[Explanation of Principles for Determination of Costs Under Government Contracts: War Department, Navy Department]
[From the U.S. Government Publishing Office, www.gpo.gov]

Explanation
OF
PRINCIPLES FOR DETERMINATION OF COSTS
UNDER GOVERNMENT CONTRACTS
WAR DEPARTMENT • NAVY DEPARTMENT
Explanation
OF
PRINCIPLES FOR DETERMINATION OF COSTS UNDER GOVERNMENT CONTRACTS
WAR DEPARTMENT . NAVY DEPARTMENT
UNITED STATES GOVERNMENT PRINTING OFFICE WASHINGTON > APRIL 1942
For sale by the Superintendent of Documents, Washington, D. C. -. - -- -- - Price 10 cents
TABLE OF CONTENTS
— Page
Introduction_____________________________________________________________________ 1
Outline of the Items of Cost_____________________________________________________ 2
Manufacturing costs:
Direct shop costs:
Materials and parts_______________________________________   4
Direct labor______________________________________________   4
Shop engineering expense____________________________________ 5
Other direct shop costs_____________________________________ 6
Indirect shop costs:
Supplies and sundry materials_______________________________ 6
Indirect labor______________________________________________ 6
Service and maintenance_____________________________________ 7
Fixed charges_______________________________________________ 7
Other indirect shop costs___________________________________ 8
Other manufacturing costs:
Amortization of patents, purchased designs, etc_____________ 8
Engineering and development expenses__________-_________ 9
Other contract performance costs:
Delivery costs__________________________________________________________  9
Installation and servicing costs_________________________________________ 9
Sundry specific contract costs__________________________________________ 10
Administration and distribution expenses:
General corporate and administration expenses___________________________ 10
Bidding and selling and distribution expenses_________________________ 11
Limitations on Admissible Costs:"
Costs of materials, parts, and supplies_______________________________ 11
Unreasonable compensation_____________________________________________ 12
Defective work_____________i__________________________________________ 12
Self-insurance_____________:__________________________________________	12
Selling expenses________________*_____________________________________ 13
Advertising_____________________________________________________________ 14
Selling and advertising expenses of independent subcontractors________	14
Interplant and intercompany transfers___________________________________ 14
Inadmissible Costs_________________________________________:_____________________ 15
Basis of Apportionment of Items of Cost:
Shop engineering expense________________________________________________ 16
Other direct shop costs_______________________________________________   16
Indirect shop costs_____________________________________________________ 16
Other manufacturing costs______________________________________________  18
Other contract performance costs________________________________________ 18
Administration and distribution expenses________________________________ 18
Summary_________________________________________________________________ 19
Examination of methods in use___________________________________________ 19
Contractor’s Accounts:
Accounting system_______________________________________________________ 20
Inventory methods_______________________________________________________ 20
Index______________________________________________________;_____________________	21
(i)
Introduction
1.	This explanation has been prepared to present in basic outline the principles according to which costs may be determined under contracts with the United States Government for supplies for the War and Navy Departments. It is not intended to designate any particular system of accounting or to provide any rigid formula or set procedure. The object is to state in principle which costs may be admissible under Government contracts, which costs may be inadmissible, and which costs may be subject to limitations as to their admissibility.
2.	In many Army and Navy contracts, provision has been made for determining allowable items of cost in accordance with Treasury Decision 5000, which Treasury Decision was promulgated under section 2 (b) of the act of June 28,1940, and other provisions (sometimes referred to as the Vinson-Trammell Act), relating to excess profits on contracts for naval vessels and Army and Navy aircraft. In the case of any such contract, or any future contract in which provision is made for determining allowable items of cost in accordance with Treasury Decision 5000, the provisions of Treasury Decision 5000 shall be applicable.
3.	The principles outlined herein are directed to the validity of items of cost as components of the total contract cost, without regard to their status as allowable deductions from taxable income for the purpose of computing Federal income taxes. In other words, whether or not an item of cost is allow able as a deduction in computing Federal income taxes is not the criterion whether such item is proper as a part .of cost under Government contracts.
(1)
OUTLINE OF THE ITEMS OF COST
4.	The total cost under a contract is the sum of all costs incurred by the contractor incident to and necessary for the performance of the contract and properly chargeable thereto. The items of cost that enter into Government contracts are classified in logical order in the following outline :
MANUFACTURING COSTS
Direct shop costs:
Materials and parts.
Direct labor.
Shop engineering expense.
Other direct shop costs.
Indirect shop costs:
Supplies and sundry materials.
Indirect labor.
Service and maintenance.
Fixed charges.
Other indirect shop costs.
Other manufacturing costs:
Amortization of patents, purchased designs, etc. Engineering and development expenses.
OTHER CONTRACT PERFORMANCE COSTS
Delivery costs.
Installation and servicing costs.
Sundry specific contract costs.
ADMINISTRATION AND DISTRIBUTION EXPENSES
General corporate and administration expenses. Bidding and selling and distribution expenses.
5.	In presenting this outline there is no requirement that the contractor shall follow this particular classification in his own system of accounts so long as that system will furnish the information here called for. As has been stated, it is not the purpose of this statement to prescribe uniform accounting methods. It is the purpose to lay down the basic principles governing the determination of costs under Government contracts, which principles can be observed by means of any suitable accounting system in accordance with accepted accounting practices.
(2)
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6.	Description in more detail of the components of the above-mentioned items of cost is given in the ensuing pages. This description is intended to be informative upon the nature of the items falling under each heading and the accounting treatment to be accorded to them. All conceivable items can not be mentioned specifically, and the description furnished is indicative and not inclusive, that is to say, omission of mention is to be in no way restrictive upon the Government in determining the costs of a contract. If an item of cost is not specifically mentioned under admissible costs it is not to be thereby automatically excluded and conversely, if an item of cost is not listed under inadmissible costs or described as one subject to limitation, it does not therefore follow that such item is acknowledged to be admissible. In such cases any questions are subject to interpretation and decision according to the nature of the item. Moreover, any of the explanations given herein naturally are subject to the application of any special provisions expressly included in a contract.
MANUFACTURING COSTS
DIRECT SHOP COSTS
Materials and parts
7.	Material cost includes all purchased materials and fabricated parts entering directly into the product or which are used directly in fabricating, converting, or processing such materials or parts. Purchases made s'pecifically for the contract should be charged at their actual prices. Withdrawals from regular stores or stock rooms should be charged at their cost under any recognized method of pricing stores withdrawals conforming to sound accounting practices and consistently followed. (See par. 73.)
8.	Incoming transportation charges are a proper part of material cost. If they are not so treated in the accounts of the contractor their inclusion elsewhere should be on an equitable basis of apportionment.
9.	Charges for material should be net, after deducting cash discounts in excess of 1 percent and all cash discounts accruing to prime contractors on subcontracts, and after deducting all trade discounts, rebates, and allowances received or receivable by the contractor. (See par. 44.)
10.	Material cost should include only the materials actually required to be used for the performance of the contract, and due credit should be given for any excess materials retained or returned to vendors by the contractor and subcontractors. The value of any scrap resulting should be taken into account at proper current scrap prices, whether or not the scrap is sold. Where such credit for scrap is made through overhead the allocation should be equitable.
11.	In some cases manufacturing material which forms a component part of the product is for one reason or another not treated as “direct” material but is included indirectly under supplies. This treatment is acceptable when it results in an equitable allocation.
Direct labor
12.	Direct labor cost consists of the wages paid for labor performed on and properly chargeable directly to the article manufactured. Such wages should be taken at the individual hourly rates actually paid, or, if a piece work or other incentive plan of wage payment is customarily followed by the contractor, at such incentive rates actually paid. Special premiums, bonuses, and overtime payments, if treated as direct labor costs, should be separately stated. Furthermore, if direct labor
(4)
5
cost is the basis of overhead apportionment, such special premiums, bonuses, and overtime payments should not be included in the base for the distribution of overhead.
13.	Direct labor may also include compensation insurance and old age benefit and social security taxes pertaining to such employment. (See pars. 47 and 54 (Z).)
14.	It is recognized that complete uniformity in the definition of direct labor does not exist even within single industries, and that therefore certain operations may be included by one contractor under direct labor and by another under indirect labor. This difference is not material for the purpose of ascertaining cost under a particular contract, as a contractor’s practice will be acceptable if it is in accordance with sound accounting procedure, and if it is uniform throughout his own activities. It should be noted that in the case of any contract which includes an escalator clause providing for adjustments according to changes in labor rates it will be necessary to have a clear understanding in advance as to what shall constitute labor subject to such adjustments.
15.	When any of the elements above-mentioned are not included as direct labor but are included indirectly, the method of apportionment to the contract should be equitable.
Shop engineering expense
16.	Shop engineering expense includes the compensation of professional engineers and other technicians (including reasonable advisory fees) and of draftsmen, etc., properly chargeable to the cost of the contract. It also includes expenses in the nature of overhead of the engineering department for supervision, clerical aid, stationery and drafting supplies, fixed charges and maintenance of engineering equipment, etc. Often manufacturing operations, particularly in the durable goods industries, require the services of a permanent shop engineering staff for the preparation of designs, blue prints, specifications, and for the study and improvement of shop and product methods and procedures. The type of engineering services here meant is that which is related immediately to manufacturing operations, as distinct from research and development devoted to future improvement in, and application of, new products or products currently produced.
17.	The expense of maintaining laboratories for chemical analysis or for testing and proving related to current manufacturing operations is not a part of shop engineering expense and is generally treated as a service department or function under overhead (indirect shop cost). When laboratory facilities are devoted exclusively to research the cost of laboratory work should be treated as research and development expense. (See par. 32.)
448916°—42——2
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Other direct shop costs
18.	Frequently there are items identifiable with and properly chargeable directly to manufacturing cost, which items do not come within the scope of materials, direct labor or shop engineering expense but which, because they are associated with specific operations or products, logically are direct shop costs. Items of this kind are:
(a)	Manufacturing royalties or license fees. (See par. 45 (J).)
(b)	Amortization of the initial cost of dies, patterns, and special tools on the basis of useful life, equitably apportioned.
19.	The extraordinary circumstances which demand the acceleration of production under the war program may entail costs and expenses attributable directly to special rearrangements of plant facilities, amortization of special facilities at a rate greater than normal, etc., which should be distinguished from normal plant rearrangement and normal depreciation. The special costs and expenses here mentioned are those which are directly attributable to production under Government contracts, for which reason they are included under direct shop costs. Ordinary rearrangements of facilities not directly attributable to production under Government contracts are provided for under indirect shop costs. (See par. 29 (a).)
INDIRECT SHOP COSTS
Supplies and sundry materials
20.	Under this description fall all supplies needed for general use in the factory in current operations, such as fuel, lubricants, heat treating, plating, cleaning and anodizing supplies, nondurable or small tools, gauges, factory-office supplies, boxing and wrapping materials, etc. The term “supplies” relates to a wide variety of miscellaneous materials the peculiar characteristic of which is that they are needed for the operation of the shop rather than to become a part of the product (although, as stated, some materials which are actually applied to the product may be treated as supplies). The terms “nondurable tools” and “small tools” refer to small portable tools which have a comparatively short term of effective life, such as axes, bits, chisels, drills, threading dies, templates, etc.
Indirect labor
21.	Indirect labor in a productive department covers the salaries and wages of employees in the department other than direct labor employees. By this is meant foremen and assistants, inspectors, machine setters, cleaners, crane operators, general laborers, oilers, timekeepers, and shop clerks, etc.
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22.	The term “indirect labor” also applies to salaries and wages paid employees in service and maintenance departments, general factory storerooms, receiving and shipping departments, factory administrative offices', laboratories, etc.
23.	In general, therefore, indirect labor represents all labor for the described various activities except (1) direct labor, (2) shop engineering labor, and (3) research and development labor.
24.	Instructions regarding direct labor (par. 13) as to compensation insurance, old age benefit and social security taxes, etc., apply equally to indirect labor.
Service and maintenance
25.	Ordinary and usual factory expenses of a general nature come under this heading, such as those for power, heat, and light (whether purchased or produced) water, gas, compressed air, ventilation, air conditioning, and for the operation and maintenance of plant assets and facilities. Service and maintenance expenses which are not ordinary and usual should be set out separately in the accounts of the contractor, in order that a conclusion may be based on the facts and circumstances concerning their admissibility and pertinence to the performance of the contract.
26.	Service and maintenance expenses will mainly consist of supplies, indirect labor, and fixed charges (except for special purchases) all of which are mentioned in other brackets under indirect shop costs. They are referred to here only for the sake of clarity, because in most modern cost accounting systems separate accounts are kept for these departments..
Fixed charges
27.	Under this heading are included recurring charges with respect to properties used for manufacturing purposes, such as :
(a)	Premiums for various kinds of property insurance.
(b)	Property and plant taxes.
(c)	Rentals.
(d)	Allowances for depreciation and obsolescence of property arid equipment (including reasonable stand-by equipment) but excluding under this heading amortization of special war production facilities (mentioned previously, par. 19). In making allowances for depreciation the rates used should be based on cost and should be such as to provide for normal exhaustion, wear and tear, and for obsolescence. Consideration may be given to an extended number of machine hours due to multishift operation. Amortization of unrealized appreciation of values of assets and depreciation of excess facilities are not admissible. (See par. 54 (?) and (&).)
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(e)	Depletion of natural resources—Depletion is generally calculated on a unit basis intended t,o amortize the estimated content of a mineral deposit or other natural resource over the period of its expected life. Depletion for purposes of arriving at costs should generally be calculated on the basis of the actual cost of the property rather than on a basis arrived at for income tax purposes.
28.	With respect to depreciation, care should be taken to observe the requirements under various forms of Government contracts. For instance, depreciation of facilities provided under an Emergency Plant Facilities contract or a Defense Plant Corporation contract may not be included as an item of cost under a Government contract for the furnishing of supplies.
Other indirect shop costs
29.	Other indirect shop costs include miscellaneous factory expenses not directly attributable to the contract but necessary and incidental to services, operations, plant, equipment or facilities involved in the performance of the contract, such as:
(a)	Ordinary and normal rearrangement of facilities within a department or plant.
(b)	Employees’ welfare expenses.
(c)	Vacation pay.
(d)	Premiums or dues on compensation insurance, not elsewhere included.
(e)	Employer’s payments to unemployment, old age, and social security funds, not elsewhere included.
(/) Pensions and retirement payments to factory employees.
(y) Factory accident compensation (as to self-insurance see par. 47).
(A) Amortization of the initial cost of dies, patterns, drawings and special equipment when not logically or practicably a direct shop cost. (See par. 58.)
OTHER MANUFACTURING COSTS
30.	Certain kinds of costs related to the conduct of manufacturing operations and the manufacture of products under a contract are sometimes not satisfactorily included under shop costs and are preferably to be set down as separate items of manufacturing cost. Examples of such items are mentioned hereunder.
Amortization of patents, purchased designs, etc.
31.	The costs of obtaining patents, purchasing designs, etc., may be amortized over the period of their useful life and absorbed in the costs of manufacture by means of suitable rates.
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Engineering and development expenses
32.	Distinction has previously been made (par. 16) between engineering services related immediately to manufacturing operations (shop engineering expense) and research, experimental and development costs not related to current manufacture but devoted to future improvement in and application of products. The cost of the latter research and experimental development work may be absorbed in manufacturing cost on a regular basis by means of absorption rates, on the principle that these activities are usually maintained under a consistent program independently and apart from current manufacturing operations, and that their benefit relates to products on a uniform scale over a period of years more properly than according to actual expenditures in any given year. When these costs are deferred or capitalized in conformity with a consistent plan, reasonable allocation may be treated as a cost of performing a contract. (See par. 64.)
33.	Alternatively, when it is the policy to charge off actual research, experimental and development expenses currently in each year rather than to use stabilized absorption rates, a reasonable portion thereof may be allocated to the cost of performing the contract.
OTHER CONTRACT PERFORMANCE COSTS
34.	The completion of a Government contract may entail costs which are not logically to be included under “Manufacturing costs” or “Administration and distribution expenses,” but which are necessary, such as delivery, installation and servicing, and sundry other costs relating specifically to the contract.
Delivery costs
35.	When outward freight and transportation are incurred under a contract for delivery of the products manufactured, the actual amounts of such charges paid or incurred are proper costs thereof.
36.	When delivery is effected through the contractor’s own shipping facilities, a proper and equitable proportion thereof, including a reasonable share of plant shipping department facilities, the expense of which is not included in indirect shop costs, may be treated as a cost under the contract.
Installation and servicing costs
87.	When the terms of the contract require that the contractor install, erect, test, or otherwise construct or assemble the product or material manufactured, the cost of materials, labor, and expense for such installation, and of general servicing for ordinary adjustments or minor defects after the delivery of the product but necessary for the
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completion of the contract, is a proper charge to the cost of fulfilling the contract.
Sundry specific contract costs
38.	Other items of cost which are necessarily incurred in order to complete the contract may be of the following kinds:
(a)	Premiums on performance or other bonds required under the contract.
(6)	State sales taxes legally imposed on the contractor.
(c)	Adjustment and test expenses not elsewhere included.
{d} Special travelling expenses not elsewhere included.
The contractor should keep detailed records of any item of cost of the character here indicated, sufficient to disclose clearly that the costs relate specifically to the contract and that no part thereof is properly chargeable to other work nor included in any part of indirect costs elsewhere.
ADMINISTRATION AND DISTRIBUTION EXPENSES
39.	This title comprehends all expenses other than those included under “Manufacturing costs” and “Other contract performance costs.” These other expenses are incurred in connection with the general administration of the contractor’s business and the distribution of the contractor’s products, a ratable part of which, by reference to all the pertinent facts and circumstances, may reasonably be held to constitute proper items of cost incident to and necessary for the performance of the contract. As to what may constitute a proper ratable part, the comments in the ensuing pages should be taken into consideration.
Administration and general corporate expenses
40.	The expenses here contemplated are those related to the general management of the business and, subject to the limitations elsewhere herein described and to the appropriateness of the apportionment used, comprise items of the following nature:
(a) Compensation for personal services, including (1) salaries of corporate officers, executives and department heads, (2) salaries and wages of administrative clerical employees and of office service employees, and (3) all incidental employer’s payments for unemployment, old age and social security Federal and State funds. As to limitations on salaries and compensation of officers and employees, see paragraph 45.
(&)	All ordinary and miscellaneous office and administrative expenses, such as stationery and office supplies, postage, repairs and depreciation of office equipment, rentals paid, and the cost of all necessary office services.
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(o)	Employees’ welfare expenses, including the cost of pension and retirement provisions for administrative and office employees.
(d)	Premiums or dues on compensation insurance, not elsewhere included. (See self-insurance, pars. 47 and 54 (Z).)
(g)	Professional fees and expenses for legal, accounting, and other consulting services.
(/) Contributions to local charitable or community and similar organizations to the extent constituting ordinary and necessary business expense.
(^) Dues and memberships in regular trade associations.
(h)	State and local taxes (other than income taxes) not elsewhere included.
Bidding and selling and distribution expenses
41.	Bidding expenses include ordinary expenses in connection with preparing and submitting bids or with negotiations upon estimated costs, but do not include any experimental or development work preceding bids or negotiations (see par. 32) and are subject to limitation to exclude any extraordinary expenses under this caption. General selling and distribution expenses include any other costs of selling and distribution insofar as these can be justified as properly incidental to and necessary for the performance of the contract. (See limitations on admissible costs pars. 48-52.)
Summary
42.	The foregoing outline of the items of cost indicates the nature of those items which may be regarded as admissible costs under Government contracts, subject to limitation as described in ensuing pages.
LIMITATIONS ON ADMISSIBLE COSTS
43.	Certain items of admissible costs described in the outline of the items of cost previously given are subject to limitations, precise rules for which cannot be stated. Judgment and interpretation in the light of all the pertinent facts and circumstances in each case will govern the application and extent of these limitations. The principles upon which they are based are discussed in the following paragraphs.
Costs of materials, parts, and supplies
44.	The cost of materials, parts, and supplies should be limited to their net cost after deduction of benefits of any kind arising from such purchases received by, or on behalf of, the contractor, including any benefits which were available to him but were not obtained by him, excepting only when he has been prevented from obtaining them by the fault or delay of the Government. The benefits herein referred to include:
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(a)	All trade discounts, rebates, allowances, credits, commissions, refunds, bonuses, etc., arising from purchases of materials, parts, and supplies.
(b)	Cash discounts on such purchases in excess of 1 percent and all cash discounts accruing to prime contractors on subcontracts.
Unreasonable compensation
45.	The total compensation paid to individual officers and employees of the contractor may be open to question and subject to limitation when the circumstances warrant, as for example:
(a)	When the total compensation paid to an individual person is in excess of $25,000 per annum.
(5)	When such compensation has been increased dispropor-tionally or unreasonably since June 30, 1940.
(c)	When bonuses are paid based upon a percentage of the profits.
(d)	When royalties are paid to officers or employees (as a rule they are inadmissible as an item of cost).
The term “total compensation” includes salaries, bonuses or other compensation for services, however paid.
Defective work
46.	There may be included as an item of admissible costs the net cost of spoiled, defective, or otherwise rejected work to the extent of the natural and ordinary run of mistakes, mishaps, or misunderstandings, due recognition being given for Government demands for abnormally rapid expansion of production. Extraordinary losses of this kind resulting from negligence and which could have been avoided by the exercise of reasonable and usual care and diligence by the contractor or his supervising agent may be subject to limitation or exclusion.
Self-insurance
47.	When, under the policy of self-insurance the contractor assumes his own insurable risks for compensation paid to employees for injuries received in the performance of their duties or for unemployment risks in States where insurance is required, there may be included as admissible cost an equitable portion of the charges set up for such purposes under a system of accounting regularly employed by the contractor, provided such system is in accordance with sound accounting practices, such charges to be at rates not exceeding the lawful or approved rates of insurance companies for such types of insurance less allowance for the acquisition cost incurred by such companies, and provided in such cases that the contractor shall consistently fol
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low this method with respect to self-insurance in connection with all contracts subsequently performed by him. As to other self-insured risks, losses and payments are admissible costs of performing a contract only to the extent of the actual losses suffered or payments incurred during and in the course of the performance of the contract and incident to and properly chargeable to such contract.
Selling expenses
48.	As a general rule, the expenses ordinarily recognized as selling expenses incurred for the distribution of the products of an enterprise through usual trade and business channels and methods are not regarded as admissible costs under Government contracts. The reasoning underlying this principle is that ordinary selling expenses are not incident to and necessary for doing business with the Government. Commissions paid by the contractor are likewise inadmissible because these are directly chargeable to the business obtained on which the commission is paid, and it is manifestly improper for the Government to recognize as a legitimate cost a commission paid for obtaining business from itself.
49.	There frequently are cases in which expenses termed “selling expenses” relate in whole or in major part to technical, consulting, and other services of application and adaptation of products to the uses and requirements of the customer, rather than merely to simple salesmanship. Salesmen whose services Consist primarily in persuading the customer to buy, are, of course, unnecessary in dealing with the Government. On the other hand, men who are nominally or actually attached to the sales department but who are primarily technicians and product service engineers render services quite as important and necessary when products are sold to the Government as when they are sold to other customers. In such cases before a sale can be effected some problem of application or design or capacity often ' exists, and must be solved by the field representatives, backed up, if necessary, by a suitable technical organization, before the customer C can place his order correctly, and obviously in these cases the selling pg effort is a minor part of the service performed. For this reason it is ¡> not possible to lay down a categorical rule that all expenses called selling expenses are inadmissible costs. The decision as to admissi-bility depends upon judgment and knowledge of all the pertinent facts and circumstances.
50.	The same considerations obtain with respect to the expense of maintaining offices and agencies in various territorial areas. The decision as to admissibility of these costs in whole or in part very probably will be largely influenced by the functional nature of the representatives working through them. Selling and sales office ex
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penses should be carefully analyzed in the accounts of the contractor in such a manner as to support and clearly disclose costs which are in the nature of engineering or technical services and of expenses which are necessary to the maintenance of essential collateral services, as distinct from purely commercial selling expenses.
Advertising
51.	As a general rule advertising is an inadmissible item of cost, on the reasoning that advertising is not required in order to do business with the Government. However, certain kinds of advertising of an industrial or institutional character, placed in trade or technical journals, not primarily with the object of selling particular products but essentially for the purpose of offering financial support to such trade or technical journals, because they are of value for the dissemination of trade and technical information for the industry are not really an advertising expense to effect sales so much as an operating expense incurred as a matter of policy for the benefit of the business and the industry. Here again the contractor’s accounts should provide for suitable analysis to distinguish between possibly admissible and inadmissible costs.
Selling and advertising expenses of independent subcontractors
52.	The considerations relating to the admissibility or limitation upon ordinary and usual commercial selling and advertising expenses may have different aspects in the case of subcontractors than in the case of prime contractors dealing directly with the Government.
Interplant and intercompany transfers
53.	The following general principles should be observed in connection with purchases or transfers of materials, parts, supplies, or services entering into the products furnished under a Government contract:
(a) Intracompany transfers between plants or divisions should be made at cost excluding any internal or intermediate profit.
(5) Purchases from subsidiary, affiliated or controlled com-.panies or by such companies from parent, affiliated or controlling companies should not be made to result in an increased ultimate cost to the Government. The net cost of such purchases should not be greater than it would have been had they been made from others. It is not the purpose to discourage such intercompany purchases at proper prices when this is in the interest of the efficient and expeditious performance of the contract. It is the purpose to prevent undue price increases through such intercompany relations and in such cases the fixed fee or the contract price should duly take all the circumstances into account.
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INADMISSIBLE COSTS
54.	Among the items which are not admissible for the purpose of computing the cost of performing a Government contract, the following may be named:
(a)	Allowances for interest on invested or borrowed capital, however represented.
(6)	Commissions, bonuses, and special premiums under .whatever name, paid in connection with negotiations for or procurement of a Government contract. (See par. 48.)
(c)	Entertainment expenses.
(d)	Dues and memberships other than in regular trade associations.
(e)	Donations other than those mentioned in paragraph 40 (/).
(/) Losses on other contracts.
(g)	Losses from sales or exchanges of capital assets.
(K) Extraordinary expenses arising from strikes or lock-outs.
(i)	Fines and penalties.
(/)	Amortization of unrealized appreciation of values of assets.
(k)	Expenses, maintenance, and depreciation of excess facilities other than reasonable stand-by facilities.
(Z)	Provisions in reserve accounts for contingencies, repairs, compertsation insurance (except as provided with respect to self-insurance, see par. 47).
(m)	Income and excess profits taxes.
(n)	Bond discounts or finance charges.
(d)	Premiums for life insurance on the lives of officers.
(p)	Special legal and accounting fees incurred in connection with reorganizations, security issues, capital stock issues, patent infringement or antitrust litigation, and the prosecution of claims of any kind (including income tax matters) against the United States.
(q)	Taxes and expenses on issues and transfers of capital stock and bonds.
(r)	Losses on investments.
(«)	Bad debt losses and charges to reserves therefor; also expenses of collection and exchange.
(Z)	In general, commercial advertising and commercial selling expenses.
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BASIS OF APPORTIONMENT OF ITEMS OF COST
55.	Of the items of cost which have been described, those for materials and parts and for direct labor are in the main directly identifiable immediately with particular products or with operations or processes performed thereon. Most of the other items of cost will require some means of apportionment by which to charge an equitable share of the various items to the cost of the products or the performance of the contract.
56.	No general rules applicable to all cases can be stated to define particular methods or bases of apportionment because they are obviously dependent upon the conditions and the nature of the operations in each individual case. Some methods commonly in use are described in the following paragraphs.
Shop engineering expense
57.	Usually shop engineering expenses can be accumulated by jobs or projects and thus related to particular products, product groups or operations. The amounts of the respective expenses can be reduced to percentages, in relation to either the direct labor cost or the direct shop cost of production, by means of which a ratable share of the shop engineering expenses can be apportioned more or less on the principle of services rendered or incidence of benefit.
Other direct shop costs
58.	Admissible manufacturing royalties or license fees are usually at stipulated rates for specified operations or production. Such rates may afford the basis of apportionment. Amortization of the initial cost of dies, patterns, etc. (see par. 18 (b)) is usually apportioned on the basis of productive output or useful life. To arrive at productive output an estimate is made on the basis of experience or engineering knowledge of the quantity of products which can be produced before the facility will be discarded. The initial cost of the facility divided by this quantity affords a unit rate which can be applied to actual production. The useful life basis as hère meant is akin to depreciation in that the initial cost is to be absorbed on the basis of time during the period in which the facilities are expected to be in use. Extraordinary rearrangements of plant facilities, etc., arising from acceleration of production for the completion of war contracts (see par. 19) should be accumulated in separate accounts and since they are caused by war contracts, it should not be difficult to apportion the costs equitably to them.
Indirect shop costs (see pars. 20-29)
59.	These indirect shop costs normally can be identified with individual departments in the factory. These departments are generally physically distinguishable and separate, involving different equipment
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and operations and individual supervision. In large factories such departments may be further subdivided into production centers. Broadly speaking, departments fall into two categories, namely (1) productive departments and (2) nonproductive departments. Productive departments are those engaged in manufacturing completed or partly completed products or parts of products. “Nonproductive departments** is a term here used to represent all other departments, such as service and maintenance, general factory storerooms, receiving and shipping departments, factory administrative offices, laboratories, etc.
60.	The indirect shop costs of the nonproductive departments are usually accumulated in separate departmental accounts under modern cost accounting procedures. That is to say the supplies and sundry materials, the indirect labor pay rolls, the fixed charges and the other indirect shop costs pertinent to these departments can be identified and set down in the departmental accounts. The total of these expenses thus accumulated then can be apportioned to productive departments on different bases, selecting for each department that which appears to be the most logical and practicable and is, so far as possible, related to the services rendered. The power plant can be analyzed into facilities for electric power, heat, light, gas, compressed air, etc., and the respective costs of these can be distributed according to their use. Electric power is usually applied on the basis of rated horsepower of motors modified by a load factor, heat on the basis of area with perhaps special rates for equipment using high-pressure steam, light on floor space and type of lighting, gas per thousand cubic feet where used, and so forth. General plant departments as distinct from service and maintenance usually must be apportioned more arbitrarily and various bases are used such as total man-hours, total pay rolls or overriding percentage on other expenses, etc.
61.	The indirect shop costs of the nonproductive departments thus distributed to productive departments then are added to the indirect shop costs directly distributed to the productive departments and their totals are reduced to departmental rates (usually called burden rates) by means of which all the expenses are distributed to the operations and products of the productive departments.
62.	These burden rates are expressed in various factors, whichever appear to be the most appropriate under the conditions, such as the following :
(a)	Percent to direct labor dollars.
(&)	Dollars per man-hour.
(c)	Dollars per machine-hour.
(d)	Dollars or cents per unit (weight, quantity, length, area, cubic content, etc.)
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In a small plant or within a department of a larger plant where labor constitutes an important part of cost and where the investment per man and the rates of pay are substantially uniform, a percentage of direct labor cost is a simple and satisfactory method of expense distribution (see par. 12). On the other hand, where labor is a relatively minor part of cost and depreciation, repairs, supplies, and maintenance of machinery are relatively large, the expenses are more equitably applied on the basis of machine-hours. When direct labor appears to be a logical basis but rates of pay are not substantially uniform, the expenses may be absorbed more equitably by means of rates per man-hour. Again, in other cases in which these methods are not logical or practicable, but a common unit of measurement exists representing volume of production for a particular process, the expenses may be absorbed by means of a rate per unit.
63.	The degree of refinement in departmental analysis along the lines which have been described will of course be dependent upon the Size and variety of the operation of the individual enterprise. In smaller plants the number of departmental accounts and the extent of the analysis of the individual items of costs will be fewer and simpler than are required in a larger plant. It is not intended by the description which has been given to require the contractor to establish a system more elaborate than is required for the scale of his operations. Even a simple accounting system, however, can be made consistent with the general principles set forth in this statement.
Other manufacturing costs
64.	The amortization of costs of patents, purchased designs etc., has already been discussed. (See par. 31.) With respect to engineering and development expenses the absorption rates previously mentioned (see par. 32) are sometimes founded upon a percentage of sales, but inasmuch as the application of these expenses may vary between different classes of products, it is commonly the practice to establish standard percentages for each product class, which percentages may be expressed in terms of total manufacturing cost as the base.
Other contract performance costs
65.	Ordinarily no arbitrary apportionment need be adopted for these expenses because they are known specifically for each contract.
Administration and distribution expenses
66.	These expenses should be analyzed in considerable detail in the accounts of the contractor so that their nature and purpose may be clearly disclosed. Such of the items as can be related directly to a
19
specific contract or Government contracts in general, should be correspondingly apportioned. On the other hand, those items which clearly do not relate in any respect to doing business with the Government (see inadmissible costs par. 54) should be excluded from apportionment to Government contracts.
67.	The remaining items (subject to limitations which have been discussed) then should be apportioned between Government business and other business on the most equitable basis. This basis frequently is to charge to Government business a proportion of the total expenses equal to the ratio between manufacturing costs plus other contract performance costs and the total of such costs for the business as a whole. Sometimes the apportionment is made on the basis of percentage to sales values. Under either or any other method the conditions and the proportions of the bases between different kinds of business activities should be carefully considered in order that the resulting apportionment shall be equitable.
Summary
68.	As has been stated in the foregoing instructions, a complete description of all possible methods of apportionment of these items of cost cannot be given. The appropriateness of any particular method or methods used must remain subject to the exercise of judgment in the administration of the contract. The costs pertaining to any particular Government contract should include only an equitable allotment of any costs which relate jointly to other activities of the enterprise.
Examination of methods in use
69.	Where the nature of the business of the contractor has not changed basically by the shift to war production, the presumption is that former methods, presumably tested by operation over a considerable period, are satisfactory, although this is only a presumption and should be reexamined in the presence of war production. When the business has changed radically because of war work, the former methods of distribution may be entirely inappropriate and should be carefully reviewed to determine whether they are in fact reasonable and equitable.
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CONTRACTOR’S ACCOUNTS
Accounting system
70.	No attempt is made in this statement to prescribe or delimit the contractor’s accounting system. Any system of accounts and any method of cost accounting in use by the contractor should be acceptable if they are in accord with generally accepted and sound accounting practices. The method of calculating costs may be of any type preferred by the contractor and suitable for the conditions, so long as its provisions are such as to produce correct figures and are consistent with the principles explained in this statement.
71.	It is usually important, however, that the cost accounts be under the control of the general accounts. By this is meant that the accounting procedure should be such that there is a definite control, through ledger accounts set up for the purpose, over all the detailed accounts in which the costs are distributed. Cost accounts separately kept without such suitable proof of control are seriously open to question.
72.	Standard cost accounting systems, that is to say, cost systems making use of standard or normal rates for manufacturing costs as a means of management control are widely in use and are acceptable for cost determination under Government contracts, if the variations from actual costs are restored properly so that in the end the costs chargeable to the contract will stand upon the basis of the actual costs.
Inventory methods
73.	Materials, parts, and supplies withdrawn from stock should be priced in accordance with the inventory method customarily used by the contractor, provided that such method is in accordance with sound accounting practices and is permitted or recognized by governmental agencies such as the Bureau of Internal Revenue and the Securities and Exchange Commission. Among such inventory methods may be mentioned:
(a) First-in, first-out.
(&)	Last-in, first-out.
(c)	Average costs.
(d)	Standard costs (see par. 72).
(e)	Specific purchase prices.
INDEX
[References are to paragraph numbers]
Acceleration of production, special costs incident to, 19, 58.
Accident compensation, factory, 29 (g).	•
Accounting :
fees and expenses, 40 (e), 54 (p).
systems, 5, 70-73.
Accounts :
general and cost, 70-73.
of contractor, 70-73.
Adjustment and test expenses, "37, 38 (c).
Administration :
and distribution expenses, 4, 39-42, 66, 67.
and general corporate expenses, 4, 40, 66, 67.
Admissible costs, 6, 43-53.
Advertising expenses, 51, 52, 54 (t).
Affiliated company transactions, 53 (&).
Agencies and offices, territorial, 50.
Allowances on purchases, 9, 44.
Amortization :
dies, 4, 18 (&), 29 (h), 58, 64.
patents, designs, etc., 4, 29 (h), 31, 64.
patterns, special equipment and facilities, 18 (&), 19, 29 (h), 58, 64.
tooling charges, 18 (&).
unrealized appreciation, 54 (/).
Apportionment of costs, 55-69.
Appreciation unrealized, amortization of, 54 (/).
Associations, trade, dues or memberships in, 40 (g).
Bad debts, 54 (s).
Bidding expenses, 4, 41, 66, 67.
Bonds :
discounts, 54 (n).
expenses on issues and transfers, 54 (q).
premiums on, 38 (a).
Bonuses :
contract negotiation, 54 (6).
direct labor, 12.
unreasonable, 45.
Capital stock, expenses on issues and transfers, 54 (q).
Cash discounts, 9, 44.
Charitable contributions, 40 (f), 54 (e).
Chemical laboratories, 17.
Collection expense, 54 (s).
(21)
22
Commissions :
contract negotiation, 54 (b).
purchases, 44.
sales, 48.
Compensation :
factory accident, 29 (g).
insurance, 13, 24, 29 (d), 40 (d), 47, 54 (I).
limitation of, 45.
personal services, 40 (a).
Consulting services, fees and expenses, 40 (e), 49.
Contingencies, reserves for, 54 (i).
Contributions, charitable, 40 (f), 54 (e).
Controlled company transactions, 53 (b).
Corporate, general, and administration expenses, 4, 40, 66, 67.
Cost, total contract, 4.
Defective work, 46.
Delivery costs, 4, 34-36.
Departmentalization, 59-63.
Depletion, 27 (e).
Depreciation :
and repairs of office equipment 40 (6), 54 (k).
excess facilities, 54 (k).
manufacturing properties, 27 (d), 28, 54 (k).
Designs and patents, amortization of, 4, 29 (h), 31, 64.
Development and experimental costs, 16,17, 32, 33, 64.
Dies, amortization of,4, 18 (6), 29 (ft), 58, 64.
Discounts :
bond, 54 (n).
cash and trade, 9, 44.
Distribution :
and administration expenses, 4, 39-42, 48-52, 66, 67.
bidding and selling expenses, 4, 41, 48-52, 66, 67.
Distribution of overhead expense, 12, 55-69.
Donations, 40 (f), 54 (e).
Dues and memberships, 40 (g), 54 (d).
Engineering expense, 4, 16,17, 32, 33, 49, 57, 64.
Entertainment, 54 (c).
Escalator clauses, 14.
Excess or idle facilities, 54 (k).
Excess profits and income taxes, 54 (m).
Exchange expense, 54 (s).
Experimental and development costs, 16,17, 32, 33, 64.
Facilities :
excess or idle, 54 (k).
rearrangement of, 19, 29 (a), 58.
special, amortization of, 19, 58.
stand-by, 27 (d), 54 (k).
Factory expenses :
extraordinary, 25.
office, 20, 22.
ordinary and general, 25, 29.
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Fees, professional, and expenses, 40 (e), 54 (&), 54 (p).
Finance charges, 54 (m).
Fines, 54 (i).
Fixed charges, manufacturing properties, 4, 27, 28, 59-63.
Freight and transportation:
incotning, costs of, 8.
outgoing, costs of, 35.
Fuel, 20.
Idle or excess facilities, 54 (k).
Inadmissible costs, 6, 54.
Income and excess profits taxes, 54 (m).
Installation and servicing costs, 4, 34, 37.
Insurance :
compensation, 13, 24, 29 (d), 40 (d),47, 54 (I).
manufacturing properties, 27 (a).
officers’ life, 54 (o).
self, 47.
Interest expense, 54 (a).
Interplant and intercompany transfers, 53.
Intracompany transfers, 53 (a).
Inventory pricing methods, 7,73.
Investment losses, 54 (r).
Labor :
direct, 4, 12-15.
indirect, 4, 21-24, 59-63.
overtime, 12.
Laboratories :
chemical, 17.
general, 22.
testing, 17.
Legal fees and expenses, 40 (e), 54 (p).
License fees, 18 (a), 58.
Life insurance, officers’, 54 (o).
Limitations, admissible costs, 6, 43-53.
Litigation expenses, 54 (p).
Lock-outs or strikes, 54 (h).
Losses :
bad debts, 54 (s).
capital assets, 54 (^).
on investments, 54 (r).
on other contracts, 54 (f).
Lubricants, 20.
Maintenance and service expenses, 4, 25, 26, 54 (fc), 54 (1), 59-63.
Manufacturing costs:
direct shop costs, 4, 7-19, 55-58.
indirect, 4, 20-29, 59-63.
other, 4, 30-33, 64.
Manufacturing properties :
fixed charges, 4, 27, 28, 59-63.
maintenance and service expense, 4, 25, 26, 54 (k), 54 (I), 59-63.
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Materials and parts:
direct, 4, 7-11, 44, 73.
sundry and supplies, indirect, 4, 11, 20, 44, 59-63, 73.
Memberships and dues, 40 (g), 54 (d).
Obsolescence, manufacturing properties, 27 (d).
Office expenses and supplies:
factory, 20, 22.
general, 40 (b).
Officers and executives:'
salaries of, 40 (a), 45.
life insurance, 54 (o).
Offices and agencies, territorial, 50.
Old age benefit taxes, 13, 24, 40 (a).
Old age fund, payments to, 29 (e), 40 (a).
Other contract performance costs, 4.
Overhead expense, distribution of, 12, 55-69.
Overtime, labor, 12.
Parent company transactions, 53 (b).
Parts and materials:
direct, 4, 7-11, 44, 73.
indirect, 4, 11, 20, 44, 59-63, 73.
Patents and designs, amortization of, 4, 29 (h.), 31, 64.
Patterns, amortization of, 18 (b), 29 (b), 58, 64.
Penalties, 54 (i).
Pensions :
to factory employees, 29 (f).
provision for administrative and office employees, 40 (c).
Premiums :
contract negotiation, 54 (6).
labor, 12.
on bonds, 38 (a).
Purchase allowances, credits, discounts, salvages, etc., 9, 44.
Rearrangement of plant facilities, 19, 29 (a), 58.
Rebates, 9, 44.
Rejected work, 46.
Rentals :
manufacturing properties, 27 (c).
office, 40 (b).
Repairs and depreciation of office equipment, 40 (b), 54 (fc), 54 (?) ; see also maintenance and service.
Research expense, 16, 17, 32, 33.
Reserve accounts:
for bad debts, 54 (s).
general, 54 (I).
Retirement :
payments to factory employees, 29 (f).
provision for administrative and office employees, 40 (c).
Royalties, 18 (a), 45, 58.
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Salaries:
administrative clerical and office employees, 40 (a), 45.
and wages, see labor.
corporate officers and executives, 40 (a), 45.
Sales taxes, 38 (6).
Scrap value credit, 10.
Self-insurance, 47.
Selling expenses, 4, 41, 48-52, 54 (t), 66, 67.
Service and maintenance expenses, 4, 25, 26, 54 (k), 54 (I), 59-63.
Servicing and installation costs, 4, 34, 37.
Shipping department costs, 22, 36.
Shop costs:
direct, 4, 7-19, 44, 55-58.
engineering expense, 4, 16, 17, 32, 33, 57.
indirect, 4, 17, 20-29, 44, 59-63.
supplies and sundry materials, 4, 11, 20, 44, 59-63, 73.
Social security:
fund, payments to, 29 (e), 40 (a).
taxes, 13, 24, 40 (a).
Special costs incident to acceleration of production, 19, 58.
Special equipment, amortization of, 29 (h).
Special facilities, amortization of, 19, 58.
Spoiled work, 46.
Standard cost accounting, 72.
Stand-by:
equipment, depreciation of, 27 (d).
facilities, 54 (k).
Strikes or lock-outs, 54 (h).
Subsidiary company transactions, 53 (b).
Sundry specific contract costs, 4, 34, 38.
Supplies:
and sundry materials, shop, 4, 11, 20, 44, 59-63, 73.
office, and expenses, 20, 40 (b).
Taxes:
excess profits and income, 54 (m).
on issue of bonds or stocks, 54 (q).
property and plant, 27 (b).
sales, 38 (b).
social security and old age benefit, 13, 24, 40 (a).
state and local, 40 (b).
Technical and trade journals, 51.
Technical organization costs, 49.
Territorial offices and agencies, 50.
Test and adjustment expenses, 17, 37, 38 (c).
Testing laboratories, 17.
Tooling, amortization of, 18 (b).
Tools, nondurable, and small, 20.
Trade and technical journals, 51.
Trade discounts, 9, 44.
Transportation and freight:
incoming, costs of, 8.
outgoing, costs of, 35.
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Traveling expense, 38 (d).
Treasury Decision 5000, 2.
Unemployment fund, payments to, 29 (e), 40 (a).
Unreasonable compensation, 45.
Vacation pay, 29 (c).
Vinson-Trammell Act contracts, 2.
Wages and salaries, see labor, also salaries.
Welfare expenses, employees, 29 (bl. 40 (c).
U. S. GOVERNMENT PRINTING OFFICE» 1941