Cost Allocations and Contract Disputes

Learning Objective 5 Explain the importance of explicit agreement between contracting parties when the reimbursement amount is based on costs incurred

to avoid disputes regarding allowable cost items and how indirect costs should be allocated

Many commercial contracts include clauses based on cost accounting information and cost allocations. Examples include the following:

A contract between the Department of Defense and a company designing and assembling a new fighter plane specifies that the price paid for the plane will be based on the contractor’s direct and overhead costs plus a fixed fee.
A contract between a consulting firm and a hospital specifies that the consulting firm receives a fixed fee plus a share of the cost savings that arise from implementing the consulting firm’s recommendations.

Contract disputes often arise over cost computations, for example, what costs should be included to calculate the costs specified in the contracts above. Managers can reduce disputes between contracting parties by explicitly writing the “rules of the game” into the contract. Such rules could include the definition of allowable cost items; the definitions of terms used, such as what constitutes direct labor; the permissible cost-allocation bases; and how to account for differences between budgeted and actual costs.

The U.S. government reimburses most contractors in one of two main ways:

THE CONTRACTOR IS PAID A SET PRICE WITHOUT ANALYSIS OF ACTUAL CONTRACT COST DATA. This approach is used, for example, when there is competitive bidding, when there is adequate price competition, or when there is an established catalog with prices quoted for items sold in substantial quantities to the general public.
THE CONTRACTOR IS PAID BASED ON AN ANALYSIS OF ACTUAL CONTRACT COST DATA. In some cases, the nature of the task, for example, a new weapon system, creates great uncertainty about the cost to complete a job. Such contracts, which often involve billions of dollars, are rarely subject to competitive bidding because no contractor is willing to assume all the risk of receiving a fixed price for the contract and subsequently incurring high costs to fulfill it. Setting a fixed price for the contract either will not attract contractors or will require a contract price that is very high to cover uncertain costs. To address this issue, the government typically assumes a major share of the risk of the potentially high costs of completing the contract. Rather than setting selling prices, the government negotiates contracts on the basis of costs plus a fixed fee. This arrangement is called a cost-plus contract.

Cost-plus contracts specify what costs are allowable. An allowable cost is a cost that the contract parties agree to include in the costs to be reimbursed. For example, only economy-class airfares are allowable in many U.S. government contracts. Contracts also identify cost categories that are unallowable. For example, the costs of lobbying activities and alcoholic beverages are not allowable costs in U.S. government contracts. However, the set of allowable costs is not always clear-cut. Contract disputes and allegations about overcharging the government arise from time to time across a range of areas including health care (see Concepts in Action: Contract Disputes Over Reimbursable Costs With the U.S. Government).

Concepts in Action

Contract Disputes Over Reimbursable Costs With the U.S. Government^*

David Coleman/Have Camera Will Travel North America/Alamy Stock Photo

The U.S. government spends billions of dollars annually with private companies for health care goods and services. In recent years, the government has pursued cases against several contractors for overcharging against these contracts. The following examples are from cases pursued by the U.S. Department of Justice’s Civil Division on behalf of the federal government.

Mylan, a drug manufacturer, paid $465 million to resolve allegations that it underpaid contractually obligated rebates to the Medicaid program by erroneously classifying its brand-name drug EpiPen as a generic to avoid its obligation to pay higher rebates. From 2010 to 2016, the price of EpiPen increased 400%, yet Mylan only paid a fixed 13% rebate to Medicaid over the same time period based on EpiPen’s misclassification as a generic pharmaceutical.
Hospital chain Health Management Associates agreed to pay $216 million to settle claims that it incorrectly billed government health care programs for more-costly inpatient services that should have been billed as less-costly observation or outpatient services.

Some allowable overhead costs, such as supervision costs, support many different contracts and activities. Government regulations stipulate that supervision costs would be allocable to a specific contract on a cause-and-effect or benefits received basis. Other allowable overhead costs, such as general administration costs, support many contracts and are difficult to allocate based on cause-and-effect or benefits received. Nonetheless, the contracting parties may still view it as “reasonable” or “fair” to allocate these costs in some manner to help establish a contract amount. The general rule for government cost-plus contracts is that the reimbursement amount is based on actual allocable costs plus a fixed fee.^*

All contracts with U.S. government agencies must comply with cost accounting standards issued by the Cost Accounting Standards Board (CASB). For government contracts, the CASB has the exclusive authority to make, put into effect, amend, and rescind cost accounting standards and interpretations. The standards are designed to achieve uniformity and consistency in the measurement, assignment, and allocation of costs to government contracts within the United States.^* The standards represent the complex interplay of political considerations and accounting principles. Terms such as fairness and equity, as well as cause and effect and benefits received, are relevant to and a part of government contracts.