Payne Hackenbracht & Sullivan

Eichleay Formula - Guidance to Government Auditors on the Application of the Eichleay Formula

(January 1997 CAM As Revised)

Eichleay Formula

a. The question of the proper method to measure unabsorbed overhead has been addressed in numerous board and court cases. The Boards of Contract Appeals and courts have generally ruled that the Eichleay formula is the acceptable method for computing unabsorbed overhead resulting from government-caused delay. The Court of Appeals for the Federal Circuit has specifically ruled that the Eichleay formula is the exclusive means for calculating unabsorbed overhead in cases arising out of construction contracts. The ASBCA has supported the application of the Eichleay formula for the recovery of unabsorbed overhead on manufacturing/supply contracts.

b. If the basic Eichleay formula produces inequitable results, the auditor should make every attempt to adjust the formula to fit the given situation. However, in some cases, the circumstances are such that no matter what adjustments are made to the Eichleay formula it will not produce equitable results. If the use of the Eichleay formula is not appropriate, it is important that the auditor demonstrate why the formula should be adjusted or why an alternative method clearly yields a more reasonable result. If another method is recommended, the auditor should still provide information in the report to properly apply the Eichleay formula, including any necessary adjustments, in the event its use is sustained.

c. The basic Eichleay formula was originally developed to allocate home office expenses on construction contracts, when there is an assumption that almost all overhead is fixed rather than variable. Under the basic Eichleay formula, the normal fixed overhead allocable to a contract is identified and expressed in terms of a daily rate. The daily rate is then multiplied by the days of delay to arrive at the total amount of unabsorbed overhead. The three step formula and a detailed explanation of each step follows:

FORMULA

Step 1:

Contract Billings

Total Billings during period of performance x Total Overhead (General and Administrative Expense) during period of contract performance = Overhead allocated to Contract

Step 2:

Allocated Overhead

Days of Performance = Daily Contract Overhead

Step 3:

Daily Contract Overhead x days of delay = Unabsorbed Overhead

Step 1. The first step computes the total fixed overhead allocable to the delayed contract. Divide the total contract billings for the delayed contracts actual performance period by the total company billings for all contracts performed during the delayed contract performance period (this is referred to as the allocation ratio), and multiply this result by the total fixed overhead for the delayed contract's actual performance period. The actual contract performance period represents both the actual days of performance and the delay days. It is the period from the date of contract award until the date of contract completion. Note that the contract billings, total billings, the total fixed overhead and the performance days should be for the same time interval, i.e., the delayed contract's actual total performance period.

Step 2. The second step computes the daily contract fixed overhead rate. Divide the fixed overhead allocable to the contract by the actual contract performance period. The actual performance period, which is expressed in number of days, includes the delay period.

Step 3. Compute the total amount of unabsorbed overhead for the delayed contract by multiplying the daily contract overhead rate, which is determined in Step 2, by the number of delay days.

d. Contract billings are contract revenues recognized for the period of actual contract performance. Total billings are revenues for all contracts (including government and commercial) recognized for the period of actual contract performance including the delay period and any modifications. Contract revenues include contract costs plus profit. There are two generally accepted methods for recognizing government contract revenues: completed-contract method and the percentage-of-completion method, including units-of-delivery method. The AICPA Audit and Accounting Guide, Audits of Federal Government Contractors, provides the following description of the two revenue recognition methods:

Completed-contract method. This method of accounting defers recognition of revenues while a contract is in process. On completion or substantial completion of a contract, aggregate revenues and costs associated with the contract are recognized.

Percentage-of-completion method. An accounting method that recognizes contract revenues and income work as a contract progresses. It provides for recognition on a periodic basis rather than on a completed-contract basis.

Billings data should be available in the contractor's financial statements and schedules summarizing contract cost and revenue data from the contractor's books and records. The revenue recognition method should be the same for contract billings and total billings.

(1) The review of the application of the Eichleay formula should include verification that the billings data used in the allocation ratio are accurate and appropriate. If the contractor uses an allocation base other than contract billings to develop an allocation ratio (see Step 1, 12-804c.), e.g., contract labor/total labor, compare this ratio with the established Eichleay formula's billings allocation ratio. Recompute the proposed Eichleay formula using the billings ratio unless the impact of a different measurement allocation base is immaterial, or unless the contractor can demonstrate that the established Eichleay billings ratio would lead to inequitable results. Show the computations in the audit report and explain how the contractor's allocation base is materially different and results in excessive recovery of damages.

(2) The review of the contractor's application of the Eichleay formula should also include an evaluation of the contractor's method for recognizing revenue (billings). The review should determine if the contractor's method for revenue recognition results in an inequitable allocation of unabsorbed overhead. For contractors that use the percentage-of-completion method, consider the acceptability of the assumptions used to measure the extent of progress towards completion. Overstatement of the percentage of completion of the delayed contract (contract billings) or understating the percentage of completion of the total contracts (total billings for the contract period) in the Eichleay formula (refer to Step 1, 12-804c) can result in over recovery of unabsorbed overhead. If the allocation ratio (contract billings/total billings) is overstated, the amount of fixed overhead allocated to the delayed contract is overstated and therefore, the amount of unabsorbed overhead is overstated. Billings may be overstated by including deleted or terminated work or unexercised options. Billings may be understated by excluding claims on other contracts and undefinitized work and modifications.

Adjustments to the Eichleay Formula

a. The Eichleay formula includes the following key assumptions: (1) the overhead costs include only fixed costs, (2) the suspended work cannot be replaced by other work, (3) there is a total work stoppage, (4) the cost of the delay is the same regardless of the percentage of contract completion (the formula will produce the same result if the contract is 1 percent complete or 99 percent complete), and (5) the plant is operating at or near production capacity.

b. Fixed costs should be used under the Eichleay formula rather than total costs, since variable costs, by definition, vary with the amount of work performed. Therefore, it is important that the overhead be thoroughly analyzed to remove all variable cost items. Variable costs are those operating expenses that vary directly, sometimes proportionately with production volume, facility utilization, or other measure of activity. Examples are materials consumed, power, small-tools expense, factory supplies, and fringe benefits. The price adjustment should cover only fixed overhead, since the variable overhead costs were not incurred during the delay period and for that reason are not part of an equitable adjustment. Ensure that unallowable costs and any recoveries of unabsorbed overhead on any contracts during the contract performance period are removed from the fixed overhead.

c. The Boards of Contract Appeal and the courts have held that the contractor has an obligation take all reasonable steps to mitigate costs allocable to the work covered by the delay/suspension. A contractor may mitigate damages by substituting replacement work or accelerating other work on hand during the period of delay or suspension. Circumstances wherein the contractor may mitigate damages include:

A contractor receives overhead reimbursement for unplanned additional work as a part of change orders on the delayed contract performed during the suspension or delay period. The replacement work should be credited against the contractor's claim for unabsorbed overhead by adjusting the delay period (see below).

A contractor is able to obtain new contract work as substitution for the delayed effort to help mitigate any unabsorbed overhead costs. Determine if the contractor obtained new work based upon higher overhead rates than those planned on the delayed contract, thus resulting in further mitigating the impact of unabsorbed overhead.

A contractor may accelerate work on another contract(s) during the period of delay which generate additional labor costs and thus mitigate any direct labor losses arising out of any delays under the contract. A comparison of planned work and actual work may show that the contractor accelerated the work as a substitute for the delayed contract effort.

When a contractor is able to completely replace the suspended work with other work, the replacement work absorbs the overhead, . Since the replacement work receives a fair share of overhead, there would be no additional overhead costs allocated to the remaining contracts. Thus no unabsorbed overhead would exist. When only part of the suspended work is replaced by other work, some amount of unabsorbed overhead will still exist. Unless this partial replacement is considered in the computation, the amount of unabsorbed overhead computed under the Eichleay formula will still be excessive. In these cases, the Eichleay formula must be adjusted by reducing the number of delay days to reflect the percentage of work replaced. For example, assume that there is a 40-day delay period, and that 75 percent of the work is not replaced while 25 percent is replaced. Using the basic Eichleay formula, the number of delay days would be 40. However, adjusting for the fact that there has been a partial work replacement, the number of delay days would be 30 (75 percent x 40 days) rather than 40.

d. The Eichleay formula assumes a total work stoppage. It does not take into account the extent of the delay (i.e., total versus partial work stoppage). Unabsorbed overhead for total work stoppage will be greater than for partial work stoppage. In cases of a partial work stoppage the number of days should be adjusted. For example, assume that there is a 30-day delay with a 50 percent work stoppage. Using the basic Eichleay formula, the number of delay days would be 30. However, adjusting for the fact that there is a partial work stoppage, the delay days would be 15 (50 percent x 30 days) rather than 30.

e. The assumption that the plant is operating at or near anticipated production should be carefully reviewed before accepting the Eichleay formula. For example, assume that a contractor who had already begun work on a government contract completes a large commercial contract and bids on, but fails to get, a replacement contract. The government contract is then delayed. Because the contractor failed to get a replacement contract for its commercial project, the government's share of the contractor's total billings for the period of contract performance is increased, possibly by a substantial amount. Because the Eichleay formula computes unabsorbed overhead as a percentage of total billings, the contractor's recovery from the government is also increased. In such cases, the total billings should be adjusted to reflect the billings that would have existed had the contractor received the commercial replacement contract.