WHITE PAPER ERP FOR DCAA COMPLIANCE

WHITE PAPER ERP FOR DCAA COMPLIANCE

CONTENT DCAA OVERVIEW... 1 Allowability... 2 Allocability... 2 Reasonableniess... 2 CAN ERP BE DCAA COMPLIANT?... 3 How to do it... 3 8 advanced tips for selection and implementation... 7 CONCLUSION... 9

ERP FOR DCAA COMPLIANCE BY BRUCE MORTIMER MANAGING DIRECTOR, RUTTERKEY SOLUTIONS CARRIE GHAI SENIOR SOFTWARE CONSULTANT, IFS Any business performing work for a ministry or department of defense will need to comply with Defense Contractor Audit Agency (DCAA) audit requirements. This is true for those doing business with the US Department of Defense (DoD), either directly or through an OEM, prime contractor or systems integrator. It is also true for companies doing business with other national defense organizations around the world due to reciprocal agreements the DoD has with other nations. Enterprise resource planning (ERP) software, as a system of record, will naturally have a role to play in DCAA compliance. But exactly how does ERP software support these auditability requirements? Are certain ERP packages approved or compliant out of the box? What features in ERP are necessary for DCAA compliance? How should a manufacturer or contractor go about selecting and implementing ERP for DCAA compliance? This article will answer all of these questions, and provide a simple framework for understanding what ERP software can, and perhaps more importantly, cannot do, to streamline DCAA compliance. DCAA OVERVIEW At the risk of insulting the intelligence of experienced aerospace executives, and in the interest of being thorough, let s take a quick look at the DCAA. The DCAA, which employs about 4,000 working under the DoD comptroller, was founded in 1965 after a number of preliminary attempts to establish a united contract audit program across the branches of service. Today, however, leaner financial times mean that audits are more rigorous than ever before, and contractors can expect requests for more background data than they had been required to produce in the past. DCAA requirements are a concern for aerospace and defense contractors outside of the United States as well, because the DoD s Defense Contract Management Agency (DCMA) has reciprocal agreements with the governments of other jurisdictions to provide contract audit services and other contract administration services for each other. The memorandum of understanding sets an expectation for an audit framework along the same lines of the DCAA. These countries include Canada, Northern Europe, Southern Europe and the United Kingdom. 1

At a high level, the DCAA audit of a contract or expenditure will focus on three variables: Allowability The cost is allowable when it is reasonable, allocable and complies with Federal Acquisition Regulation (FAR) 31.205, CAS (Cost Accounting Standards), laws and regulations, and the terms of the specific contract. Allocability A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship if it is incurred specifically for one contract, benefits both the contract and other work, or is necessary to the overall operation of the business. Reasonableniess 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 competitive business. The information to determine compliance with these requirements comes largely from within an ERP application or other accounting system of record. This accounting system must also be approved, pre-contract. According to a DCAA checklist, an approved accounting system must be in full operation and provide for: a. Proper segregation of direct costs from indirect costs. b. Identification and accumulation of direct costs by contract. c. A logical and consistent method for the allocation of indirect costs to intermediate and final cost objectives. (A contract is final cost objective.) d. Accumulation of costs under general ledger control. e. A timekeeping system that identifies employees labor by intermediate or final cost objectives. f. A labor distribution system that charges direct and indirect labor to the appropriate cost objectives. g. Interim (at least monthly) determination of costs charged to a contract through routine posting of books of account. h. Exclusion from costs charged to government contracts of amounts which are not allowable in terms of FAR 31, Contract Cost Principles and Procedures, or other contract provisions. i. Identification of costs by contract line item and by units (as if each unit or line item were a separate contract) if required by the proposed contract. 2

j. Segregation of preproduction costs from production costs. k. Financial information required by contract clauses concerning limitation of cost (FAR 52.232-20 and 21) or limitation on payments (FAR 52.216-16). l. Support for requests for progress payments. m. Records maintained in such a manner that adequate, reliable data are developed for use in pricing follow-on acquisitions. CAN ERP BE DCAA COMPLIANT? One thing that anyone involved in the defense contracting or manufacturing space will see from time to time is marketing materials that suggest that a given enterprise software package is DCAA compliant. But this may be a gross oversimplification that borders on misrepresentation. An enterprise application like ERP can usually be configured to conform to DCAA audit requirements. It may be configured so only allowed costs accrue against a given contract, for instance. It could just as easily be configured, however, to allow inappropriate costs to accrue against a contract. What this means is that no ERP product is, by itself, DCAA compliant. A great deal rests on implementation, the knowledge and skills of the implementation team and a rigorous and disciplined approach to government project accounting. How to do it Selecting and then implementing ERP for DCAA, therefore, requires a high degree of due diligence during the selection cycle and a sound methodology for implementation. An important thing to keep in the forefront is that your ERP product will not deliver compliance by simply flipping a switch. The software is a tool that can facilitate any number of different process flows that will, in fact, meet the government standards. The DCAA standards are fairly broadly worded; so broadly, that they could even encompass a completely manual accounting process. So, technically, you could write down the processes and standards you will adhere to for DCAA on the back of a napkin, just so long as you can then prove to auditors that you are following those processes. DCAA recently added a specific recommendation for an electronic or computerized accounting system, but apart from that, the onus is on you, your company and your implementation consultant to develop processes and procedures that will meet with audit agency approval. An ERP application must then be able to facilitate and document these processes and procedures to the satisfaction of government auditors. 3

The right integrated application will make compliance easier. The government appreciates full access to information in an efficient and effective way. Features that can help deliver this include: Actual costing. In many implementations, actual costing is desirable as it is the DCAA s preferred method for most programs and contractors. Other methods like standard costing may be workable, but it is hard to argue that the DoD s preferred method should not be the goal contractors strive for. Fully integrated functionality. Data to support a thorough DCAA audit can come from any number of places. A fully integrated suite of software will make it easier to collect data from various sources including customer orders, purchase orders, shop orders and government property records. Broad project accounting functionality. It is not uncommon for DCAA to audit overall finances of a project. And when they do, they will want to drill down to associated objects, such as purchase orders, that confirm the costs in the general ledger. This means transactional data should be organized by project or program, so during an audit you can drill down and supply DCAA with information specific to that project from any number of data points. These data points and objects must be attached directly to the project in ERP, which requires very deep project integration in ERP. Deep integration and drill-down capabilities to individual objects associated with a project are essential because even the most apparently mundane elements of DCAA auditability can require extensive documentation. Even something like allocatability can be hard to establish. Contractors may incur costs that may require interpretation as to whether it can be applied to a certain project. Deep integration and drill down capabilities to individual objects associated with a project are essential because even the most apparently mundane elements of DCAA auditability can require extensive documentation. 4

Perhaps you are building a test setup for a project, and you need to purchase some laptops. Normally, those would be considered an indirect cost or overhead, and depreciated as a capital expense. But if these laptops are going to be consumed exclusively on behalf of this government program, they would be an allowable cost. The ability to tie expenditures like this firmly back to a project is of particular importance in the cost plus environment, where extraneous expenses that cannot be charged can easily put a contract in the red. The ability to tie expenditures firmly back to a project is of particular importance in the cost plus environment, where extraneous expenses that cannot be charged can easily put a contract in the red. While allocatability can present documentation challenges, reasonableness can be even harder to document in an ERP system, particularly if it is not well integrated and configured for DCAA audit compliance. An ERP system properly configured for government audit compliance will include bid solicitation functionality. The system will then document the bidding process, the criteria for selection and the ultimate supplier selection. So in proving reasonableness, you can source data from what bids were received. It is not necessary to prove that you selected the lowest bid, but rather document reasons for making the selection decision that you did. Perhaps a supplier had a superior technical solution, or a better record for delivery on Defense, Priorities and Allocation System (DPAS) projects. Regardless of the reason for selecting on matters apart from price, you need to document that to establish why you selected a given supplier over a lower bid. The ERP must therefore capture the bid documentation, the rationale for making the decision and then tie that back to the purchase order ascribed to the relevant project. 5

Reasonableness of labor costs must also be documented. This can be done by reviewing the history of labor cost on similar projects. A project with a similar scope and level of effort can be identified and used to establish a historically reasonable cost for labor. Reasonableness of labor costs must also be documented. This can be done by reviewing the history of labor cost on similar projects. Apart from tracking cost, ERP for DCAA must account for borrow-payback. This means ERP must be organized around specific contracts, accounting for the degree to which inventory from the project can be borrowed by other projects and to what extent they can borrow from other projects. Some contracts forbid borrow-payback. And those that allow it carry requirements regarding the cost at which borrowed inventory is replaced. Must the borrowing contract pay the price at which the material or inventory was originally purchased by the contractor, or at the price the government pays for the material or inventory? The government is naturally concerned with such things as they do not want to loan material to another project only to find they have to pay a higher price to replace it. ERP for DCAA compliance must facilitate initial approval by the government customer of the borrowing of material as well as the ensuing cost transfer and payback. So a good, integrated ERP solution will first of all ensure compliance by facilitating the borrow-payback transactions flow properly. It will also allow you to quickly and easily answer borrow-payback questions during an audit with proper documentation. Lacking a well-configured and integrated system, you can spend a copious amount of time supporting a DCAA audit as you chase down documentation on these inter-project transactions. 6

8 advanced tips for selection and implementation 1. Look for a well-integrated ERP system versus a collection of best-of-breed solutions. The amount of time and effort required to bring a collection of bestof-breed solutions together in a way that will channel and track costs in a reliable and auditable fashion is considerable. In an enterprise system, there is already a built-in pedigree and confidence that transactions will flow where you want them to. Cost needs to flow between numerous systems and data objects, including the contract, the project, the general ledger and more. 2. No ERP software is certified out of the box for DCAA compliance. But you need to ask your ERP vendor if they have customers running the software in a DCAAcompliant environment. The answer to that question should be yes, and you should be able to talk to those customers. 3. Watch for industry-specific process models that can streamline implementation for DCAA compliance. The existence of these process models will indicate that a vendor has long experience in a DCAA compliant environment, which reduces risk. They are also a sign that you will not have to develop compliant process flows from scratch, which reduces cost. 4. As early as the initial screening of vendors, start thinking about how you need to present data to a government auditor, how you distribute cost and how you define cost, traceability of information. Build these considerations into a demo script vendors must take you through so you get a first-hand look at how they would facilitate your processes. 5. Consider all of the elements that go into actual costing. In today s environment, auditors are more likely to conduct a full-blown audit of a given project or contract, and take deep dives into related documentation. So you will need to consider how easy it is to drill down from a project or the general record into the supporting documentation for each expense. If cost is reflected on a government invoice, we need to prove that the value to that contract applies, and to do that, we need to drill down to the original purchase order, time sheets and actual work performed. That will support things like reasonableness and allocatability of the cost in the system. If the ERP system also includes document management, that will provide the opportunity to include unstructured notation and other information on why cost may be applicable and reasonable. ERP that supports document approvals can also provide valuable information to auditors because acknowledgers and approvers will be listed for each step in an acquisition or project. Those people and their roles are responsible for adhering to standards, and that shows that the company is taking care in following CAS standards. 7

6. Remember that actual cost can be hard to pin down. In order to deliver reliable actual costing, an ERP application just goes beyond cost at receipt. The invoice often reflects a slightly different cost than what was understood when materials are delivered. So ERP must be able to re-cascade costs based on any changes that come to light in accounts payable. You must be able to review all transactions material has been applied to, including whether it was issued to manufacturing, maintenance or used in an ongoing process. 7. Ask a lot of questions about borrow-payback logic. In order to comply with DCAA audits, some companies find they must also adhere to traceability of material transfer for borrow payback logic. Optimal enterprise software must include a process for netting groups that define how different groups of contracts can interact. In some cases, you may have black box projects that in no way can be a part of a borrow-payback schema. In other cases, you can transfer in, but you cannot transfer out. There are rules around each contract that an ERP application can account for through parameters that are set as the contract is defined in the system. 8. Realize that in a cost-plus environment, as much indirect cost as possible must be allocated to projects or contracts. A lot of cost would traditionally be considered overhead, but in a cost plus environment, as much cost as is feasible needs to be allocated to projects. Establishing cost associated with direct cost from a purchase order is remedial. More advanced elements of actual costing include things like landed cost, or indirect cost to operate and maintain a warehouse associated with those purchases. Indirect costs will need to be sorted into pools, with each pool having a different level of applicability for each project or contract. These indirect costs are difficult to account for in real time. They must be collected from various sources and then driven through an allocations procedure to the project. They cannot just be held in a financial system. This process of allocating indirect cost back to the original contract that drove the cost is something an ERP application must be able to do in a DCAA-compliant environment. 8

CONCLUSION DCAA compliance does not necessarily require sophisticated enterprise software. Rather, enterprise software must be seen as a way of reducing the overhead associated with operating in a DCAA-compliant environment. The right ERP software for your defense contracting organization will have been implemented and used successfully in a number of DCAA-compliant organizations. It will guide you as you define solid auditable business processes, preferably with predefined, templateprocess flows. It will allow you the flexibility to document, in great detail, the validity of your invoices. And it will automate a lot of the extremely complex requirements that are inherent in government contracts today. Bruce Mortimer is Managing Consultant at Rutterkey Solutions in Hartford, Conn. He has extensive experience implementing enterprise software in aerospace and defenserelated companies, including Honeywell, BAE and Ensign-Bickford. He holds a degree in business management from the University of South Florida. As Senior Business Solutions Consultant with IFS, Carrie Ghai provides expertise on a number of business disciplines, including finance, project management/accounting, asset design and management, services, supply chain management, multinational management, and field service solutions. She has more than 20 years of experience in enterprise software, and holds a degree from Ealing College of Higher Education in London. 9

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