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Government Contracts & Investigations Blog
• Restructuring Costs: Business combinations frequently result in restructuring activities – nonroutine, nonrecurring, or extraordinary activities to combine facilities, operations, or workforce to eliminate redundant capabilities, improve future operations, and reduce overall costs. CAS 406-61(b); DFARS 231.205- 70(b)(2). Examples of restructuring costs include severance pay, early retirement incentives, employee retraining, relocation expense, relocation and rearrangement of plant and equipment, and other related costs. CAS 406-61(b); DFARS 231.205-70(b)(4). Restructuring costs may be amortized over a period not to exceed five years. CAS 406-61(). Under Department of Defense contracts, however, restructuring costs resulting from business combinations (i.e., external restructuring costs), are unallowable unless the contractor can establish, and the cognizant DoD official determines, that the audited projected savings from the restructuring will either (1) exceed the restructuring costs by a factor of two or (2) exceed the costs allowed, and DoD determines that the business combination will result in the preservation of a critical capability that DoD otherwise might lose. DFARS 231.205-70(b)(4). Importantly, this limitation on the allowability of restructuring costs does not apply to internal restructuring costs (e.g., where the restructuring occurs within an entity that has been under common control) and also does not apply to contracts with civilian agencies.
Relevance of Novation Agreement
The standard novation agreement provides that “[t]he Government is not obligated to pay or reimburse, or otherwise give effect to, any costs, taxes, or other expenses, or any related increases, directly or indirectly arising out of or resulting from” the transfer of assets. FAR 42.1204(i), (b)(7). This provision is not limited to professional services, taxes, and corporate expenses directly related to the change in ownership. Rather, for novated contracts, the Government is not obligated to pay any increase in contract costs that would otherwise not have occurred.
The provision rendering cost increases unallowable has been interpreted to apply not only to the total cost of performance – but to each individual element of cost. For example, the Government could disallow cost increases resulting from a higher overhead rate, even if those costs were more than offset by a decrease in the applicable general and administrative expense (“G&A”) rate. The net result is that a contractor may be able to recover lower costs from the Government, even if its own costs increase.
Changes in Cost Accounting Practices
Different companies have different cost accounting methods and techniques, referred to as cost accounting practices. When two companies merge, one generally changes its cost accounting practices to be consistent with the other. A change in cost accounting practices occurs when there is a change in the method or technique for allocation of cost to cost objectives, assignment of costs to cost accounting periods, or measurement of cost. 48 C.F.R. §§ 9903.302-1; 9903.302-1. Examples of changes to cost accounting practices involving the allocation of costs to cost objectives include changes in the methods or techniques for determining whether a cost is allocated directly or indirectly, determining the composition of cost pools, determining the selection of the allocation base over which costs are allocated, or determining the composition of the allocation base. 48 C.F.R. §§ 9903.302-1(c).
Changes to cost accounting practices can result in more or less costs being allocated to particular contracts. Accordingly, there are detailed procedural requirements governing changes in cost accounting practices and the treatment of the resulting cost impact to government contracts. See generally FAR 52.230-6. The contractor must notify the contracting officer in advance of implementing any change. The contractor is also required to submit a general dollar magnitude (“GDM”) proposal that provides an estimated overall impact of the change and to assist the contracting officer in determining whether individual contract adjustments will be necessary. In most cases, the
What You Need to Know About Mergers and Acquisitions Involving Government Contractors and Their Suppliers | 39 Volume X — Accounting for the Cost of Business Combinations Under Government Contracts