Cost Accounting Standard (CAS) 403 is one of the most consistently misunderstood standards within CAS. Why? Usually because it involves more than just the segment you reside in. It requires cooperation and communication between parent entities and their segments, government and commercial segments both. The purpose of CAS 403 is simple, “to establish criteria for allocation of home office expenses to the segments of the organization on the basis of a beneficial or causal relationship.”
Key Definitions for CAS 403
To understand CAS 403, it is fundamental to know how CAS defines a home office, an intermediate home office, and a segment.
A home office is an office responsible for directing or managing two or more segments of an organization. For example, a corporate headquarters. A home office usually performs management, administrative, and other back-office functions the benefit one or more segments.
An organization can also have intermediate home offices for each group within the organization that report to one common home office. For example, a company may have an ultimate parent organization that directs strategy of the business with core executive functions and similar. And intermediate home offices may be back office support organizations that sit beneath the ultimate parent but still perform functions on behalf of multiple segments.
In order to properly comply with CAS 403, a complete cost accounting illustration is necessary to understand the big picture of who supports who and where they sit within the organizational and operating structure of the business. Just getting this part right at the on-set is a significant advantage to complying with CAS 403, but also to understanding the best way to optimize cost allocations within your business.
A segment is “one of two or more divisions, product departments, plants, or other subdivisions of an organization reporting directly to a home office, usually identified with responsibility for profit and/or producing a product or service.”
CAS 403 focuses on how home office expenses must be allocated to segments, and/or intermediate home offices, as applicable.
Allocation Pool and Base Requirements
CAS 403 requires that home office expenses are allocated on the basis of beneficial or causal relationships. The allocation methodology is hierarchial in nature, with direct allocations of home/intermediate home office costs being required to the maximum extent practicable. The concept of ‘direct allocation’ is not to be confused with the concept of ‘direct costs’. Directly allocated simply means a cost is being assigned directly to the benefiting segment.
For example, if a home office is performing legal work on behalf of an individual segment, however it has responsibility for four (4) segments, the time spent on the matter can be directly identified, and hence directly allocated to the benefitting segment. When direct allocation is not practical, home office expenses must be grouped into homogeneous expense pools and allocated subsequently.
Homogenous Expense Pools Prescribed by CAS 403
The following are the types of homogenous expense pools prescribed by CAS 403 that can be used:
- Centralized service functions
- Staff management of certain specific activities of segments
- Line management of particular segments or groups of segments
- Central payments or accruals
- Independent research and development (IR&D) costs and bid and proposal costs (B&P)
- Residual expenses
These are referred to as “functional allocations”. The number of functional allocations an organization has usually depends on the variety and significance of service and management functions performed by the home office. But to avoid having too many groupings, as long as the pooled expenses can be allocated using the same allocation base (e.g., employee headcount), they can be included in the same home office expense pool.
CAS 403 Examples
CAS 403 provides illustrated examples of typical home office allocation pools and bases. For items one through five above, following are some additional examples.
|Home Office Expense or Function
|Illustrative Allocation Bases
|Employee headcount, labor hours, payroll, number of hires
|Employee headcount, computer equipment nodes
|Square footage, value of material, volume
|Finance and accounting
|Employee headcount, square footage
Lastly, if the home office costs cannot be allocated either directly or functionally then CAS provides for the remainder of costs to be treated as “residual expenses”. Residual expenses are typically those that are not identifiable with specific activities of segments and cannot be more equitably allocated based on a functional allocation.
While it may be compliant to allocate residual expenses in different ways, the most common approach is the Three Factor Formula which is calculated by taking the arithmetical average of the following three percentages for the same period:
- Percentage of segment payroll dollars to total payroll dollars of all segments
- Percentage of segment operating revenue to total operating revenue of all segments
- Percentage of average NBV of the sum of segment tangible capital assets plus inventories to the total average NBV of such assets of all segments
Note that at certain size thresholds contractors are required to use the 3 Factor Formula. Other contractors sometimes use sales as a simple residual allocation method when not required by CAS to use 3 Factor Formula. Others still may find that a 2 Factor formula is most equitable given the nature of their business. For example, it is not uncommon for some businesses to have highly variable fixed assets across their segments which may be distortive to the allocation method.
Best Practice Strategies
CAS 403 Challenges
The most common CAS 403 challenges we find working with contractors include:
- Not understanding the operating structure of the business
- Miscommunication or misunderstanding between home offices and their segments on who’s responsible for compliance
- Confusing financial allocations with federal cost accounting allocations (yes, they may and often are different!)
- Home office parents neglecting to understand that they have a responsibility for compliance on behalf of their federal segment (even if they’re 99% commercial)
- Using 3 Factor formula for all home office expenses, skipping the hierarchy required for proper cost accounting allocations
- Insufficient review of cost allocation methodologies available resulting in equitable, or sub-optimal cost accounting illustrations
While CAS 403 is a U.S. Government contract requirement, it’s allocation methodologies are highly leverageable by companies that understand them. CAS 403 has its own dedicated audit program (DCAA > Customers > Guidance > Directory of Audit Programs) that DCAA uses when auditing and findings within CAS 403 are some of the most common CAS audit findings. While they can be a challenge, they can also be a way to ensure alignment between home office parents and their segments. We have found the contractors with the most success with CAS 403 are those that have strong communication and alignment with their parent organizations.
Lastly, Home Office allocations require a Home Office Disclosure Statement. For more information on preparing compliant Disclosure Statements, please visit: DS Done -- CAS DS-1 Form completion application (rkiaccounting.com)