look forward to many more visits from you. If there is anything else I can assist you with or even if you have any questions please come talk to me.

Until then, don’t forget to complete your weekly discussion questions based on your learning experiences this week.

Have a good rest of the day and I will see you soon!

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