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Episode 1: Manufacturing and Production Engineering Costs vs. Independent Research & Development Costs

For companies that incur manufacturing, production line, engineering or product development costs, determining the true nature of the cost can be difficult. The Federal Acquisition Regulation (“FAR”) points us to FAR 31.205-25 — Manufacturing and Production Engineering Cost, to help companies determine if the cost incurred should be considered a manufacturing and production engineering cost. However, the issue companies have is where one draws the line if the costs should actually be considered independent research & development (“IR&D”). Determining if the costs falls under FAR 31.205-25 or meets the definition of FAR 31.205-18 and is considered IR&D doesn’t just impact which general ledger account a company buckets the cost in, but also contract pricing and the application of indirect costs.

As part of our “Auditor Strikes Back” blog series on the new “Selected Areas of Cost” guidebook to replace Chapter 7 of the Defense Contract Audit Agency (“DCAA”) Contract Audit Manual (“CAM”), we will discuss the difference between manufacturing and production engineering costs and when a cost is actually considered IR&D.

First, FAR 31.205-25 defines allowable manufacturing and production engineering costs as the following:

“1) Developing and deploying new or improved materials, systems, processes, methods, equipment, tools and techniques that are or are expected to be used in producing products or services;

(2) Developing and deploying pilot production lines;

(3) Improving current production functions, such as plant layout, production scheduling and control, methods and job analysis, equipment capabilities and capacities, inspection techniques, and tooling analysis (including tooling design and application improvements); and

(4) Material and manufacturing producibility analysis for production suitability and to optimize manufacturing processes, methods, and techniques.”

The major terms to take away from the definition above are manufacturing and production engineering costs are used to deploy, improve, develop, or optimize the process to produce products or services.

The recent guidance published by DCAA provides some clarity on where to draw the line between manufacturing and production engineering costs or IR&D. The CAM states that IR&D costs are clearly intended to develop new products or services for sale. This is in contrast to FAR 31.205-25, which states manufacturing and production engineering costs are to improve or develop already existing products and services. Determining the correct cost classification for these costs is important as the cost accounting implications are very different for the treatment of IR&D costs. In certain situations, determining the nature of the costs can be subjective, so a company can ask the following simple questions to help determine if the cost is IR&D or not:

  1. Does the manufacturing and production engineering cost incurred assist in producing an existing or new product or service?
  2. Is the product or service already in production or for sale?
  3. Are the manufacturing and production engineering costs incurred improving an existing process or manufacturing line?

If the answers to these questions are yes, then most likely the costs are considered more manufacturing and production engineering in nature.

The Defense Acquisition Regulations System (“DFARS”) has published a proposed rule that would revise DFARS 231.205-18, “Independent Research and Development and Bid and Proposal Costs.” The proposed rule would, in part, require “major contractors” to engage in a “technical interchange” with certain Department of Defense employees before generating IR&D costs for IR&D projects initiated in the contractor’s fiscal year 2017 and later. The rule makes this requirement “a prerequisite for the subsequent determination of allowability.” Keep this in mind as the proposed rule keeps changing and may impact DCAA’s position found in their new guidelines.

For more information, feel free to reach out to a Cherry Bekaert Government Contractor Services Group team member.

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