The perils and promises of advanced costing in government contracting: it would behoove federal government contractors to adopt activity-based cost management, but there are many obstacles. Here is an approach for overcoming them

Management Accounting Quarterly, Spring, 2005 by Wm. Leon Grange

Commercial companies use activity-based cost management (ABCM) to focus on profitability and revenue growth. ABCM is the complete method of costing, budgeting, and managing costs based on activity drivers. It enhances profitability by aiding decision making, increasing activity efficiency, and improving organizational effectiveness. Despite all these benefits, however, federal government contractors have been reluctant to adopt it.

Why don't government contractors want to realize the same benefits that their commercial counterparts do? Is government contracting different from private sector contracting? As an employee of a defense government contractor for the past 22 years, I have long been asking myself these questions. In fact, my doctoral dissertation sought to find out why government contractors were not adopting ABCM as readily as other commercial organizations. (1)

In this article I review the environment in which government contractors work and discuss the stumbling blocks they face in adopting ABCM. I conclude by describing an accounting approach that can lead to a change in the way costing, contract negotiation, and pricing are done in government contracting, and I encourage government contractors to adopt ABCM.

GOVERNMENT CONTRACTING ENVIRONMENT

Commercial companies have shown that ABCM provides more accurate costs, improves understanding of the economics of production, and gives a better picture of the economics of a company's activities. (2) A major benefit of ABCM is the identification of activities as cost drivers. Traditional cost accounting systems lead to distorted cost allocations for government contractors because management and other overhead costs are allocated to a program/contract as a percentage of the total contract cost base, not by what activities each program/ contract actually uses. There may be activities that one contract does not use, but the contract is allocated costs of those activities just because they are part of the total cost base. In contrast, ABCM results in better and more correct costs because each program/contract is allocated costs based on the activities it actually uses. Identifying the activities that drive costs provides insight, understanding, and solutions for complex organizations to eliminate waste, improve business processes, plan organization and operation strategies, and satisfy customers. (3) ABCM helps companies understand what they do, how well they do it, and what their real costs are, which enables them to focus their marketing efforts on profitable products and services while enhancing organizational objectives. ABCM also allows companies to look closely at their business processes and, thereby, compete more effectively in a global marketplace. In short, ABCM has been shown to be a powerful management tool worth adopting.

Most government contractors have been slow to adopt ABCM concepts even though both the contractors and government know that current cost management systems are distorting costs. Several government agencies have encouraged contractors to develop advanced cost management systems, with little success. The current indirect cost allocation methods used in federal government contracting increase the probability that indirect costs allocated to products and services may camouflage unprofitable and costly programs. Because the government's main objective is to obtain more accurate cost data to enable better procurement decisions, it believes that advanced cost management systems that are highly effective in the commercial world, such as ABCM, offer parallel benefits for both the government and its contractors. By using ABCM, the government contractor would know what its product and service costs are because ABCM focuses on activity costs. This knowledge would allow contractors to establish cost targets and seek production efficiencies and cost reductions. In turn, government agencies would gain knowledge about the real costs of their procured products and services.

The motivations for government agencies to be involved in government contractors' cost accounting systems are protecting the public's interest, cost-based pricing, oligopolistic markets, and large sole-source contracts. The government's overwhelming interests in contractors' cost systems are precisely why it has laws and regulations providing unique cost and schedule reporting requirements for its contractors. The government also oversees and surveils contractors to make sure they comply with regulations. The most well-known government groups to do this work are the Defense Contract Auditing Agency (DCAA) and Defense Contractor Management Agency (DCMA). The DCAA is a cost accounting auditing agency that ensures costs are properly allocated and collected against the proper projects/contracts. The DCMA is a project engineering agency that ensures contractors maintain the tasks and specifications defined in the contract. Additional oversight comes from the Federal Acquisition Regulations (FAR), a set of regulations that guides government procurement activities; Cost/ Schedule Control Systems Criteria, the regulations defining how a contractor shows progress on long-term projects to receive cost reimbursements prior to completion of a project; and the Cost Accounting Standards (CAS), a set of government regulations that guide government contractors on how they can recoup their costs.