Even big, old-line contractors run into trouble with Defense cost accounting rules

A dispute between the Defense Department and old-line contractor Raytheon shows how tricky the rules are for cost accounting. In one recent case, Raytheon prevailed at the Armed Services Board of Contract Appeals. Then Raytheon lost when the government appealed to the Federal Circuit Court. For the details, the Federal Drive with Tom Temin spoke with Daniel Ramish, Smith Pachter McWhorter procurement attorney.

Interview transcript:

Tom Temin
Tell us about this case, because you...

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A dispute between the Defense Department and old-line contractor Raytheon shows how tricky the rules are for cost accounting. In one recent case, Raytheon prevailed at the Armed Services Board of Contract Appeals. Then Raytheon lost when the government appealed to the Federal Circuit Court. For the details, the Federal Drive with Tom Temin spoke with Daniel Ramish, Smith Pachter McWhorter procurement attorney.

Interview transcript:

Tom Temin
Tell us about this case, because you figure after all these decades, Raytheon would have had this figured out by now.

Dan Ramish
Yeah, that’s right, Tom. Raytheon designed its policies around board decisions and treatises with a deep understanding of government contracts. And the board understood this in the initial case, looking at this government claim, and the Federal Circuit looked at everything fresh without the kind of deep perspective on government contracts, and came down differently reading the regulations and determined that Raytheon had overcharged the government here.

Tom Temin
Give us a few particulars of the case. What was it that the government went after Raytheon for? And what are the kinds of costs we’re talking about that are not allowable under I guess, the [Defense Federal Acquisition Regulation Supplement]?

Dan Ramish
It’s [Federal Acquisition Regulation] part 31 that has most of the specific cost principles that are some additional principles in the DFARS. The specific costs we’re dealing with here are lobbying costs, and also organization costs, which are like M&A type costs. The government submitted claims these were indirect costs of Raytheon. The government alleged that Raytheon had overcharged by including these lobbying costs and the M&A costs and their specific problem the Federal Circuit decided on was the way that they calculated the unallowable costs, the methodology, the specific calculations, and the way that Raytheon distinguished between costs that were allowable and unallowable. For both government relations, lobbying costs and corporate development organization costs, the government said didn’t follow the regulations. to be more specific about what the methodology that Raytheon was using, that the government didn’t like, for the lobbying costs. they were using a what’s referred to as a time paid rather than a time worked method. So they calculated the essentially a factor of what portion of the government relations, hours and salary and fringe were unallowable, based on a 40 hour workweek, looking only at Monday through Friday, eight to five and not counting the weekends.

Tom Temin
It’s not clear to me why they were listed if they were unallowable, in their entirety, or were some of them allowable?

Dan Ramish
So Raytheon took all of the salary and fringe costs for its government relations and support staff. So people who engage in lobbying activities and had them record unallowable lobbying hours to pull out, and the way they they pulled it out was by creating this factor. And the government said, well, there’s a problem with your factor in excluding these costs, because you are only counting normal work hours Monday through Friday, eight to five. And by excluding evenings and weekends, you’re not taking into account you know, the golf trips that lobbyists do or other activities that wouldn’t take place during the work day. And that’s under counting. You’re not taking out enough unallowable costs by ignoring those after hours costs and weaken costs.

Tom Temin
In other words, the contractor submits its total personnel costs and then shows what it’s taking out and not charging the government. The government then is in effect saying you didn’t back enough out of the costs.

Dan Ramish
Right. Because you started with this 40 hour work week. You’re not taking into account, uncompensated overtime.

Tom Temin
Well, if it’s uncompensated, then why is it a cost for anybody?

Dan Ramish
That’s exactly Raytheon’s argument. They said, hey, work, that’s after the work day isn’t cost to either Raytheon or to the government. And the board agreed to that, and that the board in its original decision, said that the government didn’t even really contest that

Tom Temin
interesting. We’re speaking with Dan Ramish. He is a procurement attorney with Smith Pachter McWhorter. So if the government wasn’t paying it anyway, why did they appeal to the Federal Circuit Court and what happened there?

Dan Ramish
Raytheon had applied this disallowance factor to its government relations costs. And the government submitted a claim alleging that these costs were unallowable that are been charged for unallowable costs and actually saying that it was entitled to take penalties because the costs were expressly unallowable. Raytheon disagreed and appealed to the board of contract appeals. And the board looked at this and said, hey, this method that Raytheon is using is a standard method in industry for tracking labor hours, it complies with the regulations, and all the evidence shows that Raytheon was following its policies. The government didn’t like that and so appealed to the Federal Circuit. The other cost before we talk about what the Federal Circuit said. The other cost was the corporate development costs, which are like M&A expenses, acquisitions and divestitures. Those costs are also unallowable. The government says that’s a contractor thing. It doesn’t benefit the government. So as a matter a policy that’s considered an unallowable cost. But the regulations in this area are kind of complicated because economic planning costs and market planning costs are allowable. The tricky issue is where do you draw the line between allowable economic planning costs or market planning costs and the acquisition or divestiture costs which are unallowable.

Tom Temin
It even gets down to specific categories of say [travel and expense], for example, where you might have a meal on there. And if you had a hamburger with Irish coffee, well, the hamburger and the coffee are allowable, but the shot of whiskey is not.

Dan Ramish
That’s right, unfortunately.

Tom Temin
Right. So the result was the court sided with the government and saying these were unallowable costs that somehow made their way into the bill. What happened then? What’s the consequence of all this?

Dan Ramish
The Federal Circuit looked at this fresh and they said, by only looking at normal working hours, Raytheon was overcharging the government. They didn’t come at it from a sophisticated government contracts accounting perspective, they just kind of took a common sense approach. They looked at the dictionary, they said this was overcharging didn’t comply with the regulations, and that they would have to go back to the board to determine how much Raytheon had overcharged and whether penalties applied. They came to the same conclusion on the organization costs. They said, you know, the Raytheon’s rule was that they only started tracking classes on allowable after they decided to go to market or to make an offer, the court said, that’s not a reasonable line to draw that necessarily before you make the decision, to place an offer or to go to market you have to do some planning and planning and executing of mergers is not allowable. So they said that that line didn’t comply with the regulations. Again, the problem was really that they weren’t looking at all the regulations and thinking about economic planning costs and market costs. They said economic planning costs, there’s a line in the regulation that says they don’t include organization costs. But they didn’t do a sophisticated analysis of the interplay. And the board had followed a prior board case, which actually involved Raytheon and said that where Raytheon drew the line in this case, was reasonable, a reasonable interpretation of the regulations. Which, you know, could be subject to different interpretations. Reasonable minds could disagree, but the board’s reasonable minds were based on treatises and prior case law of the board that had been in place a long time. And in the case of the lobbying costs, practices in the industry, the Federal Circuit ignored all of that, and made up its own mind and read it fresh.

Tom Temin
Could the Defense Contract Management Agency, the DCMA, been for years unsatisfied with the way things working, it sounds like they were trying to break new ground here with traditional rules and regulations. And they found a court that you would think would be familiar with this, because again, the Federal Circuit Court hears millions of appeals over the years. And it sounds like this was brand new material for these judges, the whole thing is a little surprising.

Dan Ramish
That’s part of the issue. So the Armed Services Board of contract appeals hears on the order of 400 government contracts cases a year, to become a judge at the Armed Services Board, you need a minimum of five years of experience in government contracts law. So those judges really know what they’re doing this is their bread and butter. The Federal Circuit, this is not a major part of their docket. Most of what they handle is patent cases, intellectual property issues, this is kind of new to them, or they don’t have the same day to day experience with it.

Tom Temin
So could this then devolve into the need to update the rules that the Armed Services Board of Contract Appeals is dealing with?

Dan Ramish
It is possible that a regulatory fix to address these issues would be an approach. In the meantime, it’s going to cause complications for contractors that have policies similar to Raytheon’s either in how they track labor hours, and not just for lobbying costs. But for other kinds of unallowable costs any anyone who’s in a role that has any kind of unallowable activities as part of their day, contractors have to give out a hard look. And they may have to defend the cost they’ve already incurred along those lines. And then same thing on the corporate development costs. Of course, there’s been a lot of consolidation in the defense industry. This is going to be a big issue. And the court said that we’re Raytheon had drawn the line didn’t comply with the regulations, but they didn’t say where the new line should be. And so contractors are going to have to really go through a process to figure out how to redraft that policy because they have this bright line rule that was easy to follow. And everyone understood it. And now the court has kind of disrupted that.

Tom Temin
And it also sounds like the rules require an incredibly complex accounting system and compliance apparatus just for keeping the whole operation running, if you’re a Raytheon.

Dan Ramish
That’s absolutely right. It is it is a complicated, you need a complicated system. There are a lot of rules to follow. Raytheon had spent a lot of money and goes through a lot of effort to craft policies that are compliant with the regulations and the case law interpretation. And they have done that here. But the Federal Circuit just read the regulations differently.

 

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